Business and Its Environment, 7E David P Baron Solution Manual

Business and Its Environment, 7th Edition Instructor’s Manual David P. Baron Stanford University

Contents Introduction Sample Course Outline

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Part I Strategy and the Nonmarket Environment 36 Chapter 1 Market and Nonmarket Environments 37 Chapter 2 Integrated Strategy 52 Chapter 3 The News Media and Nonmarket Issues 60 Chapter 4 Private Politics 74 Chapter 5 Crisis Management 110 Part I Integrative Case: Wal-Mart: Nonmarket Pressure and Reputation Risk (A) 117 Part II Public Politics and Nonmarket Strategy Chapter 6 Nonmarket Analysis for Business Chapter 7 Nonmarket Strategies for Government Arenas Chapter 8 Implementing Nonmarket Strategies in Government Arenas Part II Integrative Case: Amazon.com and the Amazon Tax

121 122 137 150 167

Part III Government and Markets 169 Chapter 9 Antitrust: Economics, Law, and Politics 170 Chapter 10 Regulation: Law, Economics, and Politics 179 Chapter 11 Financial Markets and Their Regulation 190 Chapter 12 Environmental Management and Sustainability 205 Chapter 13 The Investor’s Perspective: Renewable Energy 214 Chapter 14 Law and Markets 221 Part III Integrative Case: Spectrum for Wireless Broadband: Old Media versus New Media 237 Part IV Global Nonmarket Strategy Chapter 15 The Political Economy of the European Union Chapter 16 China: History, Culture, and Political Economy Chapter 17 Emerging Markets Chapter 18 The Political Economy of India Chapter 19 The Political Economy of International Trade Policy Part IV Integrative Case: Toys ‘R’ Us and Globalization

239 240 254 270 280 290 302

Part V Ethics and Responsibility Chapter 20 Corporate Social Responsibility Chapter 21 Ethics Systems: Utilitarianism Chapter 22 Ethics Systems: Rights and Justice Chapter 23 Behavioral Ethics, Individuals, and Management Chapter 24 Ethics Issues in International Business Part V Integrative Case: GlaxoSmithKline and AIDS Drug Policy

318 319 330 356 365 377 385

Instructor's Manual for Business and Its Environment, 7th 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. The manual also contains a sample course outline.

Powerpoints to supplement the book are available at the Instructors Resource Center, www.peasronhighered.com/irc. A helpline is available at http://247.pearsoned.com. A Test Item File containing examination questions for each chapter is included at the back of this manual. The cases in the book and this manual can also be used as a basis for examination questions.

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 cases that are integrated with the text. The cases provide an opportunity to explore issues in more depth in complex settings.

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, 1

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, 7th 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, international trade policy and politics, country analysis and the nonmarket environment of business in China, India, 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 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 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.

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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 social and environmental entrepreneurship, Internet regulation, pricing of AIDS drugs in the developing world, activist challenges, globalization, pharmaceuticals safety, emerging markets, 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, India, the European Union, international trade, and ethics issues in international business.

Principal Changes in the 7th Edition The seventh 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 sixth edition. It also retains the strategy orientation and the guidance of the normative subjects of ethics and social responsibility. The seventh 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 seventh 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.

The seventh edition includes four new chapters: Chapter 11, Financial Markets and Their Regulation; Chapter 13, The Investor’s Perspective: Renewable Energy; Chapter 18, The Political Economy of India; and Chapter 23, Behavioral Ethics, Individuals, and Management, and three 3

chapters, Information Industries and Nonmarket Issues, The Political Economy of Japan, and Implementing Ethics Systems, from the sixth edition have been deleted. The retained chapters are updated with new conceptual materials and applications. The book also includes 26 new cases for class discussion of timely topics. ● New Chapter 11: Financial Markets and Their Regulation. This chapter examines the financial crisis of 2007–2009, the worldwide recession that followed, and the regulation that followed. ● New Chapter 13: The Investor’s Perspective: Renewable Energy. This chapter considers the nonmarket environment from the perspective of investors, such as hedge funds, with a focus on opportunities and risks. The renewable power industry in the United States provides the context. ● New Chapter 18: The Political Economy of India. This chapter considers the nonmarket environment of the world’s second largest country and a leading emerging market. ● New Chapter 23: Behavioral Ethics, Individuals, and Management. This chapter introduces behavioral ethics through an examination of laboratory experiments that explore issues such as altruism, trust, reciprocity, and cooperation. ● The remaining chapters have been updated on two dimensions. First is the introduction of new conceptual material that brings advances in research into the book. Second is the timeliness of the material to increase student interest and address emerging issues. ● The seventh edition includes 26 new cases on Google (2), Facebook (2), Amazon.com, Johnson & Johnson, News of the World, AT&T and T-Mobile, Goldman Sachs, Pacific Gas & Electric, BrightSource Energy, Apple, Equity Bank of Kenya, Boeing and Airbus, and Chipotle Mexican Grill as well as on industry-wide issues, including credit rating agencies, debit card regulation, spectrum allocation, environmental injustice, insider trading, data protection regulation, the Euro crisis, and renewable power. The new cases address issues in antitrust and regulation, social media, information technology, environmental protection, international business, sustainable energy, and business ethics and responsibility. ● Twenty-five of the cases in the book concern global and international nonmarket issues, and 20 cases 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, 4

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.

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 strategies, as illustrated in Figure 2-2 and 2-3. The chapter contains a section on the positioning component of nonmarket strategy and illustrates it with a detailed example of eBay’s positioning in legal space. The chapter includes a new case Facebook in China? and a case from the sixth edition Personal Watercraft, aka Jet Skis.

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 that 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. The chapter includes a new case The News of the World, which concerns the illegal activity and scandals associated with the Murdocks’ London newspaper.

Chapter 4: Private Politics and Social Pressure This chapter further characterizes the nonmarket environment of business by considering NGOs and 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 cases, Anatomy of a Corporate Campaign: Rainforest Action Network and Citigroup (A)(B), consider the perspective, strategy, and organization of an activist group and a campaign against Citigroup.

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Chapter 5: 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 focuses on dealing with the root cause of the crisis and with communication. The chapter includes two new cases: Mattel: Crisis Management or Management Crisis? and Johnson & Johnson and Its Quality Reputation.

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 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 20 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 is presented on the European Union in Chapter 15, China in Chapter 16, and India in Chapter 18. 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

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legislative institutions in the United States. The chapter includes a new case Business versus Business that addresses the politics associated with the regulation of credit and debit card swipe fees.

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 in Chapter 6. The chapter includes a new case Wal-Mart and Healthcare Policy.

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 with parliamentary systems that utilize advisory committees. 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: Amazon.com and the Amazon Tax This is a new case that addresses the issue of the taxation of online sales and in particular the efforts by states to tax Amazon’s sales. Background information is provided in the Chapter 8 case Internet Taxation. Because of budget pressures a number of states sought to collect use taxes on the sales of Amazon and other major online sellers. Because of an earlier Supreme Court decision

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Amazon had not collected the taxes, and it adopted a hardline strategy to counter the states’ efforts, but whether it would ultimately win was doubtful.

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 foundations for antitrust policy. 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. The chapter includes a new case The AT&T and T-Mobile Merger?

Chapter 10: Regulation: Law, Economics, and Politics This chapter introduces a general framework for government regulation, including its legal foundations, its economic rationale, and its politics. Chapter 11 is devoted to environmental 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 electric power deregulation and auctions.

Chapter 11: Financial Markets and Their Regulation This is a new chapter that focuses on the mortgage-based financial crisis and the regulation that followed. The crisis is considered in detail, including the financial instruments and credit default swaps that were at the source of the crisis. The crisis was a perfect storm of microeconomic and macroeconomic factors. The chapter considers the Dodd-Frank legislation enacted in the aftermath of the crisis, and the implementation complexities of the regulation. At the time of this writing much of the details of the regulation, such as the implementation of the Volker rule, were still being hashed out, and these details will be crucial to the effectiveness of the regulation. The chapter includes two new cases Goldman Sachs and Its Reputation and Credit Ratings Agencies.

Chapter 12: Environmental Management and Sustainability

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This chapter focuses on the regulation of environmental practices of firms, including public and private measures to mitigate environmental externalities. 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. The former had been a major success, but it succumbed to a legal challenge by the state of North Carolina. 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. The chapter includes two new cases Pacific Gas & Electric and the Smart Meter Challenge and Environmentalist versus Environmentalist.

Chapter 13: The Investor’s Perspective: Renewable Energy This is a new chapter that takes a perspective different from those in the other chapters. Instead of considering nonmarket issues from the perspective of the management of a company, this chapter considers those issues from the perspective of the investors, such as hedge funds and mutual funds, considering investing in companies that are subject to nonmarket factors. The application of this perspective is to renewable energy in the early part of the 2010s. Despite its long-run potential in the United States this industry lives on large government subsidies on both the demand and supply sides of the market, and those subsidies were at risk because of their high cost and market pressures primarily from producers in China. Market and nonmarket opportunities and risks are considered, and the frameworks from Part II of the book are used to assess the risks. The chapter includes three new cases BrightSource Energy: The Challenges, Silver Spring Networks and the Smart Grid, and T-Solar and the Solar Power Market.

Chapter 14: 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 12 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.

Part III Integrative Case: Spectrum for Wireless Broadband: Old Media Versus New Media

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This is a new case focusing on the politics and nonmarket strategies of old and new media firms in the allocation of more spectrum for mobile and wireless broadband communication. The principal issue is the reallocation of the unused white spaces between the spectrum used by the broadcast media. The wireless industry argued that with the conversion of broadcast television from analog to digital transmission the white spaces were no longer needed and should be made available for wireless services. The broadcast media argued that they had rights to that spectrum and would only give it up if adequately, and well, compensated. A policy proposal was developed to encourage the broadcast media to voluntarily give up the spectrum, and both sides deployed nonmarket strategies to strengthen their positions.

Part IV: International Political Economy 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 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.

Nonmarket issues and strategies in the EU institutional structure are emphasized. A principal development in the EU was the Euro crisis resulting from a flawed common currency institution, high levels of borrowing by governments, and slow economic growth. The chapter includes two new cases The European Union Data Protection Directive (B) and The Euro Crisis.

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. Current issues considered include human rights, corruption, workers’ rights, and piracy of intellectual property. The Google in China case pertains to Google’s struggle to operate in China while abiding by the government’s Internet censorship policy. The chapter contains a new case Apple and Private Politics in China that focuses on the early stages of environmental pressures on Apple’s supply chain in China.

Chapter 17: Emerging Markets

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This 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. The third chapter case focuses on the MTN Group, a South African wireless company that operates in Africa and the Middle East. The chapter also contains a new case Equity Bank of Kenya.

Chapter 18: The Political Economy of India This is a new chapter on India, soon to become the world’s most populous country. The chapter focuses on opportunities in India and on the nonmarket risks associated with doing business in the country. The government institutions are discussed, as are opportunities, business groups, and patent law and the pharmaceutical industry. Nonmarket issues considered include corruption, poverty and welfare, and the missing girls. One chapter case focuses on whether Tesco PLC should enter the retail market in India and if so, how it should do so, and another focuses on a company that makes portable ultrasound devices that inevitably can be used for sex selection of fetuses. The chapter includes a new case Google in India, which focuses on censorship and other Internet issues.

Chapter 19: 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 failure is considered. U.S. trade law is considered as a foundation for the chapter cases. As indicated in Figure 19-1, 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 19-4 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. The chapter includes a new case The Airbus and Boeing Trade Disputes.

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.

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Part V: Ethics and Responsibility Chapter 20: 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. The chapter includes a new case Facebook and Online Privacy.

Chapter 21: 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 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 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.

Chapter 22: 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.

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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. The chapter includes two new cases Chipotle Mexican Grill and Undocumented Workers and Environmental Injustice?

Chapter 23: Behavioral Ethics, Individuals, and Management This is a new chapter that begins with a discussion of laboratory experiments that examine the behavior of individuals in settings with moral dimensions. The experiments focus on altruism, selfinterest, audience effects, reciprocity, behavior in groups, and moral suasion, and the implications for moral philosophy and management are examined. The chapter also presents managerial approaches including guidance provide by Johnson & Johnson’s examples were selected to provide a range from those such as Our Credo that expresses a general perspective and Cummins’ principles that provide specific guides to managerial decision-making (see also Chapter 24). The chapter includes a return to the framework introduced in Chapter 2. The chapter concludes with a discussion of factors that can lead to unethical behavior. The chapter includes a new case Insider Trading and from the fifth edition the case Fresenius Medical Care in China.

Chapter 24: 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.

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 Google Out of China and De Beers and Conflict Diamonds (B).

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.

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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 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 14

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 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?

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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.

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

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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.

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.

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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 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.

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In-Class Exercises Students enjoy in-class role playing, online surveys, experiments, and exercises. Chapter 23 discusses experiments used to better understand behavior in settings in which moral dimensions may be present. The chapter also includes a brief section reporting on a survey of students’ perceptions of themselves and themselves relative to their fellow students. A variety of games and exercises are available on the Internet and are reported in published papers.

Sample Course Outline The following course outline is for a full semester, 15-week course meeting twice a week for 90 minutes. The outline parallels the organization of the book.

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GRADUATE SCHOOL OF BUSINESS STANFORD UNIVERSITY 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), (7th edition, Prentice-Hall, 2013) 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 21

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 with his prior 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 PROJECT 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 22

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.

ADMINISTRATIVE DETAILS 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

COURSE OUTLINE 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 POLITICS 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 crucial to the success of Amazon and requires a shortrun and a long-run strategy for dealing with the effort by states to collect taxes on online sales.

Case: Amazon.com and the Amazon Tax Reading: BIE Chapter 8 27

III. STRATEGY AND THE REGULATORY AND THE LEGAL ENVIRONMENT 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 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: FINANCIAL MARKETS The financial crisis that originated in the United States with risky mortgage loans has had repercussions throughout the world. This session considers the origins and the crisis and the regulation that followed using a case on Goldman Sachs, which was deeply involved in the financial instruments that contributed to the crisis. The company also spurred on efforts to regulate the industry.

Case: Goldman Sachs and Its Reputation Readings: BIE Chapter 11

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SESSION 13: 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.

Case: Environment Justice and Pollution Credits Trading System Reading: BIE Chapter 12 Session 14: The Investor’s Perspective Private equity and hedge funds invest in companies, many of which face opportunities and risks that originate in the nonmarket environment. The renewable power market in the United States, and in most other countries, depends heavily on government subsidies, and those subsidies are costly. As a result of the sluggish economy the subsidies imposed a burden on government budgets and higher electricity prices. The reaction to these forces presented challenges for renewable power companies and for the private investors than funded them.

Case: BrightSource Energy: The Challenges Readings: BIE Chapter 13 SESSION 15: 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 Readings: BIE Chapter 12

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IV. GLOBAL NONMARKET STRATEGY SESSION 16: STRATEGY AND THE EUROPEAN UNION The most important issue in the European Union in 2011-2012 was the stability and functioning of its financial markets. The crisis was caused by a combination of excessive borrowing by governments and private banks and slow economic growth in Greece, Portugal, and Ireland that raised the risk of private and sovereign default. A rescue fund was hastily created, and funds provided to Ireland and Portugal at least temporarily alleviated their problems. The problem in Greece was greater, however, and an orderly default on private sector lending to the country was negotiated. The problems in Greece, however, persisted, and the financial markets began to pressure Spain and Italy. The EU responded by integrating the banking systems in the 17 Euro countries and provided funds to shore up Spanish banks. The crisis persisted, however. This session focuses on Greece, the risks it poses for the Euro, and the alternatives for resolving the crisis.

Case: The Euro Crisis Reading: BIE Chapter 15 SESSION 17: NONMARKET STRATEGY IN CHINA 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: STRATEGY IN EMERGING MARKETS Emerging markets represent both opportunities and risks. This session considers a rapidly growing Kenyan bank that was considering expanding into neighboring countries. Associated with the opportunities in those countries were a variety of risks, and risks persisted in Kenya, which had been plagued by ethnic violence in the past. This session focuses on the risks and opportunities in extending Equity Bank’s business model to those countries.

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Case: Equity Bank of Kenya Reading: Chapter 17 SESSION 19: ENTRY STRATEGY IN EMERGING MARKETS—INDIA 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 PLC in India?

Reading: Chapter 18 SESSION 20: STRATEGY AND INTERNATIONAL TRADE 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 19

V. CORPORATE SOCIAL RESPONSIBILITY AND ETHICS SESSION 21: SOCIAL RESPONSIBILITY This session raises the issue of what a company is responsible for in the face of criticism and social pressure. The case follows 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 31

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 adopt policies under the label of corporate social responsibility.

Case: Wal-Mart: Nonmarket Pressure and Reputation Risk (B): A New Nonmarket Strategy Reading: BIE Chapter 20 SESSION 22: UTILITARIANISM AND MANAGERIAL DECISION-MAKING 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 21 SESSION 23: RIGHTS AND DUTIES 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 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 22 SESSION 24: ONLINE 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 social media and e-commerce depend on the confidence people have in how information they provide is and could be used. This session deals with a company that faces a series of decisions about the privacy of its users and its use of their data and data obtained from their actions on its website. The

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purpose of the session is to consider the privacy issue, how it affects the strategy of a company, and how it should address users’ rights and 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 session will focus on the European Union’s conception of rights and the adequate protection of those rights.

Cases: Facebook and Online Privacy The European Union Data Privacy Directive (B) Reading: BIE Chapter 22 Session 25: Justice in the Workplace This session focuses on justice considerations in the context of a company in a difficult position between ethics and the law. As a result of government investigations of its operation in Minnesota and Washington, DC, Chipotle Mexican Grill was found to be employing a substantial number of undocumented workers, most of whom were believed to be illegal immigrants. The company was forced to fire hundreds of employees, some of whom had worked for it for several years. United States law prohibited employing undocumented workers, and a company could easily check the status of its workers by using the government provided E-Verify system. The company faced the possibility of a broader investigation by the government and had to decide what to do with respect to its employees.

Case: Chipotle Mexican Grill and Undocumented Workers Readings: BIE Chapter 22 SESSION 26: 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.

Readings: BIE Chapter 20 Session 27: Unethical Conduct

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This session focuses on individuals in a business setting in which temptation is present to violate ethics standards and the law. The case involves a prominent fund manager who succumbed to temptation and those who provided the information on which he acted. Chapter 23 provides insight into human behavior in settings in which ethical behavior can, or may not, be expressed.

Case: Insider Trading Readings: BIE Chapter 23 SESSION 28: 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 Readings: BIE Chapter 24 SESSION 29: SOCIAL 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 24 SESSION 30: CAPSTONE 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 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),

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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 24

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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.

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 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.

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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 (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 38

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.

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 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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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.

Update: Cellphone Radiation Risk FCC Chairman Julius Genachowski proposed reviewing radiation standards for cellphones and other electronic devices. Environmental and Health advocacy groups had urged a review, and the CTIA stated that it expected the review to confirm that there was “no reason for concern about the safety of cellphones.4 4

Wall Street Journal, June 16-17, 2012.

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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.

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 41

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 14 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.

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.

Patent Games: Plavix (Chapter 14) Compulsory Licensing, Thailand, and Abbott Laboratories (Chapter 19) Pfizer and Celebrex (Chapter 10) Merck and Vioxx (Chapter 10) Pricing the Norplant System (Chapter 21) Consumer Awareness or Disease Mongering?: GlaxoSmithKline and the Restless Legs Syndrome (Chapter 21) Gilead Sciences (A): The Gilead Access Program for HIV Drugs (Chapter 21) GlaxoSmithKline and AIDS Drug Policy (Part V Integrative Case)

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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 14 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 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.

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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.

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.

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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. 5 (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.”6 The Chapter 14 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.”

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.”7 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 5

Fortune, August 9, 2004.

Wall Street Journal, February 23, 2005.

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

6

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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.”8 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.”9 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.”10 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.”11 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.”12 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.”

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.

8

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

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

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

11 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. 12 New York Times, January 1, 2004.

9

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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 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

DoubleClick

FTC, courts

EU privacy regulations

EU Commission, data protection offices (regulators) FCC Courts

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

Spectrum auction Google books Google news

Courts (Europe); FTC

Trademarks

Courts

Data protection

Courts

Google health Google telephone YouTube (IP) Tolls

Public sentiment Markets Courts FCC; Congress

Discrimination Environmental practices (market) Philanthropy

Courts Public sentiment

Indigenous peoples

Public sentiment

Public sentiment

Competitors Publishers; competitors Content providers Businesses (Websites) U.S. government; opponents of child pornography Privacy advocates Competitors Content providers ISPs Plaintiff [[market participants]]

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

China: human rights China: Online video China: Music downloads Microsoft and Vista Microsoft and Yahoo

China government; U.S. Congress; public sentiment Regulators Regulators

Human rights organizations; private politics Competitors Competitors

Courts; DOJ Congress; courts

Microsoft Microsoft and other competitors

responsibility Administration Administration Enforcement (or lack there of) Enforcement Interest group 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?

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?

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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 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 49

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.13 14 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.15 Within a month of offering Google.cn, 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.16 13

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.)

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

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

14

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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 14.

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.

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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 section on positioning provides a foundation for nonmarket strategy, but as importantly it affects the set of issues 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.

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 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.

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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 23.

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

Cases Facebook in China?

The Chinese government had shut Facebook out of the rapidly growing and enormous local market, and this had allowed Chinese companies to enter in virtually all segments of the social media market. Renren.com had successfully occupied the social networking space in which Facebook would naturally operate. Facebook faced the challenge of developing a strategy for the Chinese market, and three basic alternatives were available to it. First, it could enter on its own as Google had done. Second, it could partner with a Chinese company, either a social media company, a search company such as Baidu, or perhaps a mobile communications company. Third, it could stay out of China, in which case interested users would have to devise their own methods of accessing Facebook. The broader strategy challenge for Facebook was how to expand globally by setting up operations in countries or simply making Facebook available to users on its U.S. Web site.

The opportunity for Facebook stems from leveraging from its existing platform and user base and from its caché. If it were to lose the latter, entry in any form might have limited success.

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The nonmarket issues that Facebook would encounter if it entered the Chinese market include the following: ● censorship required by the government ● possible requests for personal information of users of its Web site. Facebook required people to register with their real names, and the company would have to continue to do so under Chinese law (China requires Chinese citizens who use the domestic equivalence of Facebook and Twitter to use their real names. Google notified users, “Please note that in mainland China, searching for the character ‘[xxx]’ might cause the link between the user and Google to be temporarily cut off. The cutoff is not in Google’s control.” (L. Gordon Crovitz, “Google Fights Back in China,” Wall Street Journal, June 11, 2012.) ) ● regulation—particularly if it partnered with a Chinese mobile communications company ● social unrest—Facebook could serve as a communication platform for protesters, as it had during the Arab awakening. The Never Forget June Fourth movement was an example of how Facebook would be used. ● developing relationships of trust ● private politics (Chapter 4) challenges in China and Asia ● public and private politics pressure in the United States. This is evident from the Washington Post editorial and from the letter from Human Rights Watch. Moreover, Congress took an interest in Facebook and in the online privacy issue The issues facing a social media and networking company operating in China are complex and subtle and hence difficult for a Western company to address. Taking a Chinese partner seems to be the best alternative, and large companies such as Baidu are potential partners with complementary lines of business; search in the case of Baidu. The local partner would presumably be responsible for dealing with censorship and with the government. (When it entered the Chinese market Google irritated the government, and relations were strained thereafter. See the Chapter 16 case Google in China and the Chapter 24 case Google Out of China.)

Any Chinese partner, however, will operate in full compliance with Chinese law and hence will practice self-censorship and will turn over information on users what required to do so by the government. This will generate additional nonmarket pressure in the United States and other Western countries.

A variant of the strategy alternative of entering the market without a local partner would be to operate from Hong Kong as Google has done. The problem with this alternative is that Facebook’s success could be severely limited by remaining an outsider. For example, when Google moved its Chinese search business from the mainland to Hong Kong, it quickly began to lose market share.

The following questions can be used to lead the discussion of the case.

1. How attractive is the Chinese market to Facebook? How well entrenched are the Chinese social media companies?

2. What market and nonmarket challenges would it face if it entered China?

3. What could a Chinese partner do for Facebook that it could not do for itself?

4. Should Facebook be nervous about allowing its partner to manage relations with the government and to practice self-censorship? Should Facebook insist on a privacy policy for users? What would that policy include?

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5. What pressures would Facebook face in the United States if it entered the Chinese market with or without a partner?

6. What global strategy should Facebook adopt to deal with government restrictions on its services?

The Chapter 20 case Facebook and Online Privacy addresses the user privacy issue in the United States and in other countries.

Update: As of mid-2012 Facebook had taken no action with respect to entering the Chinese market nor had it partnered with a Chinese company. Domestic companies continued to solidify their position in the Chinese market.

Facebook went public in 2012 in an IPO that valued the company at nearly $100 billion. Its share price quickly fell by 20 percent as a result of concerns about its ability to monetize its membership and about nonmarket issues that could lead to regulation that would constrain its use of information.

Personal Watercraft aka Jet Skis This case is a vehicle for taking the step from the characterization of the nonmarket environment given in Chapter 1 to the formulation of a nonmarket strategy and its integration with a market strategy. Jet skis are a major product success of the 1990s with sales of over $1.2 billion in 1996 and one million units in operation. This success generated a number of nonmarket issues contested by a range of interests in the context of public institutions. The jet ski industry addressed these issues both through market and nonmarket strategies.

In the context of Figure 1-1, the market success of jet skis generated nonmarket issues that were addressed in public institutions. These issues and their resolution then affected the market environment and the market strategies of the manufacturers. The issues are: safety, emissions into the air, discharges into the water, MTBE, noise, disturbance of wildlife, usage fees, and mandatory instruction and licensing.

These issues are addressed in the institutional arenas of the NTSB and the Coast Guard (safety); EPA (emissions into the air (a CAFE system) and water pollution); National Park Service (emissions, discharges, MTBE, noise, and disturbing wildlife); state environmental agencies— California Air Resources Board/Maine Natural Resources Division (noise, emissions, discharges, MTBE); state legislatures (safety, instructions and licensing); regional authorities—Tahoe Regional Planning Agency (water pollution); and municipal governments—Evanston, Illinois (usage fees).

These institutions have the authority to regulate and even ban jet skis from lakes and other waterways. For example, in California concerns about MTBE in drinking water led some local reservoirs to ban jet skis to reduce the MTBE pollution.

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The interests involved include jet ski manufacturers, who are organized as the PWIA and also participate in the National Marine Manufacturers Association (NMMA). Jet skiers are also organized for nonmarket action; e.g., the Northern California Marine Association and the International Jet Sports Boating Association. The PWIA and the individual manufacturers provide tracking of the nonmarket issues and encourage and facilitate grassroots action on the issue. Also involved are boat manufacturers and boat users, as considered in more detail below. A large number of environmental organizations and conservation groups were concerned with pollution and wildlife habitat issues. In addition, other users of waterways such as canoeists opposed the intrusion and noise of jet skis. Activists such as the Earth Island Institute and the Bluewater Network also were interested in jet skis and the issues they generated.

Information about the nonmarket issues was reasonably complete and did not play a substantial role in the nonmarket competition on the issues in institutional arenas.

The origins of issues can also be identified. Many of the issues were the result of technological developments such as the powerful jet ski engines that contribute to the market success of jet skis, the noise and air and water pollution they generate, and the hazards they pose to their operators and passengers and to other users of waterways. Some issues such as MTBE contamination from gasoline spills and discharges were the result of institutional change such as the federal government action requiring oxygenates in gasoline. The improvement in scientific instrumentation allows the detection of minute generated not by new understandings but by fears, as in the case of alleged health risks associated with MTBE. There is no evidence that MTBE represents a health hazard.

The issues can also be placed in the stage of their nonmarket life cycles using the pattern identified in Figure 1-2. Most of the issues are either at the legislative or the administrative stages, with government institutions evaluating alternative measures to address the issues. The nonmarket issue life cycle does not predict or explain whether or when an issue passes from one stage to another or ceases to be a contended issue. Prediction and explanation require theories about the effectiveness of strategies. Those theories are developed in Parts II and III of the book.

Nonmarket and Integrated Strategy The strategies of the interests seeking to restrict the use of jet skis and to force changes in their design; e.g., requiring four-stroke rather than two-stroke engines, are clear. They involve grassroots actions, lobbying by organized interest groups, and the use of the media to call attention to the issues.

The strategy of the jet ski companies is multifaceted. In the context of Figure 2-1 management must bring together market and nonmarket analysis and strategies in the form of an integrated strategy. In the context of Figure 2-2, the jet ski industry and the use of jet skis are relatively unregulated, although some environmental regulations are in place. The threat to the jet ski industry is that the control of market opportunities by government will be substituted for market control. The chief motivation for the opponents of jet skis is the externalities they generate, as considered in more detail in Chapter 12.

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The jet ski industry has generally caught the issues at the issue identification and interest group formation stages of their nonmarket life cycles, so the industry has an opportunity to affect the development of many of the issues and to adapt to developments on others. For example, on the safety issue the industry has pushed its model legislation in state legislatures to pre-empt more stringent legislation backed by safety advocates.

The greatest nonmarket asset of the jet ski industry is the number of jet skiers and the boaters who are concerned by the spill-over of more stringent regulations to boats. The users are organized for nonmarket action and the PWIA and the jet ski companies work to facilitate their action. They have had some success, as indicated in the case. The PWIA and the companies track the legislative and regulatory activity on the issues and issue alerts to users on pending action.

Jet skiers are the principal nonmarket asset of the industry, but a potentially more important, but tenuous, asset is the large number of powerboat users. (In Chapter 7 the concept of a rent chain is introduced to identify the source of this asset.) The jet ski companies have consistently argued that jet skis should not be singled out for new regulations; i.e., jet skis and powerboats should be treated the same. The purpose of this position is that makes allies of the powerboat companies and boaters in the opposition to new restrictions. This alliance is tenuous, however, because the powerboat companies recognize that they might be able to escape some new restrictions if they could separate themselves from the jet ski companies. Indeed, it is the jet ski companies that have caused some of the problems such as disturbances to wildlife habitats and increased noise pollution. As discussed in Chapter 8 Genstar, the largest independent producer of powerboats, withdrew from the NMMA because the association was working on behalf of jet ski companies, which Genstar maintained would in the longer run work against the interests of powerboat companies and users.

In addition to its strategy of bundling its interests with those of powerboat interests and mobilizing jet skiers to oppose new restrictions, the industry worked to develop other allies. Its strategy of lending jet skis to law enforcement and search and rescue groups could be important in demonstrating the importance of jet skis and of their use beyond recreational activities. This strategy worked for the snowmobile industry and may work for jet skis as well.

An additional component of companies’ nonmarket strategies is to provide information on the safe use of jet skis. The companies include instructions and a videotape with each purchase, and their web sites provide instructions and information on safety, including self-tests of one’s understanding of proper jet ski use.

These nonmarket strategies have been and can continue to limit the imposition of new restrictions, but they do not address the sources of the issues. For that, market strategies are required.

Both market and nonmarket strategies must be evaluated for their effect on their corresponding environment and their effect on the other environment as identified in Figure 1-1. Just as nonmarket strategies can avoid some restrictions on the use of jet skis and hence improve market opportunities, market strategies can be used to relieve pressure in the nonmarket environment for additional restrictions. Market strategies include steps to reduce noise pollution by employing new technologies and materials and meeting clean water standards earlier than required by the

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regulations. As indicated above, the companies provided information to users about safety and about not disturbing wildlife habitats.

The issue of four-stroke versus two-stroke engines is a difficult one and one that the jet ski manufacturers may well lose. Four-stroke engines substantially reduce discharges into the water, and may be required eventually to meet clean water standards. Even if not needed to meet those standards, they could be mandated by a regulatory agency or a state legislature.

Teaching the case: The class discussion can be organized around the following questions: 1. What are the issues, interests, and institutions in the nonmarket environment of the jet ski industry?

2. Where are these issues in their life cycle and where did the jet ski companies catch the issues?

3. What is likely to determine the progress, or failure, of these issues in their life cycles?

4. What nonmarket strategy should a jet ski company adopt?

5. What market strategy should a jet ski company adopt?

6. How should those strategies be evaluated; i.e., how should the return from a strategy be evaluated?

7. How should they be integrated?

Developments: Regulatory and legislative activity continued at the state level and was likely to continue for some time. These actions were likely to diminish the demand for jet skis compared to the absence of the new restrictions. For example, California passed a new law that raised the minimum age for operating a jet ski from 12 to 16 and prohibited jet skiers from jumping wakes within 10 feet of a boat or from spraying bystanders. A federal court upheld the ban of two-stroke engines on Lake Tahoe.

California also proposed new rules that would impose more stringent pollution standards than required by EPA regulations. (California is allowed to have more stringent standards than federal standards.) The proposed regulations to go into effect in 2008 would reduce emissions by more than 65% from EPA allowed levels. The Air Resources Board stated that a set ski produces as much pollution in seven hours of use as a 1998 automobile driven 100,000 miles. The Board argued that sales of new jet skis and boats would not decrease as a result of the new regulations and estimated that the price of engines would increase by only 14% or by from $150 to $2,300. A spokesperson for Californians United to Save Boating said the cost would be much higher and that the regulations would substantially harm the boating industry in California. The spokesperson predicted that as a result of mote stringent regulations boaters would hold on to their old highpollution boats and jet skis longer.

A spokesperson for Brunswick’s Mercury Marine division characterized the situation in California as follows: “What we’re talking about in California is double and triple jeopardy. We are being attacked from all sides.”17 17

Chicago Tribune, November 7, 1998.

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Jet skis were banned from most national parks and recreation areas, and in 2001 a court settlement banned jet skis in all the remaining parks and recreational areas. The lawsuit had been brought by the Bluewater Network, an environmental group, against the National Park Service. The settlement was supported by the Bush administration. Jet skis would be allowed if the Park Service were able to show on a case-by-case basis that the jet skis would not cause harm. A lawsuit filed by a PWC enthusiast, the American Watercraft Association, and the PWIA sought to block the ban from taking effect. In addition, PWC enthusiasts and the industry were working with Republicans in Congress to delay the ban for two years.18 Both the lawsuit and the congressional activity were underway in mid-2002.

18

The New York Times, April 15, 2002.

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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.

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.

Social media has joined the traditional news media (newspapers, TV, radio, magazines, etc. where professionalism is present) as a major source of information to individuals and more broadly to the public. The social media can transmit news, opinions, and rumors about companies widely and instantaneously, and many companies make it a policy to respond on their own blogs. The social media writers are dispersed and diversified, which makes certain types of responses difficult if not impossible. Procter & Gamble was able to have a targeted response to the Folger’s campaign, but that would have been much more difficult to address if the campaign had been implemented through the social media.

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 simple 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 BP), described his interview with a major television network on the issue of natural gas price regulation: “That interview lasted for about an 60

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 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.”19 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 news media are in a competitive market, and competitive pressures, career concerns, and profit incentives can affect the behavior of journalists and the news company. A particularly incendiary case is described in The News of the World chapter case, which involved unethical and illegal activities by journalists and likely condoned by the executives at the newspaper.

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. 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.)

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 19

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

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

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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.

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 62

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.’”20 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.”21 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.22 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.’”23 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.”24 Mr. Artzt had been a consistent opponent of the boycott.25 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.”26

20

New York Times, April 16, 1991.

Boston Globe, April 16, 1991.

22 Wall Street Journal, November 18, 1991.

23 Wall Street Journal, November 15, 1991.

24 Wall Street Journal, November 18, 1991.

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

26 Wall Street Journal, March 23, 1992, p. B3A. 21

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Cases

General Motors Like a Rock (A) 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 14. 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 8,606. For a Nissan light pickup the odds are 1 in 4,521. Heavy pickup trucks were considerably “safer” than passenger cars.27 27

Newsweek, May 10, 1993.

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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?

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 65

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.28 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.”29 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 28

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.

29 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.30 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.31 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.

30 31

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.32 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.33 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.34 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.”35

32

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.

33 New York Times, February 11, 1993.

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

35 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 69

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.36 37 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.”38 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.39 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.”40 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.

36

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.”

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

38 Wall Street Journal, March 2, 1993.

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

40 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.”41 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.

41

New York Times, February 11, 1993.

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The News of the World This case reports on the early stages of The News of the World scandal. As more information has been revealed, the scandal has become more detailed and complex. Criminal charges have been filed against several of the players, including Rebekah Brooks who was charged with “conspiring to pervert the course of justice.” Rather than attempt to recap the developments, this note discusses teaching the case.

The case is intended to serve as a vehicle for assessing the incentives of journalist and the news media and the restraints, or lack thereof, on their behavior arising from the law and professional standards. The behavior in this case may have been present in other UK newspapers as well as at the News and possibly the Sun, but the discussion here focuses only on the News Corp. papers.

British tabloids have traditionally been competitive and have a record of uncovering and disclosing scandals and private information such as sex scandals. The incentives to get a “scoop” on a celebrity, government official, or a royal such as Prince William are apparently quite strong and evidently can lead to breaking the law and professional standards. Since information is at the heart of the matter, it is useful to discuss the sources of information. One is traditional investigative journalism, an example of which is Woodward and Bernstein’s uncovering of the Watergate affair.

Another is paying sources, which apparently is not uncommon particularly when it involves private sources. A third is hacking into cell phones, which apparently was a fairly widespread practice at least as far as Mulcaire as evidenced by his notes. A fourth is paying government officials for information they are not authorized to disclose. The third and fourth clearly violate the law and professional standards and the second may violate professional standards but not the law. Paying police officers may constitute bribery under UK law. The third and fourth may also violate EU data protection directives. (See Chapter 15 and the chapter case The European Union Data Protection Directive (B).)

The law and professional and ethics standards were not sufficient to deter this conduct, which shows either the strength of the incentives or an attitude that the people’s “right to know” prevails over the law and standards.

One concern about the seriousness of obtaining the information is how it might be used. It could be used to generate newspaper sales, as was likely with Prince William’s knee operation. Another would be to extract favors from the subject of the information. A third is for extortion. How the information obtained and how it was used may be revealed in the upcoming trials.

Was there a cover-up of the incidents by the News? Apparently so, which means that high ranking editors and executives were aware of the illegal activities. The hiring of the law firm to investigate the reported incidents seems foolish given the self-evident facts that must have been known to the News officials and likely James Murdock. Lord Macdonald’s comment seem convincing on this issue.

A disquieting aspect of this case is the close contact between News Corp. executives and government officials, including the present and preceding Prime Ministers.

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Another topic for discussion is the effects on the companies and their employees. The News was closed down, and the UK government objected to the acquisition of the addition shares of BSkyB. Update: In late November James Murdoch stepped down as director of two of the Murdoch group’s newspapers. Commentators speculated that the News Corporation might withdraw from the UK newspaper market.

In 2012 News Corporation announced that it would split into two publicly traded companies, one of which would contain the entertainment businesses and the other the publishing businesses. Rupert Murdock would be chairman of the board of both companies and the CEO of the entertainment company. The financial markets had been calling for separating the two lines of business.

Inquiries and investigations as well as trials were still under way as of mid-2012.

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Chapter 4

Private Politics and Social Pressure 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 on 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 24, 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 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 figure can 74

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.

For an example of a cooperative NGO see the article “Nature’s Own Hedge Fund” (Bloomberg BusinessWeek, June 4—June 10, 2012) which focuses on Mark Tercek, the head of the Nature Conservancy. Among other things the article discusses a cooperative engagement with Dow Chemical in which 20 Nature Conservancy scientists are working with Dow to identify its “global land and water assets.”

An article with discussions of cooperative engagements of firms with activists/NGOs is Business Week, March 12, 2007.

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 75

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.”42 Stroh’s had contributed $100,000 to the Audubon Society for its specials.

CASES

Shell, Greenpeace, and Brent Spar 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.

42

Wall Street Journal, September 25, l989.

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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.

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.”

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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 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 78

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.

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.

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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 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 recycling the top of the rig. Oryx apparently bought another field and was preparing to dispose of another platform.

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: 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.

Nike in Southeast Asia 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 80

from which it obtains its shoes and apparel, and his offer to let the Congress members tour the 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 criticisms 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 23.

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.

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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 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:

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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 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?

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

2. 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?

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

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

5. Has Nike dealt effectively with these issues?

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

7. Should Nike negotiate with its critics?

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

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

10. 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?

11. How should Nike resolve these issues?

12. 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?

13. 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 24 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 83

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 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 24.

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.”43 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.

By the early 2000s Nike was considered the leader in working to implement high standards in its suppliers’ factories. See Chapter 24.

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 43

New York Times, May 13, 1998.

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for the purposes of applying state laws barring false and misleading commercial messages.”44 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 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 was settled out of court.

In July 2011 new allegations of worker abuse (similar to those in the case) arose at Nike owned plants in Indonesia. Nike reported that two-thirds of the 168 factories making Converse sneakers failed to meet Nike’s standards. Nike, however, said it was powerless to do anything about the conditions because the factories operated under contracts in force before it bought Converse.[1]

[1] San Jose Mercury News, July 14, 2011.

The Anatomy of an Activist Campaign: Rainforest Action Network and Citigroup 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.

44

New York Times, May 3, 2002.

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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.)

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 86

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

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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 the 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.”45 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.

45

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 24.

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Michael Brune left RAN in 2010 to become executive director of the Sierra Club, the largest membership based environmental NGO in the United States.

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: RAINFOREST ACTION NETWORK AND CITIGROUP (C) 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.46 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 dayto-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 ceasefire for another 45 days, giving Citigroup more time to develop a policy.47 THE EQUATOR PRINCIPLES—A STEP FORWARD OR A BLOW TO 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 2002.48

46

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.

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

48 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.”49 Some of the specific criticisms by the NGOs included:50  

  

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.

CITIGROUP’S NEW ENVIRONMENTAL INITIATIVES 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.

49 50

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 overfishing or irresponsible energy production.”

On January 23, 2004, RAN wrote to 10 other U.S. banks, which RAN dubbed “The Liquidators,” for “liquidating the Earth's most valuable natural assets to post short-term profits at a long-term cost to the world.”51 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 portion of RAN’s limited resources.

The initial focus was on two banks, Bank of America and JPMorgan Chase, both of which had pending mergers. The first sentence of the letters from RAN to them read, “Congratulations on your pending merger...” (See Exhibit 2 for the letter to Bank of America.)

SOURCE: Research Associate Erin Yurday, Cornell MBA 1998, prepared this case under the supervision of David P. Baron. This case would not have been possible without the help of Mike 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.

PREPARATION QUESTIONS 1. Should Citigroup have adopted its new policy? How should it 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?

51

“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 Initiatives52 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.53 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: ally feasible alternatives to avoid such areas and have addressed these issues in the publicly available EA; 54 or convert55 the critical natural habitat; 52

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.

54 Degradation is modification of a critical or other natural habitat that substantially reduces the habitat's ability to maintain viable populations of its native species.

55 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, 53

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Appendix I (continued) Citigroup’s New Environmental Initiatives and respect for the rights of indigenous communities whose livelihoods or cultural integrity could be adversely impacted; 56 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; national level have provided mechanisms for the affected communities to be represented or consulted, and international and local laws have been upheld57; and 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: roup will not finance commercial logging operations or the purchase of logging equipment for use in primary58 tropical moist forest59. forest areas of high ecological value. areas) or on heavily degraded forestland. 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).

56 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.”

57 Including those laws related to the ratification and implementation of “Convention 169 Concerning Indigenous & Tribal Peoples in Independent Countries” of the ILO. 58 Primary forest is defined as relatively intact forest that has been essentially unmodified by human activity for the previous 60 to 80 years.

59 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 24 o 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. 60 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: 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.

60

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 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. the issue of illegal logging.61 s 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.

61

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.

2.

3.

4.

5.

6.

phase out all funding and investment for extractive industries (oil, gas, mining, logging) in endangered ecosystems; commit to support the right of indigenous and local populations to have free and prior informed consent to projects on their land; cease funding for all logging projects unless chain of custody certification can prove legality; provide funding for sustainable alternatives, such as Forest Stewardship Council certified logging projects and clean energy sources such as solar and wind power; provide competitive market incentives for consumers to utilize existing opportunities in renewable energy through energy efficient and energy improvement mortgages; 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

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 110

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 24. Moreover, suppliers are often under pressure to meet tight deadlines and may cut corners to meet those deadlines. (As discussed in Chapter 24 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 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.

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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 14.)

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?

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 112

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.

Discussion questions: 1. Should Mattel make a broader recall?

2. Is it risking products liability lawsuits? (See Chapter 14.)

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

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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.”62 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.63 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.

Johnson & Johnson and Its Quality Reputation Johnson & Johnson’s acclaim for its handling of the Tylenol poisoning had contributed to a stellar reputation among its potential critics, and its profit performance of consecutive quarterly increases had made it a favorite with investors. As Weldon explained, the company’s decentralization played a critical role in its reputation. That decentralization, however, may have contributed to its problems at the end of the first decade of the 21st century. J&J’s core principles were expressed in its Our Credo, which is reproduced in Chapter 23. The company appears to have forgotten about it, however. The McNeil consumer products unit experienced a series of quality control problems, and the company’s measures to address the problems exacerbated its problems. The quality problems received additional attention because they involved medications for children. The crisis threatened the company’s reputation and performance.

The continuing series of problems at multiple plants and with multiple products suggests that there is a fundamental lack of emphasis on quality control in at least some parts of McNeil. This is the root cause of J&J’s crisis. The company’s approach seems to have been conditioned on whether the problem involved a safety or health risk, an “adverse event” in its terminology, or a quality problem. (See the Goggins comment.) The former would be reported to the FDA, whereas the latter were dealt with internally by trying to retrieve the deficient product. This approach seems to be the root cause of the failure of the company’s responses. J&J was in a position in which it could only try to limit the harm and prevent further problems.

62 63

Wall Street Journal, August 17, 2007.

New York Times, February 7, 2008.

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The response by CEO Weldon in which he took responsibility was at best too late and at worst an incredible claim that its “response to the issue was the most responsible it could possibly be.” Why did he wait two months before making a statement? One possible answer is that he believes strongly in J&J’s decentralization and hence allowed McNeil management to deal with the problems.

J&J’s problems in the United States may have encouraged social activists and NGOs to engage in private politics, as occurred in China.

Will the congressional attention result in actual harm to J&J? The answer is likely “yes.” Congress is highly unlikely to enact legislation because of the J&J episodes, but members of Congress are likely to pressure the FDA to act. Even in the absence of congressional pressure the FDA is likely to act despite there being no safety problem. The FDA’s action is likely to focus on McNeil’s manufacturing operations, as suggested by the comment about Puerto Rican plant. In addition, the FDA can pressure the company to recall products because of quality problems, particularly products that do not correspond to the label indications. For recurring problems the FDA can impose fines, and private lawsuits can be filed against the company even if there are no injuries.

Discussion questions: 1. Did J&J address the quality problems in a manner consistent with Our Credo? Why or why not?

2. What is the root cause of J&J’s problems?

3. Were its initial responses sufficient to address the root cause?

4. Did the company adequately communicate with its multiple audiences (e.g., consumers, the FDA, Congress, …)? What could it have done better?

5. Should it have followed a policy of retrieving product with quality problems rather than recalling the product?

6. Why did it take two months before CEO Weldon began to communicate to the public and government?

7. Should a recall be the standard response to a quality problem or should retrievals be used in some instances? If the latter, which instances?

8. Is J&J’s remediation plan likely to be effective?

Update: The company’s quality problems continued. In November 2010 the FDA released a report on problems at the Puerto Rico plant. The report concluded that it had little reason to believe “that the current laboratory controls are adequate to assure that drug products conform to appropriate standards of identity, strength, quality and purity.”64 Karen Riley, spokesperson for the FDA commented, “Clearly, this inspection shows that the company continues to have serious quality control issues at the plant and that it is not in compliance with current good manufacturing practices required by federal law.”65

64 65

New York Times, November 27, 2010.

New York Times, November 27, 2010.

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The company continued its series of recalls pertaining to quality control problems. The recalls were not associated with safety issues but with quality and labeling issues. For example, in November 2010 McNeil recalled 9.3 million bottles of Tylenol Cold Multi-Symptom products because of inadequate labeling. The labels failed to show that the products contain small amounts of alcohol—less than 1 percent—that are used to flavor the product.66 In January 2011 a jury in a federal court in Texas concluded that J&J should pay $482 million to a doctor whose patent was infringed.

In May 2011 Johnson & Johnson recalled 11,700 bottles of its HIV AIDS drug Prezista in Europe and Canada. Four customers had complained of a musty or moldy odor, and J&J found trace amounts of TBA in the medications. TBA is “a byproduct of a chemical preservative sometimes applied to wood used to transport and store products.”67 J&J had also associated TBA with its recalls of Tylenol, and Pfizer had cited TBA in its recall of Lipitor in 2010.

Shareholders had sued Johnson & Johnson management because of its manufacturing problems and alleged kickbacks to doctors and pharmacists to increase sales. The plaintiffs “allege that Johnson & Johnson’s decentralized management was a ‘recipe for disaster’ that gave top executives and board members ‘plausible deniability’ to claim they were unaware of a range of severe problems that dragged on, some since the late 1990s.”68 The parties reached a tentative settlement in which a committee of independent board members would receive reports directly from top executives so that rapid actin could be taken.

Update: Financial Performance Earnings per share decreased from $4.78 per share in 2010 to $3.49 per share in 2011. The company explained the decrease in profits: “The decrease was primarily due to costs associated with product liability and litigation expenses, the impact of the OTC and DePuy ASR™Hip recalls and the restructuring expense related to the Cardiovascular Care business.” (Johnson & Johnson, 2011 Annual Report) For the first quarter 2012 sales were down slightly from the previous year and profits were up slightly.

66

Wall Street Journal, November 26, 2010 Wall Street Journal, May 12, 2011.

68 San Francisco Chronicle, July 13, 2012.

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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 117

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 WalMart saw this as an opportunity to advance their agenda. The teachers’ unions jumped on WalMart 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 8 case Wal-Mart 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 Wal-Mart. 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 Wal-Mart 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 20 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 WalMart.

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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 the European Union is presented in Chapter 15, China in Chapter 16, and India in Chapter 18.

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 Part IV of the book. 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 the analysis of interests provides 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 considered as part of the institution and typically are 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

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longer period of daylight saving time continued to work for extensions. For example, Senator 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 evaluations are discussed in Chapter 7.

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

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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the additional premiums and surtax be front-loaded with the benefits to be phased-in after the tax had begun to be collected.

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 – year after year after year.”5 The result was over 5 million letters to Congress members on the catastrophic illness program. The attack on the financing of the program had spread to the program itself, and for many members of Congress repeal was the easiest way out of the predicament.

3

The repeal did not cover certain benefits provided under Medicaid, the program jointly-funded by states and the federal government.

4 The National Committee has a membership of 5 million, a budget of $48 million, and was headed by James Roosevelt, son of Franklin Delano Roosevelt.

5 Congressional Quarterly Weekly Report, October 14, 1989.

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The repeal occurred after repeated attempts in both the House and the Senate to preserve the program in some modified form. Rostenkowski introduced a proposal to reduce the surtax to no more 5 percent of an individual’s tax liability, but the surtax could still go as high as $800. In addition, the Rostenkowski proposal would double the deductible for Part B coverage and increase 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 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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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 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 wellorganized, 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 aligned 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.

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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 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

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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 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.

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An analysis of S.1415 is provided in Alan Wiseman, “Votes for Smokes: Vote-Buyer Theories and Tobacco Politics,” Working paper, Stanford University, 1999.

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.

Business versus Business Note: There were many dollar amounts estimated by interests as well as government bodies, and they did not all agree. Differences in estimates are a common feature of nonmarket analysis and strategy formulation. What is clear is that the amounts were large in the aggregate and large for many individual interests. The incentives for political action were strong.

This is a case about the competition among interests on a largely distributive issue—the level of swipe fees on credit and debit card transactions. The status quo favors the card companies and the banks and other companies, such as Capital One, that issue cards. On the other side of the completion are retailers, who want lower swipe fees. The competition is characterized by interest group politics.

10

Business Week, May 23, 2005.

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The interests are straightforward to identify, and an initial discussion could focus on two interests: consumers and issuers. Although consumers are numerous, the effects on an individual consumer are small, so their individual incentives to act are very low. Moreover, they are unorganized and costly to organize. Their interests are aligned to some extent with retailers, since both would benefit from lower swipe fees. The distribution of the benefits from lower swipe fees depends on the competitiveness of retail sectors. The more competitive the sector the greater are the benefits to consumers. Regardless of the competitiveness, however, retailers have strong incentives to work for lower swipe fees and they are already well organized for nonmarket action. Although large retailers will benefit substantially, benefits will flow to all retailers. Moreover, the retailers can claim to be acting on behalf of consumers and lower prices. In addition, the retailers have complete coverage of legislative districts. They also have resources used to fund their principal nonmarket implementation strategy of informational lobbying. The demand for the alternative of lowering swipe fees is strong.

The card companies and card issuers have strong incentives to oppose lower swipe fees, and they have the resources to mount an aggressive campaign to preserve the status quo. It seems clear, however, that Congress will take some action to lower the fees, so the issue is by how much. There are only two card companies with clearing systems, and a high proportion of cards are issued by the large banks and a few large non-bank issuers (e.g., Capital One), so their coverage of legislative districts is limited.

Coverage, however, comes from small community banks, which are located in all likelihood all congressional districts. They are the source of nonmarket strength of the side opposing lower fees.

Their effectiveness is evidenced by the initial exemption for small banks, but an exemption would not work in this setting because competitive forces would drive cardholders away from these issuers to the larger and lower price competitive issuers. The small banks deployed an effective lobbying campaign with the informational strategy and the message that competitive pressures would force them to raise fees on their depositors and borrowers—the constituents of members of Congress.

The principal institutions in whose arenas the competition took place are the Houses of Congress, the conference committee, and the Federal Reserve, which is independent of Congress and a locus of expertise. As indicated in Figure 7-5, Congress and its conference committee are highly responsive to nonmarket action, and the Fed is not responsive. Congress responds to the effects of policy alternatives on constituents, whereas the Fed has no constituents. Influencing the Fed requires information, such as that provided by the community banks about the effects of competitive pressures on their fee structure. (This is also at a point in time at which many banks, including small banks, were in precarious financial situations.) This means that the interest group competition is largely confined to the institution arena of Congress and its conference committee.

In the conference committee the Houses could not agree on an alternative, so they delegated the decision to the Fed, which proposed a huge reduction with a cap on transactions fees of $0.12 and an exemption for small banks. (The $0.12 could reflect the Fed’s estimate of the cost of processing credit and debit card transactions.) This represented a major but temporary victory for the demand side of the interest group competition. The community banks then swung into action, causing the Fed to reconsider its proposal. (Why the Fed did not anticipate the competitive effects on small

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banks is not clear.) In the terminology of Chapter 5 the small banks used a representation strategy in their complaints about the competitive effects. This was countered by a representation strategy of small retailers through the association of convenience store owners. It was clear, however, that the effects on an individual convenience store and its customers were small compared to the effects on a community bank and its customers. Although the Fed is typically unresponsive to distributive politics, this was taking place in the aftermath of the financial crisis and at a time in which the economic recovery was slow and fragile. The Fed was in a difficult position and had a lot on its plate at the time. As Ben Bernanke stated, the effects on community banks even with an exemption were of concern to the Fed. In this case the Fed could be thought of as balancing the aggregate effects of the swipe fee on consumers, both those using cards and those of banks that could be affected substantially.

The balance of the interest group nonmarket action favored retailers, and some reduction was certain. How much would be determined by the balancing of effects by the Fed. Discussion questions: 1. Identify the interests affected. How strong are their incentives for nonmarket action? What are their costs of organization?

2. Identify the principal institutions involved and assess their responsiveness to nonmarket pressure.

3. What is the nature of competition on the swipe fee issue?

4. Assess the potential effectiveness of the various interests. Which interests can provide coverage?

5. Which side is able to generate the greater supply of nonmarket action?

6. Why was the conference committee unable to reach an agreement on interchange fees?

7. What factors is the Fed likely to consider in making its decision?

8. What is the Fed likely to decide in the wake of the reaction to its proposed fee of $0.12?

Update: The Fed increased the swipe fee from its proposed $0.12 to a cap between $0.21 and $0.24 depending on several factors. No interest group expressed satisfaction with the decision, as might be expected.

Both sides launched efforts in Congress to change the fee, but none was successful.

The retailers wanted more. In November 2011 they filed a lawsuit against the Federal Reserve System. The Fed had lowered the fee from 44 cents per transaction to 21 to 24 cents a transaction, but the National Retail Federation wanted more. The lawsuit claimed that the Fed illegally allowed banks to collect up to 5 basis points to cover fraud losses rather than fraud prevention activities.

Retailers also claimed that the banks had used the Fed’s specified maximum fee as the minimum, which meant that the actual fee on small transactions was higher than before the law was changed.

Frank Keating, president and CEO of the American Bankers Association, said, “It is disgraceful that our nation’s big-box retailers are suing the Fed over their own Durbin amendment, which chopped bank interexchange revenues in half and provided them a $7 billion windfall in profits annually.”11 11

New York Times, November 24, 2011.

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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 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

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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.

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

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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.

This 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 previous chapter.

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 and Labor Organization 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.

Daylight Saving Time Update Two empirical studies have called into question the energy savings from daylight saving time.

Matthew Kotchen and Laura Grant studied the electricity usage of households in southern Indiana when some counties were on daylight saving time and others were on standard time. They estimated that when the entire state decided to go on daylight saving time electricity bills increased by $8.6 million. Less electricity was used on lighting but more was used for air conditioning in the late afternoon and more on early morning heating when it was cool. They did not estimate the usage by businesses. A 2007 study by Hendrik Wolff and Ryan Kellogg also concluded that energy usage went up in two Australian territories when they temporarily went on daylight saving time for the 2000 Summer Olympics.

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.

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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 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. Senator 45 is indifferent between q and b, since they are equidistant from her ideal point.

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 not need special favors on the issue (other than maintaining relationships, etc.). b) Do not waste your time, resources, and attention on those who are strongly opposed. c) Target pivotal legislators (41-45). In this case, those pivotal voters are the ones who are mildly opposed to your alternative. d) The value of favors or vote trades required is greater the more opposed the pivotal voter is. e) Agenda setting explains where b is located.

The outcome: Federal Express’s nonmarket strategy was successful, and the vote on cloture was 66 to 31.14 One interpretation of this situation is that Federal Express figuratively recruited some additional votes as insurance; i.e., to provide for the possibility that it might have misestimated the preferences of legislators. The bill itself then passed the Senate 92-2. Eventually the House passed the bill, too, and the president signed it.

Implementation of the strategy:

13

This is not a description of Federal Express’s analysis, but instead is an analytical characterization of the principles of vote recruitment strategies.

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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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.

Baucus (Montana) Daschle (South Dakota) Hollings (South Carolina) Johnston (Louisiana)

COPE 100 63 71 75

1994

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

15 16

New York Times, October 12, 1996.

New York Times, October 12, 1996.

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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 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. Update: Developments in this case are considered in the Chapter 10 section entitled “Accomplishing Through Regulation What Cannot Be Accomplished Through Legislation.”

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.

19 Wall Street Journal, December 22, 2000.

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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.

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.

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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.

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.

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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.

Update: Carried Interest Taxation A tax on carried interest failed in the Democratic controlled Congress in 2010. President Obama included it in his 2012 budget proposal with projected tax revenue of $15 billion over the next 10 years. The proposal was to treat carried interest as ordinary income. With the gains made by Republicans in the 2010 elections, the carried interest tax was dead on arrival.

Wal-Mart and Health Care Policy This case focuses on objectives and strategy formulation. The presumption of Wal-Mart was that the Obama administration’s health care plan would be enacted in some form, and given that belief, the company had to devise a strategy and identify specific objectives. These are typically chosen together in a recursive manner. That is, the objectives to be pursued depend on how likely they can be achieved, which requires an assessment of the strategies that could be used to achieve those objectives. Wal-Mart might have preferred that the administration’s efforts would fail, but at the time of the case success was more likely that failure. In particular the strategy of the Obama administration was to make deals with industry groups, pharmaceuticals, hospitals, doctors, etc., before trying to advance a bill in Congress. This strategy made success more likely than in the failed health care initiative in the early years of the Clinton administration.

Given such an assessment, Wal-Mart could work to defeat Obamacare, remain neutral, or support it. As the case indicates and as referenced in footnote 72, Wal-Mart had been under considerable private politics social pressure and was a favorite target for unions, NGOs, and liberal politicians.

Some of the social pressure focused on the provision of health insurance for employees. The percent of Wal-Mart employees with company-provide health insurance was only about 50 percent, but that compared favorably with the retail industry. Moreover, many of those not covered had insurance through a spouse, Medicare, or in some cases Medicaid. Nevertheless, critics viewed the company as vulnerable on the health care issue and focused their attention on it.

Given the pressure it faced, the company decided to embark on a new path with an aggressive environmental policy and a willingness to work with NGOs on specific issues. For example, it began a cooperative arrangement with the Environmental Defense Fund (EDF) that was sufficiently intense that EDF opened an office in Wal-Mart’s headquarters town of Bentonville, Arkansas.

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Unions and liberal NGOs began to soften their views of Wal-Mart, which helps to explain the three signatories to the letter to the White House.

Wal-Mart decided not to oppose Obamacare and to support it conditionally on the health care reform including an employer mandate, which was clearly in the interest of the SUEI and the Center for American Progress. The company’s specific objectives were: 1) to obtain a seat at the bargaining table, 2) to level the playing field by requiring competitors to provide insurance, and 3) to be able to argue for cost containment, since health care costs were increasing rapidly. The company may also have sought to develop good relations with the Obama administration. For example, Wal-Mart joint with Michelle Obama to bring fresh fruits and vegetables to “food deserts” within urban areas. (See the “Michelle Obama and Wal-Mart” example in Chapter 8.)

Despite its support Wal-Mart would probably have been just as happy if Obamacare had failed as passed.

Wal-Mart pledged support for Obamacare conditional on an employer mandate. The employer mandate and Wal-Mart’s support for it were quickly and vigorously opposed by the NRF, which represented small retailers as well as some large retailers. The NRF took its opposition to Congress and the media with the message that an employer mandate would be a tax on jobs. (This is certainly correct. That is, in a competitive labor market, which was surely the case in 2009 with high national unemployment, the cost to an employer of a worker was the employee’s total compensation including the cost of benefits including health insurance. If employers were required to provide and pay for health insurance for their employees, they would pay the employee lower wages in equilibrium. This would not necessarily occur immediately because wages are sticky downwards, but over time it would result.) The Chamber of Commerce, which represents thousands of small businesses, also opposed an employer mandate as well as Obamacare more broadly.

If an employer mandate were likely to be enacted, the NRF and the Chamber would seek an exemption for small businesses. Wal-Mart was unlikely to oppose an exemption, since Congress would surely provide a limited one, but it would like the exemption provided only for very small retailers.

The strategy adopted by Wal-Mart was low profile focusing on working on the inside. The company also restricted its nonmarket actions to the White House, and not Congress. That is, it focused on where the deals were being made, leaving the interest group politics to others.

Consequently, Wal-Mart was not using representation or majority-building strategies, but instead was using an informational strategy coupled with bargaining.

Obamacare passed with an employer mandate, and as of mid-2012 little of the law had taken effect.

It was not clear if small businesses subject to the mandate would provide insurance or would choose to pay the fine. It was clearer that Obamacare would do little to contain the rising cost of health care. The high cost of health care and the anticipated growth in that cost had, however, induced a variety of private parties to work to contain their own health care costs.

This would be a good case for role playing with students in the roles of Wal-Mart, the NRF, the SUEI, and Rahm Emanuel.

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Discussion questions: 1. What are Wal-Mart’s objectives in supporting an employer mandate?

2. Why did it decide to focus on the White House?

3. Why did it join with the SUEI and the Center for American Progress?

4. What is Wal-Mart’s strategy with respect to the health reform initiative of the Obama administration?

5. Should Wal-Mart support an exemption for small business?

6. Should Wal-Mart instead have opposed Obamacare and worked to defeat it?

Update: It is too early to know whether Obamacare and the employer mandate will be successful, whether companies (and individuals) will provide insurance or pay a fine, and whether health care costs will be contained.

The following case provides a perspective on the bargaining in the White House on Obamacare.

Dealmaking and the Affordable Care Act The 2009-2010 health care reform initiative in the United States was extremely contentious, and the journalistic account of the politics characterized it as policy initiatives careening between likely failure and possible success at numerous points in the process, with the Obama administration pulling a reform out of the fire at the last moment. An alternative view is that the outcome was largely determined at the beginning of the process when a coalition was identified and deals with interest groups were made. The dealmaking was led by President Obama and his staff, who made the deals with interest groups and assembled a coalition in Congress to support those deals. Once the deals were struck and the coalition identified, the incentives were in place for the subsequent legislative bargaining and interest group lobbying. Moderates were prominent in the coalition, which gave interest groups confidence that the deals would be honored in the subsequent legislative bargaining. The extent and details of the deals are, of course, unknown to outside observers, and not all interest groups were willing to support a federal health care initiative. For example, the Chamber of Commerce and the insurance industry opposed health care reform and worked to defeat it. The following is a stylized description of the health care reform process.

In the coalition selection stage, the interactions between the White House and the interest groups were managed by Chief of Staff Rahm Emanuel. The process began with a Forum on Health Care Reform in March 2009 hosted by the White House and moderated by Dr. Ezekiel Emanuel, an official in the Office of Management and Budget and brother of Rahm Emanuel. The forum was open to the media.20 Interest groups were included among the participants, and notably the head of the Pharmaceutical Research and Manufacturers Association (PhRMA) and the CEO of Pfizer were invited. The Generic Pharmaceutical Association was not invited.21 20

In contrast, the health reform process led by Hilary Clinton and Ira Magaziner in the Clinton administration was conducted in the White House behind closed doors.

21 Measures to speed the introduction of generic drugs were not included in the final bill even though House Democrats pushed for the measures.

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Along with initiating interactions with industry groups, the White House identified a majority coalition of legislators that included liberals, blue dogs, committee chairs, and initially some Republicans to participate in the subsequent legislative bargaining. Some coalition members, such as Senator Max Baucus (D-MT), chair of the Senate Finance Committee, participated in the negotiations with the interest groups and played a key role in containing the cost of health care reform.

Deals were subsequently struck with a number of key interest groups. PhRMA agreed to support health care reform in exchange for a 10-year cap of $80 billion on price reductions to be made by the brand name pharmaceutical companies. A portion of the $80 billion would cover the so-called doughnut hole in Medicare prescription drug benefits as sought by the American Association of Retired Persons (AARP). Shortly after the deal with PhRMA, AARP announced support for the health care reform initiative. The pharmaceutical companies also received assurance that imports of low-cost drugs from Canada would not be part of the bill. The American Medical Association (AMA), which includes fee-for-service doctors, also pledged to support the initiative provided it did not reduce the compensation of doctors. The White House also struck a deal with the hospitals, which pledged $155 billion in cost reductions toward the Obama goal of a reform that was fiscally responsible. PhRMA’s and the hospitals’ pledges of support for the bill precluded a Harry and Louise-style advertising campaign, which was instrumental in defeating the Clinton administration health care initiative in 1993.22 In addition, the deals included a PhRMA pledge to fund advertising to support the ultimate bill. The industry groups also formed the Partnership to Improve Patient Care to support health care reform. This time, Harry and Louise would come out in support of health care reform.

Why were the deals credible? First, breaking pledges with the White House is not wise for an interest group. Moreover, the White House had put the interest groups in a difficult position.

Rahm Emanuel said, “All the constituencies that have been the most vocal critics of any form of health reform in the past are now invested in its success. ...It leaves those who oppose reform as the defenders of the status quo.”23 Second, if the White House broke the deals, it would have difficulty working with interest groups in the future. Billy Tauzin, head of PhRMA, stated, “Who is ever going to go into a deal with the White House again if they don't keep their word?”24 Perhaps as importantly, the deals were made credible by the selection of a coalition that included moderates such as Senator Baucus.

The nature of the deals was clearly understood. Senator Byron Dorgan (D-ND) said, “If we pass legislation allowing people freedom to import drugs, the pharmaceutical industry might not support the health care bill.”25 After the coalition was identified and the deals made with interest groups, the reform initiative moved to the legislative bargaining stage in Congress to determine the specific provisions of the health care reform. The White House was no longer in control. The interest groups, and particularly those that had made deals with the Obama administration, were active, and their lobbying along with the blue dogs in the coalition directed congressional efforts toward a moderate 22

Early in the health care reform process Ezekiel Emanuel asked Chip Kahn, president of the Federation of American Hospital Systems, “Are you going to run an ad? That's what we really want to know.” (Wall Street Journal, March 6, 2009) In 1993 Kahn worked for the lobby that sponsored the Harry and Louise advertisements.

23 Washington Post, July 9, 2009.

24 New York Times, December 23, 2009.

25 New York Times, December 11, 2009.

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bill in the Senate that would honor the deals. Baucus, for example, negotiated with key Republicans on the Senate Finance Committee in arriving at a less costly bill than that making its way through the House.

Members of Congress frequently sought to insert provisions that would violate the deals.

The Pelosi-Waxman wing of the House sought greater concessions from the pharmaceutical industry. Pelosi said, “We know we can squeeze more from the system. The minute the drug companies settled for $80 billion, we knew it was $160 billion. The President made the agreements he made. And maybe we'll be limited by that. But maybe not!”26 The $80 billion cap stuck.

Liberal Democrats also sought to extend Medicare to everyone 55 years and older, which would hurt the income of fee-for-service doctors. Senate Majority Leader Harry Reid struck a deal with the AMA to continue its support of the reform initiative in exchange for blocking the Medicare provision. Similarly, PhRMA and the congressional Democratic leadership reached a deal to avoid a ban on so-called “pay for delay” agreements between brand name and generic pharmaceutical companies that delay the introduction of generic drugs when patents expired.

The legislative bargaining also included deals among members of the coalition. In the Senate, Majority Leader Reid bought the vote of Senator Ben Nelson (D-NE) with the “cornhusker kickback,” where the federal government agreed to a permanent cap on Medicaid expenditures for Nebraska.27 For $300 million Reid also bought the vote of Senator Mary Landrieu (D-LA) of Louisiana.28 In the House votes were bought by the President, who issued an executive order ensuring that the longstanding prohibition against using federal funds for abortions remained unchanged. House votes were also obtained by the leadership pledging a tax exemption for socalled Cadillac health care benefits that unions obtained through collective bargaining.

Although most Republicans ended up voting against the bill, the Affordable Care Act was passed and signed into law by President Obama. The Act was challenged in numerous lawsuits, and the court decisions differed by jurisdiction. The most contentious issue was the individual mandate requiring that individuals purchase health insurance, which opponents argued was an unconstitutional use of government powers. The Supreme Court would have to resolve the issue.

If the Court held that the individual mandate was unconstitutional, the Act could unravel since the individual mandate was needed to bring healthy individuals into the new government sponsored health care system.

The Act was very unpopular with a sufficiently large number of voters that in the 2010 congressional elections the Republicans gained 63 seats in the House and a substantial majority in the chamber, 6 seats in the Senate, and governorships in many states. The election outcomes were similar to voter reactions to the failed health care reform effort of the Clinton administration.

Copyright © 2011 by David P. Baron. All rights reserved. Reprinted by permission.

Preparation Questions: 1. Identify the components of the Obama administration’s majority building strategy (Chapter 7). Why was it important to make deals with the industry groups?

2. Identify the instruments used by the White House and the Democratic leadership in Congress to buy votes (Chapter 7).

3. What role did lobbying play in advancing the health care reform bill?

26

New York Times, August 7, 2009.

The cornhusker kickback was widely criticized, but instead of repealing it in the reconciliation bill, the deal with Senator Nelson was honored, and the political criticism was deflected by extending the cap to all states.

28 Commentators referred to this as the Louisiana Purchase.

27

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4. Why was Speaker of the House Pelosi unable to obtain more from the pharmaceutical industry?

5. Why did the Obama administration push so hard for legislation that it recognized was unpopular with voters?

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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 most frequently. 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 parliamentary systems, as discussed in more detail in Chapter 15 for the European Union. 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

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breaks.” With the coining of this slogan, the tax benefits to U.S. exporters that used leasing for their exports were imperiled.

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.”29 Example: Soft Cookie Politics An example 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.30 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.

29 30

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.”31 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.32 Frito-Lay stated that it would pay less than $20 million and that insurance would cover the payment.

Cases

Internet Taxation 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.

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.

31 32

Wall Street Journal, August 27, 1984.

New York Times, September 13, 1989.

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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?

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

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--e-tailers do not use state resources --cost of administration --how active should it be on the California bill --strategy 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 --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?”33 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.”

33

Wall Street Journal, June 29, 2000.

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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 was given to Democrats.

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.”34 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 whould 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.

34

Los Angeles Times, June 7, 2000.

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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 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.

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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.

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.

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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 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

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also vowed to work with local aldermen Howard Brookins (21st) and Emma Mitts (37th) to identify ‘community initiatives’ to support with its charitable dollars.”35 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.”36 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.

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 treatment 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.

35 36

Chicago Sun-Times, May 26, 2004.

USA Today, May 27, 2004.

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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,” were likely directed more to building support for mandatory vaccination as influencing decisions by parents to seek Gardasil for their daughters.37 Merck also directly lobbied state governments and may have exploited personal relationships, as alleged in Texas.38 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.

37

Direct-to-consumers advertising by pharmaceutical companies is intended to lead individuals to ask their doctors for the drugs by brand name.

38 GSK and Digene also engaged in some of these activities.

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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.

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.”39 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 39

Chicago Tribune, October 10, 2008.

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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.

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.

As of September 2009 only Virginia and the District of Columbia had passed laws requiring an NPV vaccination, and both relented and allowed parents to opt out for any reason. In most of the other states the proposals for mandatory vaccinations failed. “Health officials said they expect as many as half of parents to opt out.”40 A number of states passed laws requiring insurance coverage for a vaccination. Merck has sold 26 million doses in the United States and 40 million worldwide for revenue of $1.4 billion. Reported side effects have been relatively small with 54 voluntary reports of side effects per 100,000 doses.41 GSK’s Cervarix had not yet been approved by the FDA. The following is a discussion of the case Fuel Economy Standards 2007 from the 6th edition of the book. The discussion contains a distributive politics spreadsheet

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.42 In 2002 the interests that would be harmed by the bill 40

San Jose Mercury News, September 3, 2009.

San Jose Mercury News, September 3, 2009.

42 The McCain-Kerry bill would have increased fuel economy standards to 35 mpg.

41

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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

Alternative

Combined CAFE of 35 mpg

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 CO 2 emissions. .......................Demand Side..............

............................Supply Side............

Supporting

Substitutes

Magnitude

Per Capita

Numbers

Coverage

Environment -alists

few if any (carbon tax)

High

low

high

extensive

public (global warming)

"

moderate

very low

huge

complete

Resources

Cost of Org.

Exp. Impact

Modest

low for group high for indiv

substanti al

Huge

very high

little if any

UAW (if outsourcing is restricted)

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

shift to very small cars

very high

high (per company)

moderate

moderate (suppliers, dealers)

high

low

moderate

UAW

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*

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Resources

Cost of Org.

Exp. Impact

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. 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

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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.

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?

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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 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 be 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 II Integrative Case Amazon.com and the Amazon Tax Amazon faced the challenge of developing a nonmarket strategy to address not only the broad issue of online sales taxation but also to deal with the specifics of a variety of state initiatives. The broad issues are discussed in the Chapter 8 case Internet Taxation, and the interest group politics competition over that issue is discussed in this Instructors’ Manual. As of the time of the case there was little chance that Congress would act to impose a tax on online sales or to overturn Quill.

Although federal action may be more attractive to Amazon than dissimilar actions by individual states, it could not wait for action by Congress. It had to deal with the state initiatives on both a reactive and proactive basis.

Quill had a number of important implications for Amazon. It provided a defense against attempts to collect sales and use taxes. Avoiding those taxes gave it a clear competitive advantage relative to brick and mortar retailers and retailers such as Barnes and Noble with stores in a state. It also affected location decisions for units such as warehouses and affected how it organized.

Warehouses were owned by subsidiaries, and units such as its Kindle design studio were organized as business units separate from Amazon’s sales activities.

One issue for discussion is why the states are acting now rather than earlier or later. The explanation comes from the effects of the financial crisis. The crisis, the subsequent recession, and slow recovery put severe budget pressures on most states, forcing them to make large reductions in expenditures and in some cases to increase taxes. In addition, during the recession brick and mortar retailers had lost sales to online sellers. Moreover, the rise of price comparison Web sites had added to the risk of lost sales. Large retailers were also affected, both their offline retail operations but their online sales as well. Retailers and citizens, such as public sector union members, concerned about state budget cuts put pressure on governors and state legislatures.

Another issue for discussion is what constitutes a “nexus.” The Quill decision was in a mail-order catalog case, and the court’s reasoning was that it would be overly burdensome to collect taxes when there were 7,500 tax jurisdictions each with its own tax rate. In 2009-2010 the nexus issue for Amazon centered on affiliates and subsidiaries. Amazon stated that a nexus was something that sold goods, but New York passed a law stating that an affiliate was an “instate vendor.” Amazon’s response was to sue the state, but it collected the tax until the case could finally be resolved.

Colorado took a different approach, requiring Amazon to notify residents of the taxes they owed and also to report the information to the state. Amazon ended its affiliates program in Colorado and New York to support its argument that it had no nexus in the state. North Carolina sought to collect back taxes from Amazon and ordered it to report to the state what residents bought. Again Amazon sued along with the ACLU, and the court decided for them. In Texas Amazon closed its warehouse and cancelled plans for an expansion. Amazon’s strategy was to eliminate things that could be construed as a nexus, but this was not a long-run solution.

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Amazon sought to reduce uncertainty by bargaining with states, offering to build a warehouse in Tennessee and South Carolina in exchange for an exemption. California was more complicated.

Amazon eliminated its affiliates, but it had its Kindle design unit and an online advertising unit in the state. The company could file a lawsuit, move its units out of the state, or sponsor a ballot initiative to block new taxes on online sales. Whether a referendum would succeed was unclear, but what was clear is that it would complicate the governor’s plan for a referendum on a temporary tax increase to cover a large budget deficit. The threat to the governor was real, and Amazon sought a moratorium on the collection of taxes to give Congress an opportunity to resolve the online tax issue. The likelihood of congressional action was small, however.

Amazon was fighting fires state by state which in some states bought time, but a longer-term resolution was the online sales tax issue was elusive. It seems inevitable that taxes will be collected on online sales, and Amazon’s collection of taxes in New York shows that it is possible to collect the taxes despite the many tax districts. Amazon’s best strategy may be to delay the resolution as long as possible.

Discussion questions: 1. Why are the states acting at this point in time?

2. Is eliminating affiliates sufficient to avoid state efforts to collect taxes?

3. How should Amazon have addressed the threats in the various states?

4. What should Amazon do if it wins the lawsuit in New York? If it loses the lawsuit?

5. Is the approach Amazon is taking California, South Carolina, and Tennessee likely to be effective?

6. What is likely to be the ultimate outcome of the Internet sales taxation issue?

Update: In September 2011 Amazon and the state of California reached an agreement under which Amazon agreed to drop the ballot initiative in exchange for a one year reprieve on collecting the taxes. If federal legislation were enacted in the interim, it would take precedence. Amazon reportedly spent $5 million to collect over 500,000 signatures to put the online tax measure on the ballot, so its threat was credible. It was possible that Amazon could use the year to move its subsidiaries out of the state, in which case it could then escape the tax.

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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 selected 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 merger guidelines that the Federal Trade Commission and the Department of Justice issued. 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 AT&T and T-Mobile Merger? deals with an important horizontal merger case in which the government challenged a merger that AT&T believed would be approved. The

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company was so confident that it agreed to pay T-Mobile $3 billion in the event that the merger was rejected by the government.

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. 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, 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.

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.

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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?

Update: In July 2009 during a trial of 3 former and 1 current British Airways employees, it was revealed that Virgin Atlantic CEO Steve Ridgway had been involved in the price fixing that had led to British Airways guilty pleas. Ridgway said, “I apologize unreservedly for my involvement in this case. I have fully co-operated with the competition authorities since their own enquiries began in 2006. Although I did not have any direct contact with BA in relation to passenger fuel surcharges I regret that, on becoming aware of the discussions, I did not take steps to stop them.”

He added, “Since 2006, I have ensured that a thorough and far-reaching competition law training program has been put in place at Virgin Atlantic so that everyone understands the serious nature and true extent of competition laws and so that this does not happen again within our team.”3 Virgin Atlantic and Ridgway escaped prosecution by revealing the price fixing to the authorities.

3

Wall Street Journal, July 14, 2009.

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As of March 2011, 21 airlines had paid $1.7 billion in fines for price fixing and 19 executives have been charged. Four executives have gone to prison. No major U.S. airlines have been charged.

The AT&T and T-Mobile Merger?

At one level this is a complex case involving competing claims, competing nonmarket strategies, and broad benefits and costs. At another level it is a simple case in which an already highly concentrated industry could become even more concentrated. Concentration analysis, however, may not be so straightforward in this case, since the wireless communication market cannot sustain a substantial number of firms due to network effects. That is, there are efficiencies in networks that should drive the number of suppliers down to a very small number, which could be 2 or 3. Another complicating factor is whether if the merger is abandoned, will T-Mobile be able to remain a viable competitor or will it wither away and sell its assets piecemeal along the way?

AT&T obviously understood the concentration concerns but sought to justify the merger on efficiency grounds. It argued that the capacity that would be obtained would allow the company to expand quickly its network to provide service to 97 percent of the population. More importantly, it argued that substantial efficiencies would be achieved and innovation would be stimulated. The relation between size and innovation is not obvious from economic theory or empirical studies, so AT&T would have to show how innovation would be increased. The support of Silicon Valley Internet firms and venture capital firms for the merger provides some indication that there may be innovation implications, but those endorsements could also reflect the desire to have an expanded AT&T network as soon as possible. AT&T would also have to identify the specific efficiency gains and how those gains would be passed on to consumers.

AT&T argued that there lots of other carriers as well as new entrants such as LightSquared with national network ambitions. The effect of these carriers and entrants on the market was, however, tenuous at best. (LightSquared subsequently declared bankruptcy.)

To support the merger, AT&T launched a broad scale nonmarket strategy to enlist endorsements and support. The company was able to obtain endorsements from Silicon Valley firms and private equity funds, NGOs, governors, members of Congress, and the principal union. Some, such as the CWA, were clearly self-interested parties. The CWA had already bargained with AT&T over the unionization of T-Mobile’s workers.

The opposition to the merger was broad and vocal. The opposition used the media, lobbied in Congress, and presented their arguments to the FCC. Most of their criticism focused on the concentration in the market and the inevitable costs resulting from a duopoly. The “digital divide” argument of the Minority Media and Telecommunications Council did not dissuade the critics.

The opposition’s nonmarket strategies included two components intended to delay any possible approval of the merger. First, the opposition sought to intervene at the state level. Second, it asked for FCC hearings.

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The opposition also focused on pockets of concentration in urban markets where concentration could “jump dramatically.” AT&T responded with a new filing in which it proposed fix-it measures to deal with specific concerns. It also proposed giving up some spectrum in some areas.

Another relevant factor in the decisions of the FCC and the DOJ is whether T-Mobile is a viable entity if Deutsche Telekom continues not to invest in it? The only possible acquirer is Sprint, and it certainly cannot afford $40 billion. However, if T-Mobile’s viability is in question, then its market value must be substantially lower than $40 billion. The minimum value of the company would be its salvage value—what it could get if it sold its spectrum and other assets. An acquisition by Sprint at a lower price is conceivable.

Despite the nonmarket strategies mounted by both sides, the concentration issue is likely to be the most important factor in the decisions by the FCC and the DOJ. Discussion questions: 1. What factors will be the most important in the decision of the FCC about transferring spectrum as a result of a merger?

2. What factors will be the most important in the decision of the DOJ regarding whether it will attempt to block the merger?

3. How compelling are AT&T’s justifications for the merger?

4. How effective is AT&T’s nonmarket strategy?

5. How effective are the nonmarket strategies of the opponents of the merger?

6. Was it wise for AT&T to agree to a break-up fee of $3 billion?

7. What decisions will the FCC and the DOJ make?

Update: In August 2011 the DOJ filed a lawsuit to block the merger. AT&T pledged to vigorously defend the merger in court. The FCC also expressed concerns about the merger. The situation became more complicated in November 2011 when the FCC chairman announced that it would require a hearing, like a trial, before an administrative law judge on the economic benefits and costs of the proposed merger. This would be the first hearing by an FCC administrative law judge in 8 years. At the least the requirement of a hearing would delay the merger, and it could block it.

In December 2011 AT&T abandoned its efforts to acquire T-Mobile and paid the break-up fee of $3 billion to Deutsche Telekom.

The Microsoft Antitrust 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 175

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.

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 4

San Jose Mercury News, May 17, 1999.

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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.

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 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

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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 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 cases 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 addresses the regulation of financial markets, and Chapter 12 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.

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 12.

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 12 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 14. 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.

Update to the “Accomplishing Through Regulation What Cannot Be Accomplished Through Legislation” section: The NLRB majority decided to accelerate its decision to shorten the time between certifying an election to be held and the actual vote. The Democrats decided on this strategy because the term of one of their members would expire at the end of 2011, and the incensed Republicans in the Senate were certain to block the appointment of any Democrat. The NLRB had 2 Democrat members and 1 Republican, and two seats were open. Consequently, when the current member’s term expired the NLRB would be unable to take any action for lack of a quorum. (The NLRB had not had a quorum beginning in 2008 during the Bush administration and continuing for 26 months into the Obama administration.) To stop the accelerated action, the sole Republican member threatened to resign, which would prevent the NLRB from acting on the shortened voting period. This would also prevent a final vote on the Boeing case.

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Republicans in Indiana had majorities in both houses of the state legislature, and the governor was a Republican. Republican members of the legislature announced that they would introduce a rightto-work bill in 2012. The law would allow all private-sector workers not to join a union and hence not to have to pay union dues. Twenty-two states had right-to-work laws, with Oklahoma the most recent to adopt it in 2001. In the other states all workers at a unionized facility had to belong to the union and pay dues. Republicans said that the law would help reduce unemployment which stood at 8.9%.

Cases 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.[1] 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.

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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 14 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 have the information on risks. That right would be instrumental.

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.

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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 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,

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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.

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 a 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 a 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.

Developments: In 2011 Merck paid $950 million and pleaded guilty to criminal misdemeanor charges “that the company illegally promoted its former painkiller Vioxx and deceived the government about the drug’s safety.”5 Earlier Merck had settled thousands of products liability lawsuits alleging deaths and injuries for $4.85 billion. The $950 million was to be paid to the federal and state governments.

Pfizer and Celebrex Much of the analysis for the Merck and Vioxx case in Chapter 5 is relevant to this case and will not be repeated.

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.)

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 5

Wall Street Journal, November 23, 2011.

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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.6 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 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.

6

The previous month the FDA had forced Pfizer to withdraw two ads for Viagra.

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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.

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

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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. These 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. This 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 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.

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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.”7 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 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.

7

FERC News Release, June 25, 2003.

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Chapter 11

Financial Markets and Their Regulation This is a new chapter focusing on the financial crisis and the regulation of the financial markets that resulted from it. The rulemaking on the regulation was far from complete in mid-2012 with regulators grappling with the Volcker Rule, capital requirements, and many other issues. The lobbying on the issues was intense, and the outcomes were uncertain.

The causes of the financial crisis are many and varied. Moreover, considerable disagreement remains over the causes. A lecture could recap and evaluate the explanations given in the chapter.

The leap from the identification of causes to the appropriate actions to take is a long treacherous one, since intervention in highly competitive markets can be hazardous. New regulatory rules will be written over the next months and years, and only experience will identify the wisdom of the rules. The financial services industry is waging an intense lobbying effort to obtain favorable interpretations of Dodd-Frank. One instance pertains to what is a “qualified residential mortgage,” which would be exempt from the 5 percent retention requirement. The industry argues for a broad definition such as that used for “qualifying mortgages” under Fannie May and Freddie Mac. The proposed rule was for a 20 percent down payment, which was considerably narrower than a “qualifying mortgage.” Both industry and consumer groups called for a more inclusive rule.

Consumer groups feared that credit would be less accessible under an 80-20 rule. More than a year has passed since the proposed rule was announced, and a final rule has yet to be promulgated.

The chapter provides some details on the collateralized debt obligations and credit default swaps that were at the heart of the financial crisis, and some additional explanation could be provided in a lecture. The securities were not the cause of the crisis, but they did make it easier to issue bad mortgages and leverage a financial services firm with off the balance sheet financing. These securities play a role in the chapter case Goldman Sachs and Its Reputation.

The chapter case Credit Ratings Agencies presents information on the companies that securities and identifies the principal alternatives available to regulators.

Jamie Dimon, CEO of JPMorgan Chase, was a strong advocate for less regulation of financial firms than called for by Dodd-Frank. He and the company were humbled by a hedging loss initially reported to be $2 billion. The company had knowingly adopted a supposed hedging strategy for exposure to European financial risks. The hedge was not a true hedge but instead was a bet on the direction of movement of European financial securities. The hedge strategy was ordered by top management. An internal JPMorgan Chase memorandum reportedly stated that the loss could reach $9 billion, and on the disclosure of the memorandum, the company’s stock price dropped by 2.2% more than the other financial stocks. For many people, Dimon’s credibility was called into question.8

8

San Jose Mercury News, June 29, 2012.

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The Dodd-Frank Act contained a requirement that all findings and conclusions provided in the underwriting of the securities had to be made publicly available, whereas in the past these had been privileged communications. This meant that lawyers, accountants, and investment bankers faced having their opinions and judgments made public. Ed Gainor of the law firm Bingham McCutchen said, “Lawyers and accountants would be highly reluctant to publish their opinions and conclusions because their letters are specifically for the parties to whom they are addressed.”9 This aspect of Dodd-Frank may provide a field day for trial lawyers.

The Volker rule is Section 619 of the Dodd Frank Act. Former Citibank CEO John Reed commented on the need for the Volker rule. “You asked me why trading exploded. Profit. An aggressive trading culture is very difficult to control within the context of a bank. That is why culturally it’s important to keep proprietary trading separate from the commercial banks.”10 Proprietary trading is of two types. One type is not client-facing and involves the investment of the firm’s own funds; this is sometimes referred to as principal investing. The second takes place in conjunction with client-based activities including market-making and securities-backed transactions.

The alternative to proprietary trading is to form a hedge fund, and critics of the Volcker rule warned that funds would be moved from the banks on Wall Street to unregulated hedge funds. In 2010, nine traders in Goldman’s financial strategies group left Goldman to join KKR to set up a new hedge fund. Gary Cohn, the number two executive at Goldman Sachs commented on the effects of the new regulation: “In the next few years, the unregulated sector will grow at an exponential rate. Risk is risk. My concern is that…risk will move from the regulated, more transparent banking sector to a less regulated, more opaque sector.” He added, “What I worry most about is that in the next cycle, as the regulatory pendulum swings, we are going to have to use taxpayer money to bail out unregulated businesses that, unlike the banks in the last crisis, may not be able to repay them.”11 The unregulated sector refers to hedge funds and other financial activity outside the purview of regulators.

In addition to working to loosen the stringency of the regulation called for by Dodd-Frank, banks worked to reduce or at least delay the Basel III requirements.

Incentives for Mischief in Mortgage and Financial Markets The following note describes some of the incentives for bad loans in the mortgage market.

In the loan origination market mortgage brokers, non-bank lenders, and some banks operated with an explicit strategy of “originate to distribute,” under which there was no intention of holding the loans made. The loans were used to back collateralized debt obligations (CDOs) issued by a special-purpose vehicle (SPV), a paper vehicle that held the mortgages and issued CDOs. Writing in the New York Times Joe Nocera described the incentives provided by the securitization of mortgage loans: ``Economists call the phenomenon moral hazard. Bankers have a different term: I.B.G. The phrase implies that by the time a deal goes sour, ‘I’ll be gone’ after having 9

Wall Street Journal, July 22, 2010.

Institutional Investor (America’s Edition), December 2010.

11 Financial Times, January 27, 2011.

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received a sizable bonus."12 Farmer and Geanakoplis (2008) wrote (p. 28), “But [lenders] apparently underestimated the amount of fraud in the loans. The brokers arranging the loans did not own them. The loans were sold and repackaged into bonds that were in turn sold to hedge funds and other investors. Since the brokers knew they would not bear the losses from defaulted loans, they evidently did not have enough incentives to check the truthfulness of the borrowers.

And the investors apparently did not monitor the brokers carefully enough, perhaps lulled by the good behavior of the loans during the period of housing appreciation.” Indeed, those who expressed concerns about the CDOs could be fired. Ken Linton, a former trader for Lehman Brothers, commented on the culture that led the firm to be the top producers of mortgage-backed securities: “Anyone at our level who had a different view than senior management would find themselves going somewhere else quick. You are not paid to rock the boat.” 13 The incentives of intermediaries in the mortgage lending market were asymmetric with large payoffs on the up-side and small risks on the down-side. Kane described the incentives as follows: “When commissions and other fees for service are paid upfront, managers and line employees of firms that originate, securitize, rate, or insure loans fear that they are passing up short-run income whenever they nix a questionable deal. At the same time, accountants, appraisers, and even government supervisors know that they can win business from competing enterprises in the short run by establishing a reputation for not challenging a troubled client's dodgy representations about asset values or assessing its efforts to transfer risks off balance sheet as conscientiously as a third party might suppose.”14 Blinder described the incentives that motivated the deal-makers: “Take a typical trader at a bank, investment bank, hedge fund or whatever.

Darwinian selection ensures us that those folks are generally smart young people with more than the usual appetite for both money and risk-taking. Unfortunately, their compensation schemes exacerbate these natural tendencies by offering them the following sort of go-for-broke incentives when they place financial bets: Heads, you become richer than Croesus; tails you get no bonus, receive instead about four times the national average salary, and may (or may not) have to look for a new job. These bright young people are no dummies. Faced with such skewed incentives, they place lots of big bets. If tails come up, OPM [Other People's Money] will absorb almost all the losses anyway.” 15 Many mortgage brokers relied on automated loan approvals for which documentation of the borrower's qualifications was not required or was incomplete. Jeff Schaefer, the former executive in Lehman Brothers’ Aurora Loan Services unit, reported that he “used to talk with [a Lehman trader] three or four times a day to get his marching orders on mortgage pricing and credit standards. It was these conversations, he says, that helped him decide whether to require borrowers to document their income on whether to give them so-called no-doc loans.”16 Schaefer explained the lack of documentation, “A lot of it was risk based on FICO (credit) scores,” he says. “While you may have had no-doc loans, people had very high credit scores, which are based on the ability to pay their debt. And because they have been paying, the income they stated is reasonable.”17 Some lenders went further and encouraged their brokers to make riskier loans. The head of Taylor, 12

New York Times, September 12, 2009.

New York Times, September 13, 2009.

14 Edward J. Kane, “`Incentive roots of the securitization crisis and its early mismanagement.” www.voxeu.org, March 3, 2009.

15 Alan S. Blinder, “Crazy Compensation and the Crisis.” Wall Street Journal. May 28, 2009.

16 New York Times, September 13, 2009.

17 St. Petersburg Times, September 27, 2009.

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Bean & Whitaker Mortgage Corporation, which became the 12th largest home mortgage lender, “acknowledges it was one of the few lenders making FHA loans for mobile-home purchases and one of the last to impose minimum credit scores for FHA borrowers. ‘I felt that the spirit of the program was to try to provide home loans to those borrowers,’ he says.”18 The absence of documentation was hidden from investors who bought CDOs, although not necessarily from the credit ratings agencies.

With complete information investors would reduce the price they paid for a CDO by the cost of the risk thereby imposing the full consequences on the lender. Information, however, was far from complete. In particular, subprime loans were made to a new class of borrowers who previously had not qualified under traditional lending standards, so the models and historical data used by the credit ratings agencies were inadequate for rating the new CDOs. In addition, lenders and the investment banks that designed the CDOs influenced beliefs through their marketing of the CDOs to investors. In some cases their messages involved misrepresentation and possibly fraud, and in others they reflected the exuberance of riding a wave of rapid economic growth, rising housing prices, and large capital gains.

The new class of mortgage loans was inherently riskier than traditional mortgage loans, but these new mortgages could be profitably packaged, tranched, and sold to investors. For nonbank lenders profits were earned on the difference between the price at which loans could be sold and the cost of the borrowed capital used to fund the loans. The premium was due in part to exuberant expectations and false diversification, but it was also due to demand fueled by regulatory changes that allowed financial institutions to pursue higher returns by purchasing high yield CDOs. Sheila Bair, chairman of the FDIC, commented on the impact of the regulatory changes: “The same dollar of capital could now support as much as five times the volume of these triple-A securities. It is not entirely coincidental that in the subsequent years, financial service companies swung into high gear creating new classes of rated securities. With their promises of triple-A quality and higher yields in some cases, these products were very attractive to banks that wanted to boost returns on equity, and to economize on regulatory capital.”19 The marketing of securities backed by subprime mortgages was aggressive and in some cases involved unethical practices and possibly fraud. Elizabeth MacDonald wrote, “behind the scenes Goldman Sachs worked hard to clean up its books by burying the worst ‘dogs’ of these assets in baskets of subprime securities, then traveling the world over to sell these investments by targeting the ‘buy and hold’ crowd, investors not as smart as their other hedge fund clients.20 Fraud could result, for example, if the subprime lender misrepresented information to a credit rating agency or from false statements to investors and shareholders about the quality of the loans.21 For example, in its complaint against Countrywide CEO Angelo Mozillo and two other former Countrywide executives, the Securities and Exchange Commission (SEC) stated that the executives “misled the market by falsely assuring investors that Countrywide was primarily a prime quality mortgage lender that had avoided the excesses of its competitors. ... But concealed from shareholders was the true Countrywide, an increasingly reckless lender assuming greater and

18

Wall Street Journal, September 17, 2009.

Sheila Bair, “Remarks to the Global Association of Risk Professionals,” February 25, 2008.

20 http://emac.blogs.foxbusiness.com/2010/04/27/new-details-emerge-goldman-case 21 See Roger Lowenstein, New York Times, April 27, 2008, for a description of risky mortgages and Moody's review of them.

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greater risk.”22 Similarly, the SEC accused three former executives of the New Century Financial Corporation of fraud, stating in its civil complaint, “The calculations [of bad loans] misled investors by implying that virtually all of New Century's borrowers had considerable equity in their homes, whereas, in fact, nearly one-third of New Century's borrowers had no equity in their homes whatsoever.”23 Fraud allegations were also directed at the investment banks that constructed and marketed the CDOs. In December 2009 Morgan Stanley was sued by a pension fund alleging that it collaborated with Moody's and Standard & Poor's in obtaining a AAA rating for a CDO backed by mortgages from New Century and Option One Mortgage. “The complaint asserted that Morgan Stanley knew the CDO's assets were far riskier than the ratings suggested, but was ‘highly motivated to defraud investors’ with pristine ratings because it was simultaneously ‘shorting’ almost all the assets....’Morgan Stanley was betting the entire investment it was promoting would fail’ ...’The firm achieved its objective.’”24 As former Lehman Brothers securities salesman Tom Ollquist stated, “I have blood on my hands.” 25 Although lenders operate under a variety of organizational forms, one common characteristic is that they operate through loan originators. The originators could be either loan officers employed by the lender in decentralized offices, as in the case of Countrywide's 1300 storefront offices and Washington Mutual's retail branches that between 2000 and 2003 grew by 70 percent to 2,200, 26 or independent mortgage brokers. Mortgage brokers accounted for 60 to 70 percent of the lending during the early part of the decade. Herbert Sanders, head of World Savings, said “You have to understand how independent brokers work. They are the whores of the world.”

Yet by 2006 independent brokers were accounting for 60 percent of World Savings' loan business.27 In most jurisdictions in the United States mortgage brokers do not have a fiduciary duty to borrowers. Consequently, a broker could originate a first mortgage knowing that the borrower would have to take out a second mortgage and would be unlikely to be able to make the payments on both unless the economy was strong. Similarly, a broker could require only a small down payment, increasing the likelihood that the borrower might walk away if housing prices fell. Or, a broker could originate a first mortgage with an adjustable interest rate knowing that it was unlikely that the borrower could meet the payments on the adjusted rate and would have to refinance, which could be problematic if the economy were weak or credit were tight at that time. Brokers thus could knowingly violate traditional lending standards by exploiting borrowers so as to maximize their income within the compensation structure provided by the lender.

Whether subprime lenders believed that their loans had a negative expected return at the time they were made is unclear, and the returns on subprime loans could have changed over time.

For example, in its fraud complaint against the three former Countrywide executives, the SEC stated, “Countrywide engaged in an unprecedented expansion of its underwriting guidelines and was writing riskier and riskier loans, ...”28 The SEC also stated, “By the end of 2006, Countrywide's underwriting guidelines were as wide as they had ever been, and Countrywide made 22

Securities and Exchange Commission, Press Release, June 4, 2009.

New York Times, December 8, 2009.

24 New York Times, December 30, 2009.

25 New York Times, September 13, 2009.

26 New York Times, December 28, 2008.

27 New York Times, December 25, 2008.

28 Securities and Exchange Commission, Press Release, June 4, 2009.

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an increasing number of loans based on exceptions to those already wide guidelines, even though exception loans had a higher rate of default.”29 In its fraud complaint against the former executives of New Century Financial Corporation, the SEC stated, “New Century's business was anything but ‘good’ and it soon became evident that its lending practices, far from being ‘responsible,’ were the recipe for financial disaster.”30 These complaints suggest that the expected return on some subprime loans was negative at least is the latter part of the bubble period.

The difficulties in avoiding writing high risk mortgages were in part due to the activities of brokers. Taylor Bean was fined $75,000 by the state of Kentucky for funding loans originated by unlicensed brokers. It also paid $9 million in a settlement with 14 states over “alleged improper lending practices that stemmed from weak internal controls on high-risk mortgages ...”31 Taylor Bean had a department to screen “out fraudulent loans, but they struggled to keep up with the flow of new mortgages. ‘It was kind of like trying to write speeding tickets on an eight-lane highway with a moped,’ says Craig Weitzel, who was the fraud department manager.”32 Lenders thus frequently had imperfect information about the practices of the brokers that originated the loans.

The expanded and more risky lending and the marketing of mortgage-backed securities sowed the seeds of their own destruction. The expanded lending was fueled by expectations of rising house prices, and as housing prices began to fall in 2006, some borrowers became delinquent on their mortgages and some walked away from their investments. At Lehman Brothers, Ken Linton “recalls vividly the days in early 2007 when his financial models began to throw up more warnings showing delinquencies and defaults, and he remembers colleagues on his desk raising questions about loan quality. But he said the firm's ranking as the top loan originator on Wall Street, not to mention the pressures put on the desk by Lehman's growth-obsessed leadership, made it difficult for even the most senior executives to raise questions, even a senior vice president like Mr. Linton.” 33 As an illustration of the information problem when lenders relied on brokers, Taylor, Bean “used short-term loans … to buy mortgages from a network of brokers and community banks that dealt with customers.”34 Moreover, lenders may have had difficulty identifying the quality of the loans the brokers initiated. Particularly with the prevalence of no-doc loans, assessing the brokers' lending decisions and inferring their type was likely to have been difficult and costly.

Many subprime lenders operated through independent brokers in the originate-to-distribute market, and brokers had strong incentives to originate loans. Monitoring of the origination decisions was difficult, as illustrated by the comment from the manager of Taylor, Bean's fraud department. Moreover, loan origination was subject to a variety of types of fraud by borrowers and brokers, as detailed by the Mortgage Asset Research Institute. According to CNNMoney.com, the fraud cases “include so-called ‘liar’ loans, in which mortgage professionals knowingly listed false income claims for borrowers; inflated appraisals, in which mortgage loan officers or brokers pressure appraisers to overvalue a home so it would qualify for a bigger mortgage; and false

29

Securities and Exchange Commission, Press Release, June 4, 2009.

New York Times, December 8, 2009.

31 New York Times, September 17, 2009.

32 New York Times, September 18, 2009.

33 New York Times, September 13, 2009.

34 Wall Street Journal, September 17, 2009.

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occupancy claims, which is when buyers claim they will live in a home but are actually buying it for investment purposes.”35

Cases Goldman Sachs and Its Reputation Goldman Sachs became a whipping boy of the media and Congress as a result of its active role in the financial markets leading up to their collapse and because of disclosures of some of its transactions. Goldman was a major player in financing mortgage lenders, constructing and marketing CDOs, and trading in securities on its own account. The company also reorganized as a bank holding company so that it could receive TARP funds. As conditions worsened prior to the collapse, Goldman had aggressively decreased its exposure to mortgage backed securities and had hedged its remaining risks with credit default swaps. It had aggressively pursued payments from AIG on CDSs, and its pressure was widely believed to have contributed to the failure of AIG, requiring a bailout by TARP. During the crisis Goldman outperformed other banks, remained profitable, and continued to have the highest average compensation of any bank.

The AIG, Abacus AC1, and Facebook episodes are well described and can each be discussed. The major unknown is whether these are isolated incidents or whether they are typical of Goldman’s conduct, which had not been disclosed.

Whether Goldman did anything wrong depends on whether its clients were sophisticated investors as Tourre and Blankfein suggest. But, even if they were, there is a question of whether fraud was involved, as the SEC charged. If the Abacus AC1 transaction was not fraud, it was a close relative, and Goldman was sufficiently concerned about facing a trial that it agreed to a settlement.

Another central issue is whether Goldman’s culture when its reputation earned from its investment banking business has been replaced by a trading culture emphasizing short-term profits.

The class discussion could address the extent to which Goldman’s reputation had been damaged and whether its clients’ views of the bank have been affected.

One consequence of the developments described in the case is that Goldman is now a focus of media attention with its actions widely reported. Goldman now lives in the eye of the media.

A central issue for the future is what effect Dodd-Frank will have on the bank, and how the bank will adapt to the final regulations.

Discussion questions: 1. Are Goldman Sachs’ problems ones of perception, as Blankfein indicated?

35

http://money.cnn.com/2010/4/26/real-estate/mortgage-fraud-rose/index.htm?source=cnn...

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2. Did Goldman do anything wrong in the AIG episode?

3. Did it do anything wrong in the Abacus AC1 episode?

4. In trading on its own account does Goldman look for counterparties that have “a view different” from its own?

5. Is it likely that there were other similar episodes that were never disclosed or were these idiosyncratic?

6. Did it do anything wrong in aggressively reducing its exposure to mortgage backed securities?

7. Was Goldman living up to its first business principle: “Our clients’ interests always come first.”?

8. Is part of the problem that the bank is run by traders, as John Whitehead implies?

9. As a client of Goldman Sachs would you be confident that it was putting your interests first?

10. Why did it attempt to skirt the SEC 500 investors rule in the Facebook funding? Was the SEC skeptical of the Facebook deal because of the Abacus and other episodes?

11. Has its reputation been damaged or does it remain the elite of the elite?

12. Are the recommendations of its Business Standards Committee sufficient to reassure clients and ensure that their interests come first?

13. Is there an inherent conflict of interests in try to serve four roles as advisor, fiduciary, market maker, and underwriter? Should it operated in its four roles at arm length?

14. How will Dodd-Frank affect the bank?

Update: Goldman’s profits have declined, and some commentators attributed the decline to less aggressive trading on its account. The bank stated that the lower profits were due to taking less risk.

Goldman was not the lead underwriter for the Facebook IPO. Whether Goldman would have done a better job than JP Morgan Chase and Morgan Stanley is not clear.

Goldman contributed $350 million to its charitable foundation in 2010, down from $500 million in 2009.

The British excess compensation tax was $600 million for Goldman.

Asset management involves investing other people’s money. BlackRock manages $3.45 trillion and Pacific Investment Management manages $1.3 trillion, whereas Goldman Sachs Asset Management manages $677 billion.36 Goldman is a major player in asset management, but is dwarfed by larger asset managers such as BlackRock.

The practice in the industry is not to tell a client on one side of a transaction who is on the other side.

With regard to the failure of AIG and Goldman’s role in the failure, a New York Federal Reserve official deleted a sentence from the RFP for the Maiden Lane III vehicle created for managing the TARP funds for AIG. The sentence mentioned that the CDS holders were paid in full. On 36

Institutional Investor (America’s Edition), December 2010.

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November 11, 2008 he explained, “As a matter of course, we do not want to disclose that the concession is at par unless absolutely necessary. In this case, not sure it is necessary because this has nothing to do with the ML III structure.” Congressman Darrel Issa (R-CA) commented, “It’s not conjecture, it’s not speculation, it’s fact, the New York Fed gave a back-door bailout to AIG’s counterparties and then tried to cover it up. The veil of secrecy that swept through the Fed embraced a mentality that treated transparency as a dispensable luxury rather than a moral imperative.” (House Committee on Oversight & Reform, no date).

Two quotations that could be used in the discussion are: “The world’s most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.” Matt Taibbi, Rolling Stone, 1082-1083, July 9-23, 2009.

I’m just a banker “doing God’s work,” quipped Lloyd C. Blankfein, CEO, Goldman Sachs, in an interview with the London Times, November 8, 2009.

Credit Ratings Agencies The credit ratings agencies play a role in the securities industry, although their role is not the typical one prescribed to them. The ratings are used less by sophisticate investors and more by unsophisticated investors as in the case of a municipal government agency. The ratings are also used in loan covenants under which the interest rate on a bank loan may be conditioned on maintaining an investment grade rating. Many institutional investors are required by law or regulations to invest only in investment grade securities. The ratings are seldom used by traders except, for example, when a trader is attempting to guess whether a bond, for example, will be downgraded. The credit ratings agencies did not anticipate the financial crisis and missed several crucial events such as the Worldcom collapse and the Lehman Brothers bankruptcy, as did investors. Whether and what to do about the credit ratings agencies was unclear, and Dodd-Frank largely delegated responsibility for new regulations on the agencies.

The current issuer pays model has the advantage of making ratings available to all investors, which can be valuable to unsophisticated investors. The system, however, has a number of weaknesses, such as ratings shopping and reliance on the issuer for data. Moreover, the agencies give their ratings models to the issuers, allowing them to engineer securities such as CDOs, to meet the minimum standard for an investment grade rating, for example. The principal criticisms of credit ratings agencies, however, are that in many instances they fail to predict well and that they are slow to revise ratings, as in downgrades. How ratings accuracy and timeliness can be improved is not obvious, and if there were improvements that could be made, competitive pressures would lead the agencies to make them. The chapter discusses in more detail the criticism of the credit ratings agencies and the boxed example “Unintended Consequences—Experts” illustrates the consequences that mistakes can have.

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The user pays model is attractive in principle, and two agencies (one of which is Kroll) used a subscription model. This model avoids many of the incentive problems inherent in an issuer pays system, but its weakness is that the agencies in all likelihood would be unable to generate sufficient revenue to cover the cost of producing the ratings. The reason is that the ratings are not useful to large and sophisticated investors, which have their own means of assessing risks. As Buffett said, they will not pay. (McGurn’s analogy to college guides is thus not a good one.) Whether there is enough demand among unsophisticated investor s to cover the cost is unclear, and if there were, the free-rider problem would plague the agencies.

The alternative of easing entry is something that the SEC has been doing in recent years, and smaller firms such as DBRS have been gaining market share through faster decisions on ratings.

This has been in the context of an issuer pays system, and many of the weaknesses of that system, such as ratings shopping would persist and perhaps intensify. Easing entry may well improve credit ratings performance, but it will not solve the problems inherent in an issuer pays model.

An alternative that addresses the ratings shopping problem is to have the SEC select the agencies to rate each security. The obvious problem with this alternative is determining the basis on which the SEC selects. Whatever would be chosen would be subject to lobbying pressure and lawsuits, and if Congress became involved, politics would prevail. Certainly the financial services industry would vigorously oppose further SEC involvement in ratings.

Removing the liability shield by, for example, designating the “opinion” of the agency as a judgment by an expert could shut down the credit ratings business, as the boxed example suggests.

Allowing fraud-like lawsuits under a “knowingly or recklessly” standard is a more cautious measure that would allow for lawsuits in instances of fraud. The agencies would likely respond to a change in the standard by bureaucratizing their ratings methods to satisfy the courts, providing little in the way of improved performance.

The SEC could act on its own as a result of the 2006 legislation, and it has taken the first steps to do so. It could even eliminate the requirement for a rating, i.e., remove the reference to credit ratings, for a new security. The alternative of eliminating required ratings is attractive because it would allow the marketplace to determine when and where ratings would be used. The alternative of having the government provide ratings is fraught with all the problems of government.

Moreover, the government cannot bring the same talent and expertise to producing ratings as the market can. There is little reason to believe that the government can do a better job than can the market.

The most attractive alternative seems to be to eliminate required ratings and let the market determine when and how ratings would be used and produced. One possibility is that if ratings are valuable to unsophisticated investors, they could form a body to assess risks or could rely on an agency which would be paid on a subscription basis. Whether there is sufficient demand would be determined by the marketplace.

Discussion questions: 1. Is the criticism of the credit rating agencies warranted?

2. Is the First Amendment protection sufficient for the credit ratings agencies?

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3. Evaluate the alternatives from a feasibility and public policy perspective 4. Which alternative should Moody’s support?

5. Which alternative is best from a public policy perspective?

Update: The credit ratings issue is sufficiently complex that little has happened to change the system. The most likely outcome is additional measures by the SEC, which could include reducing the types of securities for which ratings are required.

Update on lawsuits: The credit ratings agencies were sued by a large number of investors.

Pension funds in Wyoming and Detroit sued alleging that the ratings agencies had both provided ratings and assisted in the design of mortgage based securities. The case was dismissed in a federal court, and the plaintiffs appealed the dismissal. In a unanimous vote of a three-judge panel the Second Circuit of Appeals upheld the dismissal. In addition to upholding the free speech protection enjoyed by the ratings agencies, the Court ruled that the ratings agencies had not acted as underwriters. Moody’s said that since the financial crisis 20 lawsuits against the company had been dismissed or withdrawn.37

Citigroup and Subprime Lending This case has been used in Part V Ethics and Corporate Social Responsibility to examine the duties of a financial services firm operating in a market in which abuse was possible and frequent. 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 disclosure were complete and borrowers understood, there is nothing objectionable to the choice to borrow on the subprime market, according to utilitarianism.

It seems clear, however, that disclosure was not complete and that some borrowers did not understand the consequences.

37

Wall Street Journal, May 12, 2012.

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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.

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 was engaging in questionable practices. It also should have known that activist

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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.38 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.

38

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.39 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 (Hopea). 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.’”40 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 federal legislation to establish federal standards that would cover all banks. The draft bill was not 39 40

CitiFinancial, “Real Estate Lending Initiatives Progress Report,” October 2001.

New York Times, May 4, 2005.

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as stringent as the regulations in some states. The bill under consideration in the House had bipartisan support.

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Chapter 12 Environmental Management and Sustainability 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 usual restraints arising from limited budgets are not present. The politics of environmental protection thus involve powerful interests on both sides of the issues with environmental NGOs opposing businesses concerned about the cost of additional measures.

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 chapter. 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.41 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 remain uncompensated damages. This provides incentives for additional regulation and spurs the politics of environmental protection.

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

41

The Wall Street Journal, December 10, 1991.

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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.

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.

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 vice-president 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.’”42 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.”43 Sustainability is the underlying concern in Chapter 13 which focuses on renewable power.

Environmental and sustainability cases in the book in addition to those in this chapter include Personal Watercraft aka Jet Skis (Chapter 2), Shell, Greenpeace, and Brent Spar (Chapter 4), Anatomy of a Corporate Campaign: Rainforest Action Network and Citigroup (Chapter 4), BrightSource Energy: The Challenges (Chapter 13), Silver Springs Networks and the Smart Grid (Chapter 13), T-Solar and the Solar Power Market (Chapter 13), The European Union Carbon Tax (Chapter 15), Apple and Private Politics in China (Chapter 16), and Environmental Injustice?

(Chapter 22).

42 43

The New York Times, September 20, 1992.

San Jose Mercury News, March 12, 2002.

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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.”44 “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.”45 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.”46

Cases Pacific Gas & Electric and the Smart Meter Challenge This is a case about implementation of the installation of a technology intended to contribute to sustainability goals and provide major cost efficiencies. Smart meters are at the heart of the consumer side of a smart grid and enable demand response pricing. The meters, however, have 44

The Wall Street Journal, April 17, 1991.

Boston Globe, April 17, 1991.

46 The Wall Street Journal, April 17, 1991.

45

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encountered considerable opposition, particularly in California, which as one commentator observed is home to lots of strange views. The challenge for PG&E is to address the complaints and opposition in a tightly regulated and media sensitive environment.

The complaints took a variety of forms. Concerns were raised about privacy, violation of rights, government control (conspiracy), EMF and EHS, and billing errors. Perhaps the most important for smart grid efficiency was that the meters will not shift demand and hence represent a costly and unneeded technology that will only reduce metering and billing costs. Demand shifting may not result because of timid regulators fearful of public reactions and placing burdens on people who, for whatever reason, do not shift their demand.

Regulators in a number of states have expressed an unwillingness to price peak load electricity at its (high) cost, preferring to offer discounts to customers who shift demand. Discounts work in the right direction, but cannot be large enough to have much impact. Regulators fear that if consumers do not shift their demand and peak load prices are used, consumers will have higher bills and complain to not only the regulator but the state legislature and governor. Regulators also worry about burdening the poor and elderly who might be unable to shift their demand, although many states have programs to help the poor and elderly with their utility bills.

The complaints and timid regulators mean that the gains from smart meters and a smart grid could be substantially lower than projected.

Some complaints, such as those about billing errors, were investigated and shown to be unfounded, but anger among some customers remained. PG&E’s Devereaux has already compromised the credibility of the company’s efforts to address the complaints. Dealing with EMF and EHS is more difficult, since the evidence is clear, but some people will never believe the evidence. The natural reaction may be to ignore them, but they can take, as they have done, their beliefs to the media, town councils, state legislators, and the regulatory commission. As the PUC did, one means of quelling their anger is to allow them to opt out of the smart meter program. Two issues then remain. First, how many will opt out and how badly will efficiency be impacted. Second, how much should they pay to opt out? The answer to the former depends on the latter. The required payment has to at least cover the cost of bypassing the smart meter and sending someone to read the meter or replacing a smart meter with an electromechanical meter. Economics principles indicate that they should also pay for the inefficiency their failure to participate in the smart grid causes. This could be high. If the cost of opting out is high, the complainers will have their willingness tested. The interests of the regulators and PG&E should be aligned on this issue, since the regulators would like participation to be as broad as possible.

Discussion questions: 1. Are the complaints about the smart meters valid?

2. Can the complaints be ignored?

3. Would you have fired Devereaux?

4. What should PG&E do about the complaints about EMF? 5. Why are the regulators so unwilling to use peak-load pricing for consumers?

6. What kind of opt out opportunity would you propose to the California PUC?

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7. How should PG&E determine the opt out charge; i.e., what costs should it take into account?

8. As PG&E do you support Joshua Hart’s call for a moratorium and public hearings?

Update: PG&E proposed an opt-out option of an analog meter at a one-time cost of $270 and $14 a month thereafter. The PUC reject the proposal and proposed a one-time fee of $90 and $15 a month, but its final order was a one-time fee of $75 and a monthly charge of $10 a month, and for low income customers the cost was $10 and $5 a month. With only a couple of days left before the May 1, 2012 deadline for opting out, only 20,000 out of some 9 million customers had opted out.

In May 2011 PG&E announced that it had found 1,600 defective Landis+Gyr meters that ran faster than they should have. PG&E said it was a “rare defect” representing less than 0.1% of the 2.1 million Landis+Gyr meters installed. A PG&E spokesperson said, “In a nutshell, Landis+Gyr sent us a small number of meters with a defect that cause them to run fast when they operate at high temperatures, and they may miscalculate energy bills.”47 Customers affected were given a new meter, a rebate that averaged $40, and a $25 “customer inconvenience” credit on their next bill.

Mark Turney, executive director of TURN, said, “The meters themselves alerted PG&E to the fact they weren’t running properly, which makes them look smarter than PG&E, which has ignored customer complaints for too long.”48 Toshiba announced in May 2011 that it would acquire Landis+Gyr for $2.3 billion.

Environmental Justice and Pollution Credits Trading Systems 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 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.

47 48

San Jose Mercury News, May 3, 2011.

San Jose Mercury News, May 3, 2011.

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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 system is 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 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

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a utilitarian outcome such as point C in Figure 22-7 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 claims about the distribution of pollution reduction are 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 22-3. 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 12 and 14. 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.

Teaching the case: 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?

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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 than 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.

Environmentalist versus Environmentalist Environmentalists had pushed hard for AB 32, and the ARB chose a cap-and-trade system to reduce emissions to 1990 levels by 2010. A cap-and-trade system was being used in the U.S. for SO2 and NOx emissions, in the European Union for reducing CO2 emissions, and under the Kyoto Protocol for greenhouse gases emissions. As the case indicates the system was opposed by California special interest groups with the old environmental justice refrain, claiming that the capand-trade system would allow polluters to increase their emissions and endanger vulnerable communities. (See the chapter case Environmental Justice and Pollution Credits Trading Systems and the discussion in this Manual.) The groups sought command-and-control regulation with the “maximum technologically feasible and cost-effective reductions.” The interest groups also supported a carbon tax that they apparently believed would force all polluters to reduce their emission. The groups took their cause to the California courts, which rejected the command-andcontrol approach but held that the ARB should have justified more fully its rejection of a carbon tax.

The interest groups also objected to the offsets alternative incorporated in the cap-and-trade system.

Offsets were permitted under the Kyoto system and were widely used in the European Union. The groups objected to the offsets because the benefits from the reductions in emissions could accrue to people in other states rather than to Californians. Although the cap-and-trade system primarily

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pertained to CO2 emissions which would equally benefit everyone, the interest groups argued that when CO2 emissions were reduced, other harmful pollutants would necessarily be reduced benefitting Californians.

Emitters had strong incentives to oppose a carbon tax because that would impose a distributive burden on them. They, however, were confident that the ARB would reject a carbon tax as it had in the first place.

Although the author of AB 32 referred to the claims of the interest group as “false assertions,” the groups repeated their allegations and applauded the court’s decision.

Discussion questions: 1. What underlies the objections of the California Communities Against Toxics and the Communities for a Better Environment?

2. What kind of regulation do they want?

3. Are their objections warranted?

4. Did Judge Goldsmith decide the case correctly? Should he have required a carbon tax?

5. Is a carbon tax better or worse than a cap-and-trade system?

6. What effect is the cap-and-trade system likely to have on the California economy?

Update: The ARB adequately justified its cap-and-trade decision, and the regulatory system went into effect in mid-2012. One concern with the regulation was that it would increase the marginal cost of emissions substantially and thus increase the cost of doing business in California. With an unemployment rate of 10.8 percent in June 2012, 2.6 percent above the national average, increasing costs could drive more jobs out of the state.

Many companies that would be subject to the cap-and-trade system did not vigorously oppose it because they understood that the allowances would be allocated to them without a charge. With the state of California having huge budget deficits activists began arguing that all the allowances should be auctioned rather than given for free to the emissions sources. The companies obviously opposed the proposed change. The ARB did not change its proposal which called for the auction of only a small proportion of the allowances with companies receiving their allowances for free. The scope of the cap-and-trade system is to expand in 2015 to include the transportation and natural gas sectors. The revenues from the auction are expected to increase substantially at that time.

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Chapter 13 The Investor’s Perspective: Renewable Energy This is a new chapter that takes a different perspective from the rest of the book. Instead of focusing on the management of firms in their market and nonmarket environments, this chapter adopts the perspective of an investor such as a private equity firm that is considering making an investment in a post-start-up firm. The concern of the investor is with the opportunities and risks associated with the investment in various firms. The focus in the chapter is on firms in the renewable energy market and on nonmarket risks. That industry was selected because of its longrun importance and because it largely survives due to government subsidies. Those subsidies are subject to nonmarket risks that have been heightened by large government budget deficits. Some of those subsidies have supported producers of wind units and solar panels, and the U.S. production is subject to market forces arising in low cost countries, primarily China. Companies in the United States are thus subject to both market and nonmarket risks.

The availability of government subsidies attracted large amounts of venture capital and private equity funds that provided the equity for numerous start-ups and growing firms. In addition to these firms several large European companies operated in the United States. It is from the perspective of venture capital and private equity funds that the chapter was written.

Not all subsidies are equal. Subsidies can be granted on the demand and supply sides of the market. The former generate demand for solar panels and wind turbines that can be produced anywhere, and as in many industries production has moved to China. Supply side subsidies are targeted to producers, and the Obama administration has aggressively pushed funds out. As of mid-2012 when this is being written, the producer subsidies have not been successful. Solyndra was selected as an example (prior to its bankruptcy) because of its comment that the cost of its solar units was high, placing it in a potentially uncompetitive position.

Not all subsidies are alike. The grants and loan guarantees provided by the federal government are subject to budget pressures, as well as public politics pressure arising from failures such as Solyndra. Demand-side subsidies for installation of solar panels are perhaps less vulnerable because they generate installation jobs that cannot be lost to foreign suppliers.

Also, not all subsidies are subject to budget pressures. Subsidies provided through high feed-in tariffs for solar and wind power producers do not affect budget deficits. Instead, the subsidies are borne by the customers of the electric power. The high feed-in tariffs required to make renewable power viable are spread among all consumers of electricity and are hard to identify. These tariffs, however, are subject to the risk that customers will complain about the high prices and move to states with low electricity costs. This has happened in Europe, which had caused countries to reduce their feed-in tariffs for new projects and in the case of Spain to unilaterally reduce the tariffs for existing solar producers. (See the chapter case T-Solar and the Solar Power Market and the discussion in this Manual.) In the United States the risk to companies dependent on high feed-in tariffs is the cost of alternative energy sources. Natural gas is now plentiful and projections are that it will remain so for 100 years. Natural gas is a relatively clean fossil fuel, and its low price means

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that the marginal cost of power is low. The cost of the power from proposed renewable power projects should be compared to that cost.

A lecture on the market and nonmarket opportunities and risks in renewable energy can be structured around Figure 13-1.

Subsidies for solar and wind power are justified by the reduction in environmental externalities and security considerations, but the remaining question is how large the subsidies should be. The subsidies have been quite large in the United States in part because of special interest groups and politicians claiming credit for the subsidies. Recipients on the supply side are organized, and those in the labor-intensive installation industry are beginning to organize. The rhetoric coming out of Washington is that the subsidies create jobs in a time of high unemployment, providing another source of support for the subsidies. The economics and politics of subsidization would be a good topic for a lecture.

Manufacturers of wind turbines and components were predicted to lose 10,000 jobs in 2012, and if the renewal of a price premium of 2.2 cents per kilowatt hour for 10 years granted to producers were not renewed, more jobs would be lost. Steven Lockard, CEO of TPI Composites, said, “Without an extension this industry is going to be in real trouble.” 49 The loss to the government from the Solyndra loan guarantee was less than half of the loss to private investors, who had invested over $1 billion in the company.

Investigations of the Solyndra failure were ongoing, and whether they would uncover any improprieties was unclear. In an election year the Republicans in the House were aggressively pursuing the issue. The oversight and investigations subcommittee of the House Energy and Commerce Committee issued a subpoena for documents relating to the $535 million loan guarantee. The subcommittee majority said that the Office of Management and Budget had rebuffed its requests for the documents, and OMB denied it. Solyndra’s president Brian Harrison reported that 2010 revenue was $140 million and that the company had added 300 jobs and suppliers since receiving the guarantee.50 A review by the Inspector General of the Treasury Department concluded that the Department’s review of the Solyndra loan guarantee was “rushed.” The Department was not consulted until the very end and had only “about a day” to finish its review.51 Solar panel producers continued to fail. Solar Millenium A.G. of Germany declared bankruptcy in Germany in December 2011. Solar Millenium’s Solar Trust of America declared bankruptcy in the United States in April 2012, listing assets of approximately $100 million and debts of approximately $500 million. Solar Millenium was constructing the 7,000 acre Blythe, California project, one of the largest in the world.

49

Bloomberg Businessweek, June 11-17, 2012.

San Jose Mercury News, July 15, 2011.

51 San Jose Mercury News, April 5, 2012.

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In addition to Solyndra’s bankruptcy Abound Solar, a solar-panel manufacturer in Loveland, Colorado, declared bankruptcy and suspended operations in June 2012. The company had received a $400 million loan guarantee from the Department of Energy, but had borrowed only $70 million Earlier Beacon Power of Massachusetts, a maker of energy storage devices, declared bankruptcy, owing the government $12 million.

Competitive pressures were felt by other U.S. producers as well. In February 2011 MiaSole raised $106 million from venture capital funds, and the implied valuation of the company was less than half its value in 2008.

A topic for a lecture and discussion is the trade dispute between China and the United States.

China initially sought to defuse the solar panel trade cases by stating that Chinese solar panel producers were considering moving some production to other countries including the United States.

One Chinese producer was said to be seeking to have an Oregon company to do the final assembly of its solar panels sold in the United States. China was also considering filing a trade complaint against the United States in retaliation. Speculation was that the case would focus on the export of polysilicon to China. Both sides filed trade complaints in 2012. Some commentators argued that the U.S. trade complaint could have been politically motivated in an election year.

The environmental pressures on solar power producers would also be a good topic for a lecture.

These pressures are discussed in the BrightSource Energy: The Challenges case. The government was reconsidering its policies for the use of public lands. “A Bureau of Land Management official said Thursday the department anticipates eliminating and reducing some zones.” The government had identified 24 solar development zones.52

Cases BrightSource Energy: The Challenges This case illustrates the risks associated with large solar projects. The risks are associated with the market (the cost of power from other sources including natural gas and photovoltaic plants), the environment (desert tortoise), Native American culture, regulation (the feed-in tariff), and politics (the threat in the House to the loan guarantee program). The opportunities for BrightSource were provided by the ready availability of capital from private investors and the government and the popularity among the public of the concept of renewable power. The opportunities were immediate, and Goldman and the company seized them.

The subsidies included the value of the $1.37 billion loan guarantee without which the project would not have moved forward, the 30 percent cash reimbursement for construction costs under the 1603 program, and the undisclosed feed-in tariff. The tariff was set relative to other RPS projects, so it was clearly substantially higher than the average or marginal cost of power. The analyst for 52

San Jose Mercury News, July 15, 2011.

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Bloomberg estimated that the cost was 75 percent higher than the cost of power generated from natural gas, and the price of natural gas was continuing to fall.

The environmental challenges focusing on the desert tortoise were well understood by BrightSource and the federal government, but putting the issues in the courts posed a risk of delay and possible other requirements regarding mitigation and protection. It is important to observe that it takes only one environmental group to file a lawsuit, and the fact that other environmental groups such as the Sierra Club have given their (grudging) support to the Ivanpah plant does not prevent lawsuits. Although the lawsuit has been filed, project construction proceeds unless the judge issues a preliminary injunction.

The cultural challenge by the Native American group was innovative and has been repeated against other projects. Whether these claims will win out in court is unclear, but the lawsuit poses a risk to Ivanpah and other solar projects on public lands. Because this claim is novel, it is unlikely that a court would issue a preliminary injunction.

The risk to the loan guarantee program is real, but it is likely to survive because of the Democrat’s majority in the Senate. It is politically attractive in an election year for the Republicans to call attention to the Solyndra case, but elimination of the program in the short-term seems unlikely.

The type of nonmarket and political analysis used in the chapter supports this conclusion. In any event BrightSource already has its loan guarantee, and it is unlikely that the political opposition to the program will be sufficient strong to rescind the guarantee. Nevertheless, it is helpful to have Goldman lobby in Washington.

The risk to the long-term contracts is that the price paid for the power is subject to PUC approval.

Although the PUC is a strong supporter of renewable energy as is a majority of the public in California, it is possible that the high cost of electricity will generate pressure for lower feed-in tariffs. Whether the contracts have been written to protect BrightSource is unclear.

Additional risks are associated with possible cost overruns in the construction of the Ivanpah plant.

Discussion questions: 1. How attractive are the opportunities for BrightSource?

2. How large are the subsidies to the Invanpah project?

3. Identify the risks BrightSource faces and assess how likely it is that an unfavorable outcome will result.

4. What should BrightSource do to reduce the risks?

5. What are the implications of market forces for BrightSource beyond the Ivanpah project?

Update: How successful BrightSource will eventually be remains to be seen. Investors and the capital market have become less optimistic. Due to the turmoil in the stock market, BrightSource postponed its IPO in 2011. The company announced in 2012 that it would go public, but the day before the scheduled offering it withdrew its offering because of a lack of demand for its shares.

As of mid-2012 construction was well underway on the first part of the project.

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The magnitude of the feed-in tariff subsidy for the Ivanpah project is not public information at this point.

It is unclear at this point in time whether the solar thermal technology will prove to be cost effective. The alternative mentioned in the case of using solar panels becomes more and more attractive as their cost decreases.

Silver Spring Networks and the Smart Grid In contrast to Solyndra, Silver Spring Networks was selected as a case subject because I thought it would be a survivor. I spent several months trying to get access to the company to write the case from the inside, but despite their initial enthusiasm for the case project, it never materialized. It may have been to its performance as indicated in the update below. The case was written from public sources.

SSN makes software for the smart grid, and the company had received numerous awards for its technology. Its software links the components of the smart grid, allowing utilities and grid owners to better manage the flow of electricity. Its software is also used in smart meters including household demand response technologies such as a smart thermostat. Its principal customers were utilities and grid owners, and they were mostly regulated.

The efficiency gains projected for the smart grid were huge and were projected to be realized by 2020. The potential market for software was substantial, but SSN faced market risks. It faced substantial competition from other small companies and from large companies such as Cisco and IBM. The company also faced nonmarket risks. Subsidies were provided for smart grid projects through the Obama administration’s stimulus program, and it was uncertain whether those subsidies would continue. They were threatened by the large federal budget deficit.

SSN also faced the nonmarket risk associated with the rebellion against smart meter installation by Pacific Gas & Electric, SSN’s largest customer. See the preceding discussion of that case in this Manual. SSN could play a role here by lobbying the PUC by providing information on the cost savings that could be realized.

The more important nonmarket risk stemmed from the reluctance of state regulators to use responsive pricing. Regulators were fearful of two things. First, higher rates during peak times could result in complaints, particularly if the customer did not shift its demand. Second, vulnerable customers, including the poor and the elderly, could be adversely affected. This is the key concern for SSN, since the household market is threatened by both concerns. SSN is too small to mount a nonmarket campaign, but it can join with its customers to lobby the regulators to go ahead with responsive pricing. The role of SSN in the lobbying would be to provide expertise on implementation of smart grid applications. Influencing the regulator would be a challenge in many

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jurisdictions, however, since its effectiveness depends on the quality of the relationship between its customer and the regulator. Power companies were frequently the focus of private as well as public politics, and regulators were sensitive to both.

The broader issue is whether the reality of the smart grid lives up to its promise. The immediate issue is about the pace of projects and applications and when and whether the benefits will be realized.

Discussion questions: 1. What market risks does SSN face?

2. What nonmarket risks does it face?

3. Should it implement a nonmarket strategy or rely on its customers to deal with challenges and advance the realization of the promise of the smart grid?

4. If it is the former, what should it do?

5. How attractive an investment opportunity is SSN? It had never made a profit and has accumulated losses of $450 million. Its annual revenue in 2011 was projected to be $200 million.

Update: Due to the turmoil in the stock market and its weak financial performance, SSN postponed its IPO in 2011. It had planned to raise $150 million. Foundation Capital owned 41.5 percent of the company.

For the first quarter 2012 SSN had sales of $55.5 million and a loss of $18.4 million, compared to a loss of $33.4 million in the same quarter 2011. SSN has an accumulated deficit of $479.2 million, but has considerable deferred revenue on its contracts with utilities. Whether and when SSN will be profitable is unclear. It has raised additional capital from private sources, and how long that will be possible is also not clear. There are no indications as of mid-2012 that it plans again to try an IPO. The company’s customer list continues to grow, and it continues to receive awards.

T-Solar and the Solar Power Market T-Solar both manufactures solar panels and produces power in solar farms. The Spanish company has expanded its power production business into Italy, India, and Peru. The company grew rapidly, and its prospects flourished in the booming Spanish and broader European solar market. The solar power markets were booming due to extremely generous government subsidies for solar power.

The boom was interrupted by the financial and economic crisis in Spain, which originated in an overheated housing market. The bubble in Spain burst in 2007. Moreover, an economic and financial crisis developed broadly in the southern tier of the European Union as Greece, Ireland, and Portugal had to be rescued. (The Euro crisis is discussed in Chapter 15, and the chapter 15 case

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The Euro Crisis provides additional information.) The generous subsidization was no longer sustainable.

The crises in Spain and in the Euro zone threatened the generous feed-in tariffs that solar power producers had enjoyed. Spain and other countries reduced their subsidization of new solar projects, and Spain announced that it was preparing to reduce the feed-in tariffs in contracts already in effect. This retroactive lowering of the feed-in tariffs threatened T-Solar, causing it to withdraw its IPO. The Czech Republic took a different approach to the costly tariffs. It announced that it would tax the tariffs, in effect reducing the existing tariffs by 26 percent. Whether other countries would do the same was not yet clear.

T-Solar and the rest of the solar power sector faced a major nonmarket risk, and began to work through the EPIA to obtain limits on any reduction in tariffs. EPIA focused on the European Union and proposed a “corridor” for tariffs so that uncertainty could be reduced. T-Solar could participate in EPIA’s efforts, but in Europe industry associations do much of the work in the nonmarket environment.

T-Solar was a prominent company in Spain, and undoubtedly had the opportunity to lobby the government. The previous socialist government that had provided the subsidization was defeated, and the new government had pledged to reduce the government budget deficit, which had reached 11 percent of GDP. T-Solar’s manufacturing operations were also threatened by competition from China, which had become the low cost supplier.

Discussion questions: 1. How serious are the changes in the government support for solar power in Europe?

2. What does Spain’s reductions in feed-in tariffs on existing contracts do to T-Solar’s ability to raise capital in Europe? How are power projects financed?

3. How should T-Solar finance its projects in Italy, India, and Peru?

4. What nonmarket actions should Laso and T-Solar take to deal with the changing environment in Europe?

5. As a private equity firm would you invest in T-Solar?

Update: In addition to reducing the feed-in tariffs for new renewable power projects, the Spanish government reduced the feed-in tariffs on existing contracts of companies including T-Solar.

Whether T-Solar is profitable is not publicly known. It is also not know how leveraged the projects in Italy, India, and Peru are.

Solar projects are complicated organizationally. For example, the $165 million project in Peru is financed by $131 million is senior debt provided by OPIC, an agency of the U.S. government.

OPIC made the loan to Conduit Capital Partners which has a portfolio of loans and investments in the independent electric power industry in Latin America. T-Solar is the “developer” of the project, which will use the “SunFab” technology T-Solar purchased from Applied Materials. It is not clear what share of the project T-Solar owns.

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Chapter 14

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 12 provides one framework for understanding contracts and remedies for breach, as developed by Polinsky (2011).

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.

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 21. Justice considerations may also be relevant as considered in Chapter 22.

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 14-4, 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 12, 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 21.

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#anchor887148.53 Motorists claimed that Toyota and Lexus models suddenly accelerated causing accidents. The National Highway Traffic Safety Administration investigated the complaints and found three causes of the sudden acceleration. One was a sticky gas pedal, which was rejected as an explanation by the manufacturer of the pedals. The second was that floor mats could be dislodged and cover the gas pedal resulting in unexpected acceleration. The third, and what the public undoubtedly believed in the firm place, was referred to by NHTSA as “pedal misapplication.” That is, the drivers hit the gas pedal when they thought they were hitting the brake. NHTSA found no defect in Toyota’s electronics.54 Secretary of Transportation Ray LaHood concluded, “The jury is back. The verdict is in. There is no electronic-based cause for unintended high-speed acceleration in Toyota’s.”55 Joan Claybrook, former head of NHTSA and president emeritus of Public Citizen, criticized her former agency, saying, “I think it’s a failure of evaluation because there are so many cases where there are so many 53

San Jose Mercury News, May 9, 2002.

Wall Street Journal, February 9, 2011.

55 New York Times, February 9, 2011.

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cases where there was no problem with the floormat and it was clear the vehicle had runaway on its own. It has to be some vehicle related malfunction. The failure to find that is a failure of analysis.”56 Claybrook apparently viewed drivers as infallible and was unpersuaded by NHTSA having brought in a scientist from NASA to help conduct the study. Toyota’s shares increased 4 percent on the day of the announcement.

Music Piracy After 5 years of litigation the music publishers and LimeWire settled the lawsuit filed by the publishers. The publishers and the Recording Industry Association of America had alleged that LimeWire was running a web site for the purpose of piracy. The plaintiffs had sought $1.4 billion and settled for $105 million. The court had earlier found LimeWire and founder Mark Gorton guilty of copyright infringement. The judge ordered LimeWire to shut down and the company did at the end of 2010.

Cases California Space Heaters, Inc. (A) 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 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

56

Wall Street Journal, February 9, 2011.

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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 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.

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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?

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.

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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 19. 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 21 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.”57 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.”58 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.59 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 33,746.60 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 stand on this greatly reduced number and whether obesity is truly worse than the Black Death, as you have stated.”61 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.

61 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.”62 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 62

San Jose Mercury News, January 26, 2005.

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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.63 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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Part III Integrative Case Spectrum for Wireless Broadband: Old Media versus new Media This case concerns the ongoing issue of the allocation of spectrum to accommodate wireless broadband. The FCC had already reallocated the white spaces (see the boxed example in Chapter 2) and proposed providing an additional 500MH, with 120 MH coming from TV broadcasters. The spectrum currently allocated to broadcasters was ideal for wireless broadband. In his 2011 budget proposal President Obama called for the use of “voluntary incentive auctions” for the reallocation.

The FCC had used auctions on numerous occasions, and in those auctions the proceeds went to the government. In the case of spectrum currently used by broadcasters the spectrum was owned by the government and it could wait until the broadcast licenses expired and then conduct an auction as in the past. With the explosion in the demand for wireless broadband waiting was not an attractive option, and the broadcasters would surely sue the government further delaying the reallocation. In a voluntary incentive auction broadcasters rather than the government would receive the proceeds; this is the incentive. This would establish a de facto property right to the spectrum, and the FCC did not have authority to do so, so Congress had to pass a law granting that authority. The auctions would be voluntary. That is, the TV broadcasters were not required to make spectrum available for auction.

The broadcasters through the NAB opposed the idea of voluntary incentive auctions presumably because they feared that if not enough was made available the government would then seize the additional broadband it sought. The broadcasters were also opposed to the inevitable repacking of the remaining broadcast spectrum. The number of people watching broadcast TV was believed to be between 10 and 15 percent and the number had been falling, so the weight of interests was against the broadcasters.

The NAB advanced two kinds of messages to support its position. One emphasized the importance of free TV to viewers and to the community, as in the case of an emergency, and the need to avoid interference. It also pointed to innovations such as HDTV coming from the broadcast industry.

The other pointed to adequate capacity except in New York and Los Angeles and identified alternative sources of spectrum capacity for wireless broadband, substitutes in the terminology of Chapter 6.

The most obvious means of freeing up capacity would be for carriers such as AT&T and Verizon to price based on usage. A small number of users used a very disproportionate share of capacity for video, for example. Pricing based on usage had largely been avoided by the carriers for fear of losing customers. (By 2012 carriers had begun to charge higher prices.) The carriers could also build more towers, add femtocells, and manage their capacity more efficiently. The NAB backed their case with a study.

The wireless carriers also mounted a nonmarket campaign, and the CEA conducted a survey showing strong public support for reallocating broadcast spectrum. As the issue moved to Congress the usual lobbying strategies were employed.

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A central issue in the design of a voluntary incentive auction is what share of the proceeds the broadcasters would receive and what share the government would receive. The NAB’s objective is to obtain as large a share as possible, and its nonmarket strategy can be thought of as trying to establish bargaining power to gain a larger share. Billions of dollars are at stake.

The interests of the broadcasters, the wireless carriers, and the device manufacturers are apparently aligned on the share issue. The higher the share that goes to the broadcasters the more spectrum they will make available. Also, the lower will be the auction price, although the total revenue should be greater.

One issue for discussion is how an auction should be designed. For example, can the broadcasters set a reservation (minimum) price for the spectrum they make available. The auction would have to be voluntary, but the FCC could indicate what would be done if enough spectrum were not made available.

A point that could come up in the class discussion is that the wireless carriers might have to pay more in a voluntary auction than if they waited for the licenses to expire. However, the spectrum was made available, there would have to be an auction, and while waiting capacity crunches could develop, resulting in even higher prices in the auction. The wireless carriers and companies such as Apple and Google wanted the capacity to be available as soon as possible.

The weight of consumer, and hence voter, interests is clearly with the wireless carriers and the FCC, and they should prevail in Congress. This is the arena in which the share of the revenue should be decided.

Attention then would turn to the FCC, and both sides were experienced in that arena. They had recently gone through a similar episode in the reallocation of the white spaces, and the strategies deployed should be more or less the same. The broadcasters will attempt to get assurances about the auction being truly voluntary and obtain assurances that repacking will not be disadvantaged.

The FCC will have to identify how the repacking will be done, and the broadcasters are likely to get more or less what they want on the repacking.

Discussion questions: 1. Why don’t the wireless carriers charge for usage?

2. As Apple and Verizon are you satisfied with the FCC’s plan for a voluntary incentive auction?

3. As a broadcaster what would you hope to achieve through your opposition to the FCC plan?

In Congress and in the FCC? 4. As the FCC what share of the proceeds from an auction should go to the broadcasters?

5. As Apple and Verizon what share of the proceeds would you advocate should go to the broadcasters?

6. What is the likely outcome?

Update: In February 2012 Congress passed a law granting to the FCC the authority to conduct voluntary incentive auctions. As of mid-2012 the FCC had not announced an auction.

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PART IV GLOBAL NONMARKET STRATEGY

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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.

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 14 and 9, 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 19.

The introduction of the euro has highlighted a number of nonmarket issues in the EU. One is that with a common currency the differences 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 a automobile company had more than 10 percent to 15 percent of the market. The automobile companies were expected to opposed 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.

In June 2012 the General Court upheld the verdict against Microsoft, which had appealed, and set the fine at €860 million. Microsoft had already paid €778 million.

Cases The European Union Carbon Tax

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 242

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.

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 12. 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.

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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 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

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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.)

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.

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. The chapter discusses the effectiveness of the

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The European Union Data Protection Directive (B) This case follows on the case The European Union Data Protection Directive (A), which appears in earlier editions of this book. It considers the second round in the EU’s measures to protect personal information. The continued development of e-commerce, the use of mobile communications and smart phones, the growth of social media, new technologies such as GPS location and image identification, more sophisticated tracking of Internet activity, and a host of other developments had revealed the inadequacy of the 1995 Directive. A number of other countries that interact with the European Union on a regular basis had complied with the EU regulations, whereas the United States had negotiated a safe harbor agreement with the EU as discussed in the (A) case. The United States continued to rely on self-regulation and social pressure rather than regulation.

Commissioner Reding has made strong statements about protections to be incorporated into the new directive. (The Treaty of Lisbon formalized a right of privacy that had existed outside the treaties of the EU.) She sought improved safety of PII and advocated informed consent to any data collection. This would require opt-in and perhaps also opt-in for individual actions on the Internet or through mobile communications. She would also likely advocate a right to be forgotten. The Working Party of JUST advocated a strict agreement with the United States to replace the safe harbor agreement. The EU again sought to extend its policies to third countries with which its citizens interacted.

The 1995 directive had an adverse effect on the development of Internet commerce, and the revisions advocated by Redding had a further chilling effect. Industry in the EU opposed opt-in, and Professor Tucker estimated that advertising effectiveness was much lower in the EU than in the United States as a result of the 1995 directive. Opt-in would further reduce effectiveness. Without effective advertising many Internet companies would be severely limited. The prospects for an EU industry would be further dampened by a stronger directive based on opt-in and other measures.

Opt-out is the prevailing practice in the United States.

One of the most difficult issues pertains to third countries. The EU has been accused of imposing its laws on other countries and the Working Party specifically called for a “strict” agreement with the United States. The American Chamber of Commerce to the European Union filed a 42-page brief with the commission warning against revisions to the directive that would inhibit the free flow of information.1 The U.S. has never adopted federal legislation or regulations on data protection or Internet Privacy and seems unlikely to do so in the near future. The Internet and the flourishing of mobile communications have given rise to innovation and new ventures that have transformed the way people conduct their lives. It is little wonder that the most valuable companies in the world have grown up in this space. The U.S. government seems unlikely to take measures that would stifle this innovation and growth, and while the U.S. public expresses concerns about data protection and privacy, the behavior of most people belies those concerns. See the Chapter 20 case Facebook and Internet Privacy for additional information.

1

New York Times, November 10, 2011.

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The approach taken in the United States seems sure to clash with a new EU data protection agreement as in the case of the 1995 directive. This implies that there will be negotiations on a new agreement, and the positions of the two governments will be little different than in the 1995 negotiations. The bargaining strength of the United States arises from the strength of its companies and their innovations, whereas the strength of the EU is due to its ability to enforce its directives of companies doing business in the EU. The United States prevailed in the 1995 negotiations, and it may do so in the second round. An impasse, however, seems more likely.

Discussion questions: 1. How broadly should PII be defined? Does it include a picture of one’s home in Google’s Street View?

2. Should Reding write opt in, a right to be forgotten, and other strong measures into the new directive?

3. What ate the implications of a strengthened data protection directive for the formation and growth of e-commerce, social media, mobile broadband, etc. companies in the EU? Will EU companies become leaders in these lines of business?

4. Would U.S. citizens support U.S. law imposing the same privacy protections as in the new EU directive? Are they satisfied with current practices?

5. Is the United States likely to concede to the EU’s demands on the PII protections of a revised directive?

6. What is the likely outcome of negotiations between the EU and the U.S.?

Update: As of this writing in mid-2012 a revised directive has not been issued.

The European Union Data Protection Directive (A) The following is a discussion of the (A) 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.”2 American Express reached a similar agreement with several countries. An official with the Data Protection 2

Business Week, November 2, 1998.

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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.”3 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.”4 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.”5 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 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 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 Safe Harbor Principles that can be found on the Department of Commerce Web site given later.

3

The New York Times, October 26, 1998.

San Jose Mercury News, October 26, 1998.

5 Business Week, November 2, 1998.

4

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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 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.6 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

6

This agreement did not pertain to data collected in the United States.

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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.”7 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.”8 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.”9 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.10 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 addressing what kind of privacy policy should apply on that country.”11 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.”12 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 7

San Jose Mercury News, June 5, 2000.

Department of Commerce, “Safe Harbor Overview,” www.export.gov/safeharbor.

9 San Jose Mercury News, June 5, 2000.

10 The New York Times, June 5, 2000.

11 The Wall Street Journal, April 6, 2000.

12 The Wall Street Journal, April 6, 2000.

8

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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.”13 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 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 with 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.14 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.

13

The Working Party, February 23, 1999. The Working Party was established by the Directive and consisted of national privacy commissioners.

14 Yahoo! News, August 16, 2001.

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The Euro Crisis Much has changed and little has changed since the case was written. The threats remained the same, and the alternatives remained the same. The crisis itself had evolved with the financial markets being concerned not only about sovereign risk but also about the failure of banks.

Economic growth was at a standstill in much of Europe, countries were again under pressure from the financial markets, and growth was negative. For some countries it became clear that they could not work their way out of the crisis through austerity measures, and leaders began to embrace stimulus measures to spur growth, they hoped.

(The United States also incurred huge budget deficits during the Obama administration, but the United States differed from the Euro zone countries in two principal ways. First, it historically had a higher growth rate than Europe and its economy was structurally more market-oriented and flexible. Second, the U.S. was not constrained by a common currency and could always print dollars if it came under pressure from the financial markets.)

Greece, which had never complied with Euro zone requirements, agreed to austerity measures in exchange for the third tranche of rescue funds. This included an orderly default on private party lending to Greece, with lenders agreeing to accept about half the value of their loans.

Greece did little to solve its problems. Its government fell, an election was held but no party could form a government. Another election was held and a government was finally formed by a rightcenter left coalition. The government promptly indicated that it would not abide by the austerity agreement, since it was more important to stimulate its economy to recover from the sharp contraction in its economy. As the Wall Street Journal wrote, “Despite promises, Greece has failed to shut down superfluous state agencies, privatize state assets, lay off public-sector workers, recapitalize its banks, overhaul its tax code and identify €11.5 billion ($14.5 billion) of spending cuts for the next two years, among other things.”15 The Greek finance minister on his first day in office stated, “The [bailout] program is indeed off course.”16 The new prime minister pledged to sell off government assets, eliminate some government agencies, and reform the public sector, but he refused to take measures to reduce excess employment, lower wages, reduce pensions, or increase flexibility in the financial markets. Another bailout or renegotiation of the previous bailot conditions seemed inevitable. The financial markets were watching. Whether reform would happen remained to be seen. Unless German citizens are willing to continue to pay for Greece’s budget deficits and its refusal to undertake structural changes in its economy, it is hard to see how the country can remain in the Euro zone.

Spain remained in precarious condition, and the financial markets were pressuring Italy. The new socialist government in France faced a huge budget deficit and could be the next Euro zone country to experience the nervousness of the financial markets. The Euro crisis, recession in much of 15 16

Wall Street Journal, July 6, 2012.

Wall Street Journal, July 6, 2012.

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Europe, a slowdown of growth in China, and slow growth in the United States raised the risk of a worldwide economic slowdown.

The EU made some structural changes to alleviate the crisis. It allowed the EMS to make equity investments in banks, but only if the investment was guaranteed by the sovereign. This allowed the EMS to provide funds to rescue Spanish banks. The purpose was to allow bailouts of banks without formally adding to sovereign debt. The EU also approved a Fiscal Compact to impose fiscal discipline on member states, but how the requirements would be enforced is unclear.

The cause of the Euro crisis should be understood to be both irresponsible borrowing by countries and irresponsible lending by the countries that provided the funds.

As of mid-2012 the threats to the Euro zone and the world remain as characterized in the case, and the alternatives remain much the same.

Discussion questions: 1. What were the causes of the Euro crisis?

2. What institutional deficiencies contributed to the crisis?

3. Why is economic growth so sluggish in the European Union?

4. Why is the German economy so strong?

5. Do the costs of a common currency outweigh the benefits?

6. Should Greece be expelled from the Euro zone?

7. If the Euro is to be preserved, what institutional reforms will be needed in the European Union?

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Chapter 16 China: History, Culture, and Political Economy With over 1.3 billion people and a huge economic potential, China is an economic powerhouse. 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 parts of its economy from competition, welcoming foreign direct investment but imposing special protections in the case of duties imposed on imports of SUVs. 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. China continues to impose censorship on the Internet, and the Chapter case Google in China concerns Google’s decision to enter the Chinese marketplace despite the censorship. The Chapter 24 case Google Out of China concerns Google’s decision to leave China.

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 infusion of capital to prop up the SOEs made many Chinese banks insolvent.

A lecture could also focus on culture, only one aspect of which—Confucianism—is considered in the chapter. As the chapter 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 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.

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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. With membership in the WTO came a large number of trade complaints, including the tariffs on SUVs that the United States took to the WTO. China is reconsidering its “one child” policy in place since 1980. In conjunction with the national People’s Congress an advisory committee raised the possibility of a “two-child” policy. Critics argued that the one child policy and the Chinese preference for male children had resulted in a gender imbalance. The one child policy had a number of exceptions “including many rural families, ethnic minorities and couple where both people are the only child themselves. But most urban families still have to pay fines if they have more than one child. Those who dodge the fines cannot register their children for public services including state education and health care.”17

Cases Apple and Private Politics in China As the chapter indicates, an environmental movement is emerging in China, and NGOs have been formed to address environmental conditions and working conditions in factories. The Chinese government supports better environmental protection and hence has not clamped down on the NGOs. In addition to the organized private politics, local residents have frequently taken to the streets to protest environmental conditions.

Apple is a company that maintains secrets well and keeps thing close to the vest. Many companies such as Nike and The Gap that had been subject to private politics social pressure disclosed the names and locations of their suppliers, allowing NGOs and social activists to monitor performance and compliance with standards. Apple had refused to do so. Apple was under pressure in the United States not only on environmental issues but also on working conditions in suppliers’ 17

Wall Street Journal, March 9, 2011.

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factories. Apple had not been responsive. The initiative by the Institute of Public & Environmental Affairs chose to target Apple because of its unresponsiveness. This occurred at the same time that Apple was attempting to penetrate the Chinese market.

The approach taken by the Institute was typical of private politics in developed countries. The Institute tried to identify likely Apple suppliers, conducted interviews with local residents, and took videos of pollution at “suspected” Apple suppliers. The NGO then released a report to capture the attention of the media and posted a video on the Internet. The issues of concern to citizens and the Institute were broader than the environment and included working conditions in the factories.

Director Ma challenged Apple to live up to its green claims and said that Apple customers did not want products that come “at the cost of poisoning the environment, harming communities, and sacrificing employees’ rights.”

Apple’s initial response was to repeat its commitment to the environment and to good working conditions, and pointed to inaccuracies in the Institute’s report.

Dealing with the private politics social pressure in this case requires a strategy, and Chapter 4 provides the foundations for formulating the strategy. Apple is clearly behind the curve in its disclosures and dealings with activists, and it faced the choice of fighting the Institute and its claims or attempting to deal with the substance of the issues. At a minimum Apple should initiate a series of meeting with the Institute to better understand its concerns. Apple could drag this out for an extended period, but rather than have the issues fester, Apple should attempt to deal with the issues quickly and to the extent possible resolve the problems. The environmental movement in China will surely demand that actions be taken.

Apple must decide whether to disclose the names and locations of its suppliers. Doing so would open the company’s suppliers to further investigation, and Apple would have to be prepared to deal with the findings. NGOs are suspicious of Apple because of it secrecy, and the company will have to establish credibility.

Discussion questions: 1. Should Apple meet with Ma and the Institute?

2. Should it disclose the names and locations of its suppliers?

3. If not, how should it deal with the mounting criticism of the company?

4. If so, what further demands might it face? Will it then have to deal with the identified problems?

5. How can Apple generate credibility for its commitments to the environment and good working conditions (Dowling’s statement)?

Developments: Under increasing social pressure in China and the United States, Apple finally released the names and locations of its suppliers. The issues raised by the Institute and other concerns such as working conditions were ones that other companies had addressed, and Apple also had to do so or stand out like a sore thumb.

To develop credibility, Apple could begin to work with NGOs on the issues identified. One positive measure was to use an existing inspection and compliance organization. The footwear and

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apparel industries had addresses the working condition issues by forming the Fair Labor Association (FLA) with NGOs. The FLA arranged for independent inspections of factories supplying member firms and issued public reports on the working conditions along with steps the companies were taking to address problems. The consumer electronics industry had no such organization, and the FLA had not been involved with industries other than footwear and apparel.

Apple decided to ask the FLA to inspect its suppliers’ factories, and its February 2012 announcement can be found at: http://www.apple.com/pr/library/2012/02/13Fair-Labor-Association-Begins-Inspections-ofFoxconn.html The first inspection was at Foxconn, the largest supplier of the consumer electronics industry. The FLA found serious problems and violations of Chinese law at three Foxconn factories.

Foxconn, which had frequently been subject to complaints, had experienced at least 10 suicides of its workers, and NGOs had pressured it on a number of issues. As a result of the FLA inspection Foxconn pledged to improve conditions. Information on Foxconn’s commitment can be found at: http://www.nytimes.com/2012/03/30/business/apple-supplier-in-china-pledges-changes-inworking-conditions.html?pagewanted=all This episode was covered by all the major media.

An article on Mr. Ma can be found at: http://www.nytimes.com/2012/04/23/business/global/advocate-helps-track-polluters-on-supplychain.html?pagewanted=all In July 2012 Apple dropped out of EPEAT environmental certification. U.S. law requires that 95 percent of U.S. government electronics purchases have EPEAT certification. EPEAT does not cover cellphone or tablets. Whether Apple withdrew from EPEAT because it knew it could not meet the standards or for some other reason is not known. One day after the disclosure of Apple’s decision the city of San Francisco announced that it would no longer purchase Apple products, and the University of California began studying whether it could buy Apple products. Apple quickly reversed its decision. Bob Mansfield, executive vice president, posted an open letter on Apple’s Web site, “We’ve recently heard from many loyal customers who were disappointed to learn that we had removed our products from the EPEAT rating system. I recognize that this was a mistake.”18 He stated that all eligible products would be submitted for EPEAT certification.

Direct Selling in China 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

18

San Francisco Chronicle, July

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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).”19 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?

19

South China Morning Post, April 21, 1998.

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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.”20 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.”21 20 21

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. 22 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 22

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 2001.23 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.”24 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.

23

The effect of China’s entry into the WTO on Amway’s business is discussed in New York Times, November 17, 2001.

24 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.”25 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.”26 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.”27 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.

25

South China Morning Post, February 14, 2004.

South China Morning Post, March 6, 2003.

27 New York Times, March 12, 2003.

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In July 2004 Amway announced that it would establish a research center in China employing 20 scientists.

Update: After suspending direct selling in 2006 China allowed direct selling to resume. Amway and Avon resumed their expansion, and the cosmetics firm Mary Kay joined them. Mary Kay had much the same strategy as Amway and Avon and emphasized empowerment and entrepreneurship in recruiting its independent direct sellers. Mary Kay’s revenue in China increased to $600 million, and its worldwide sales in 35 countries was $2.6 billion. “The company’s message of female empowerment and femininity seems to resonate in China, a country where young women have few opportunities to start their own businesses…. But not everyone succeeds, Shang Qun, a 29-year-old sales agent in eastern Jiangsu Province, said she was pressured to meet unrealistic sales goals and to deliver dozens of names of potential clients to the company during her first months of selling.

‘Mary Kay has many direct selling refugees,’ she says. ‘They claim Mary Kay can make you big money, but their pockets are empty. Crayton Webb, a Mary Kay spokesman, defended the company. ‘Mary Kay is extremely careful in communicating to members of the independent sales force that their success is up to them, he wrote in an e-mail message. ‘There are no guarantees and that they should invest in their business carefully.’”28 Zhang Xiaoying whose income was only $200 a month said, “I love this company because they give us professional training.”29 “Avon says it now recruits 50,000 women a month and now has one million agents.”30 Direct selling had $8 billion in revenue in China and goods sold include “products as diverse as health supplements, cosmetics, toothpaste and dishwashing liquid.”

Google in China China represents a tremendous opportunity for Google, but censorship comes attached to that opportunity. The alternative is to stay out of China and provide information to people in China through its website google.com. The Chinese government, however, monitors the Internet gateways and censors information at that point. It can do so by closing access to web sites.

Although the level of censorship may be little different operating in China from operating outside of China, the former requires direct compliance with the censorship apparatus in China. Moreover, Google employees can be at risk if they violate the law regarding banned information.

Censorship in China has two basic components. The first is self-regulation by companies and ISPs. More important is state censorship which is directed by the State Council Information Office. The State Council is China’s paramount executive body, indicating that the highest levels of government are involved in the control of information. The government monitors a wide array of 28

New York Times, December 26, 2009.

New York Times, December 26, 2009.

30 New York Times, December 26, 2009.

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communications among its citizens ranging from texting to blogs to email to information provided by news services. Baidu.com, the leading search engine in China, allows the government to direct monitor its Website. In addition, citizens participate in the monitoring as the student indicates in the case.

China’s concerns are less about criticism of the government or of social conditions and more about the development of collective action that might threaten internal stability of the country and ultimately the control of the Chinese Communist Party. That is, the CCP is concerned about collective activities that could develop into a movement that could pose a threat to the current political system. China suppresses the Falun Gong movement less because of its religious activities and more because it has the potential to enlist a large number of citizens across the country, and it is conceivable that those citizens could be called to action. Some commentators argue that China is tough on corruption because widespread corruption could lead to protest in many parts of the country and provide the foundation for a broader movement.

Much of China’s censorship apparatus is embodied in the law, and companies are required to abide by the law and cooperate in it enforcement. Yahoo’s experience in the Shi Tao affair is a good example that has continued to haunt the company both morally and through social pressure. Liu argues that the practices in China are of the same nature as those in other countries, which of course is not believable, since the terms “illegal” and “harmful information” are far broader than in a democracy. Most Chinese citizens, however, seem little concerned about the censorship. Those who are concerned and are more broadly concerned about human rights risk arrest if they attempt to organized collective action.

Google’s decision to operate in China through google.cn is understandable, but it has resulted in both private and public politics pressure being directed at the company. The company has been criticized on moral grounds and scolded by members of Congress in hearings. Activists have criticized the company for cooperating with the censorship apparatus and demanded that it lobby the Chinese government to end its censorship. (This would have no effect on government policy but could turn the government against Google.)

The public politics pressure manifests itself in the State Department office created to decrease censorship, congressional hearings on the issue, and possible legislation. Despite these activities the U.S. government has not pushed the censorship issue. (It will be interesting to see if the Obama administration decides to act on the issue.)

In conjunction with the decision to operate in China comes a set of issues about how to do so without violating the law or putting employees or Internet users at risk. Google’s operating decisions seem prudent and thoughtful about the tradeoffs necessarily involved. Google does not store personally identifiable information, although IP addresses are stored. Google did not offer services, such as blogs and email, that allowed content to be posted. This was surely costly to Google in trying to obtain a larger share of the market in China. Google also exercised selfregulation and complied with the government’s requirements. It decided to post a notice whenever information was censored. It did this in other countries as well, although the scope of censorship is far greater in China. These actions led to criticism placed in government-run newspapers. The

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reference to operating without a proper license may have been a thinly veiled threat to shut down google.cn if it failed to tightly comply with the law and the censorship apparatus.

Censorship is not unique to China. The U.S. Department of State reported that in 2007 27 countries censored information on the Internet.

Discussion questions 1. What does China fear that leads it to censor information on the Internet and more broadly communication among its citizens?

2. Evaluate Liu’s explanation of China’s censorship.

3. Should Google have entered China? If so, were its precautions appropriate? What else should it have done?

4. Should Google offer Gmail in China? Should it hose blogs?

5. Should it lobby the Chinese government regarding Internet censorship?

6. Should Google lead in organizing companies operating in China whose activities are subject to censorship? If such an association were formed, should it address the social pressure in the United States or the censorship in China or both?

7. What policy should Google adopt to deal with information that is viewed as disrespectful to Islam?

The Chapter 1 case The Nonmarket Environment of Google concerns the broad array of issues faced by the company.

Developments 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.31 32 In 2006 Google sold its stake in Baidu.

Human rights pressure continues. In October 2008 the European Union warded its highest human rights prize to Hu Jia for his defense of human rights in China. In April 2008 Hu was sentenced to 3 ½ years in prison for his work.

Kaiser Kou, director of international communications of Baidu, said, “Google no longer incurs the costs of censorship that we continue to incur; those costs include not only hardware, software and 31

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.)

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manpower but most importantly the time of our very senior managers. We should not labor under the illusion that censorship is some sort of competitive advantage to Baidu.”33 China requires Chinese citizens who use the domestic equivalence of Facebook and Twitter to use their real names. Google notified users, “Please note that in mainland China, searching for the character ‘[xxx]’ might cause the link between the user and Google to be temporarily cut off. The cutoff is not in Google’s control.” (L. Gordon Crovitz, “Google Fights Back in China,” Wall Street Journal, June 11, 2012.)

33

New York Times, November 17, 2010.

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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 cases of fair trade and microfinance. Greater detail on one emerging markets country, or post-emerging markets country, is provided in Chapter 16 on China and Chapter 18 on India. Chapter 24 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.

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 6. 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 21 and 22 and the frameworks provided in Chapter 24. 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.

Fair Trade: The withdrawal of Fair Trade USA from the Fairtrade International system threw the fair trade movement into turmoil. The fair trade system in coffee had been set up based on an ideological perspective by requiring farmers to belong to cooperatives. This excluded businesses 270

that operated coffee plantations or farms and also excluded individual farmers. It also limited the supply of fair trade coffee and may have resulted in lower quality coffee. Fair Trade USA sought to increase supply by including a broader set of producers. Paul Rice’s move sought to use business to expand supply.

By mid-2012 the price of Aribica coffee futures had fallen to $1.50 a pound from $2.50 a pound in late 2011. The principal reason was an anticipated large Brazilian crop.

Cases 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 Comapartamos

Kiva

Comapatamos is a for-profit firm, which means that it can raise equity capital. This means that, other things equal, it is able to scale up its operations quickly.

Compartamos needs funds not only to cover its operations, but also to fund the loans it makes.

Kiva is a non-profit organization, which means it cannot raise equity capital.

Instead, it relies on donations to provide it with funds to cover its operating cost. Kiva has a much lower need for funds since it does not itself make the loans.

Because it is for-profit Comapartamos 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 Comaprtamos. 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 open branches and hire more field personnel to monitor lending.

To scale up its operations Kiva must grow the number of field partners or hope that its field partners can increase their scale independently.

Compartamos has the advantage of operating in one country. That country is middle income.

Kiva operates in many countries which makes monitoring its field partners more difficult. These countries are low income.

Lends primarily to groups of borrowers.

Kiva lends primarily to individuals, but has This requires personnel to help organize the expanded its lending to groups. This 271

groups, but the groups provide internal monitoring of individual borrowers.

increases the costs to the field partner to monitor the loans.

Compartamos faces risks of default and attempts to control them by monitoring conducted by their own field personnel.

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 relative to whether the customer can borrow at all and if so what the interest rate is. The interest rate is high, but with over 800,000 borrowers the interest rates must be lower than otherwise available, if at all, to the borrower.

The benefits to borrowers are very large, since interest rates are low. One reason the interest rates are low is that part of the funds are charity; i.e., lenders do not receive interest on the funds they provide.

Also, Kiva receives contributions to cover its expenses.

Moral considerations 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 seem 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.

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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 must be that those banks have high transactions costs. The costs of investigating borrowers’ qualifications and making collections are likely to be high. It should be noted that in the United States it is finance companies rather than banks that make unsecured, short-term loans.

Banco Compartamos has grown rapidly and others have entered the market, which has driven interest rates down.

Social Entrepreneurship: Kiva Kiva represents an important innovation in microfinance. It basically facilitates the matching of 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 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 Comapartamos Comapatamos is a for-profit firm, which means that it can raise equity capital. This

Kiva Kiva is a non-profit organization, which means it cannot raise equity capital.

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means that, other things equal, it is able to scale up its operations quickly.

Compartamos needs funds not only to cover its operations, but also to fund the loans it makes.

Instead, it relies on donations to provide it with funds to cover its operating costs.

Kiva has a much lower need for funds since it does not itself make the loans.

Because it is for-profit Comapartamos 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 Comaprtamos. 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 open branches and hire more field personnel to monitor lending.

To scale up its operations Kiva must grow the number of field partners or hope that its field partners can increase their scale independently.

Compartamos has the advantage of operating in one country. That country is middle income.

Kiva operates in many countries which makes monitoring its field partners more difficult. These countries are low income.

Lends primarily to groups of borrowers.

This requires personnel to help organize the groups, but the groups provide internal monitoring of individual borrowers.

Kiva lends primarily to individuals, but has expanded its lending to groups. This increases the costs to the field partner to monitor the loans.

Compartamos faces risks of default and attempts to control them by monitoring conducted by their own field personnel.

The benefits to borrowers are measured relative to whether the customer can borrow at all and if so what the interest rate is. The interest rate is high, but with over 800,000 borrowers the interest rates must be lower than otherwise available, if at all, to the borrower.

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 very large, since interest rates are low. One reason the interest rates are low is that part of the funds are charity; i.e., lenders do not receive interest on the funds they provide.

Also, Kiva receives contributions to cover its expenses.

The following questions can be used to guide the discussion.

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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.

In an embarrassment for Kiva it was revealed the actual funds a lender provides do not go to the person designated but instead go into a general account from which funds are transferred to field partners. Kiva was working on a way of having a lender’s funds go to the designated reciepient.

Equity Bank of Kenya Equity Bank had grown rapidly as a result of Dr. Mwangi’s vision of serving the unbanked population and small account holders. This is a low margin, high volume business, and the bank has been able to maintain a low wage bill. The bank has been innovative in developing mobile banking and agency banking services, which eliminates the need for brick and mortar branches.

The bank has begun to broaden its activities into housing and development.

Mwangi has adopted a strategy of taking its mobile and agency banking model to neighboring countries, with expansion into Uganda and South Sudan and planned expansion in Rwanda and Tanzania. Focusing on countries in the Common Market of Eastern and Southern Africa may limit the risk a bit, but the common market is large including 19 countries, so its enforcement mechanisms may be weak.

Judging the opportunities is difficult given the limited information available, but the opportunity in Rwanda appears to be substantial, since only 20 percent of the population is banked. Moreover, Equity Bank appears to have the support of the Central Bank of Rwanda and the National Bank, suggesting that the bank does not face substantial political risk. The support for entry appears to be based on the benefits mobile and agency banking can bring to the unbanked.

Equity Bank has on the ground knowledge of the risks associated with particular countries, and from afar only a general feeling for the risks can be obtained. Nevertheless it is a useful exercise to compare the ratings of countries such as Tanzania, Uganda, and Zimbabwe. Additional information on the situation in Zimbabwe is presented in the Chapter 24 case De Beers and Conflict Diamonds (B) case.

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In addition to the risks in other countries there are risks associated with Kenya. After the ethnic violence associated with the 2008 election the country has been stable and economic growth has been strong. But inflation has accompanied the growth, government budget deficits have grown, and ethnic violence is again possible for the next elections which are now scheduled for 2013. In addition, Kenyan troops have entered Somalia to fight Al Shabaab militants, and the militants have conducted a series of bombings in Kenya.

In addition to the domestic risks and the risks in neighboring countries, Equity Bank faces risks associated with its entry into housing and development.

Discussion questions: 1. What are the causes of Equity Bank’s success in Kenya?

2. Evaluate its business model of low margin, high volume banking. Is this a model that can be transported successfully to other countries?

3. Assess the opportunities and risks associated with its expansion into Rwanda and Tanzania.

4. Should it expand into Zimbabwe?

5. Assess the overall domestic and international risks the bank faces and the business risks associated with its broadened banking activities.

6. Is Equity Bank expanding too rapidly?

Update: By June 2012 Equity Bank’s share price had recover to 2009 levels, but its price-earnings ratio lagged behind that of Barclay’s Bank of Kenya and Standard Chartered Bank of Kenya.

Dr. Mwangi was named the Ernst & Young World Entrepreneur of the Year 2012.

Elections were scheduled for 2013 in Kenya. As in the past ethnicity was expected to be the principal factor governing voting. The favorite was Uhuru Kenyatta, son of the founding president of the country. Kenyatta was at risk of being charged by the International Criminal Court in The Hague. (Economist, June 9, 2012.)

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 Lebanon in 2005, giving the company a strong present in North Africa and the Middle East.34 At the time of the case MTN was in merger discussions with Reliance Communications of India.

34

Syria accounted for 6 percent of MTN’s revenue and the Sudan and Iran 2 percent each.

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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.

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

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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 20.) 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 24.

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.

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?

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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 India India is a complex country that presents major opportunities. It has a vibrant democracy where the rule of law prevails. Yet, it has remnants of its socialist past including some lingering restrictions on foreign direct investment and excessive regulations. Corruption is a problem as is the intense political competition both at the level of individual states and the country as a whole.

FDI was restricted in the retail sector, which was highly inefficient with a huge number of small stores and merchants. The Tesco PLC in India? case concerns a large UK retailer considering entry into the Indian retail market, which requires an Indian partner. Some of the possible partners are members of family-owned business groups.

The Tata Group was scheduled for a transition in leadership. Ratan Tata retired in 2012 and had no sons. Cyrus T. Mistry, managing director of Shapoorji Pallonji Group which owned 18% of Tata Sons, was chosen to head the group.

The Indian government announced that it was relaxing the restrictions on the retail sector, but it soon retracted its plans as opposition was intense.

The political opportunism in Andhra Pradesh that led to the collapse of SKS Microfinance was disturbing to other private-capital microfinance lenders. Vikram K. Akul, head of SKS Microfinance, stepped down from the company he had founded under pressure from social activists and state politicians. The pressure stemmed from the high interest rates charged and aggressive collection practices. The chilling effect of the political attacks on the company were felt in other countries, where for example a principal in Banco Compartamos in Mexico remarked that he was well aware of what happened to SKS. (See the Chapter 17 case Social Entrepreneurship: Banco Compartamos.)

India had recorded strong economic growth, but in 2012 the Indian economy began to slow. The government planned to take stimulus measures.

In the aftermath of the Mumbai terrorist attack the Indian government had imposed restrictions on Internet speech, and in 2011 it made the restrictions more explicit. The new rules posed challenges to Internet companies, as considered in the Chapter case Google in India.

The issue of the missing girls received renewed attention in 2012. The Advanced Technology Laboratories, Inc. concerns an ultrasound device manufacturer whose handheld ultrasound device may be used for sex selection.

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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. 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 281

India to relax its restrictions in retailing, but India had already chosen not to do so under pressure 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.”35 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.

Google in India Internet penetration in India is low, and whether it will be mobile communications and wireless broadband or the Internet that will prevail remains unclear. Google is a leader in both and views the Indian market as very attractive, particularly after departing from China and moving its search business to Hong Kong. Google had withdrawn from the .cn market because of government required censorship and hacking of users accounts that originated in China. India’s new rules for 35

Wall Street Journal, August 12, 2008.

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the Internet impose “reasonable restrictions” to protect “public order, decency, or morality,” and the 2011 rules clarified the restrictions. The 2008 law resulted in many requests for data from the government, and the 2011 rules seemed to place additional restrictions on the company. The 2008 law was spurred by a terrorist attack that killed 163 people, and the 2011 restrictions were said to be justified by a need to avoid exacerbating ethnic and other tensions.

Unlike China, India is a vibrant democracy in which Google and other companies had had an opportunity to speak on the rule writing and could file complaints with the government. Also, the government did not practice active censorship nor identify sensitive topics, such as Tiananmen Square, that had to be avoided. Nevertheless, the possible restrictions on free speech were alarming to human rights advocates and others. The restrictions were also in conflict with Google’s commitment to free speech. (Censorship in China is discussed in the Chapter 16 case Google in China and the Chapter 24 case Google Out of China.)

Google had to decide whether it would self-censor its sites and users’ postings or whether it would instead be conscientiously responsive when ordered to remove content. Certain things were banned, and Google would have to police its services to make sure banned material was deleted.

Google faced such bans in a substantial number of countries. (The United States also has rules that ban certain things, such as child pornography.)

One issue is whether Google would be required to turn over to the government information about users. To avoid having to do so in China, Google had limited its offerings so as not to place users in jeopardy. India was apparently not at that point.

Google apparently could be in a reactive mode with respect to government requests to take down material, and it would have to decide on a case by case basis whether it would comply. The government then could accept Google’s decision or take further action. Google could also face private lawsuits.

Discussion questions: 1. Is India practicing censorship? Does it differ from that in China?

2. Should Google or the industry take nonmarket action to try to change the 2011 rules?

3. What principles should guide whether it complies with a government request? Should it take down political postings if asked to do so?

4. Should Google stop offering Orkut and YouTube in India to avoid objectionable content being posted?

5. If India request information on a user, should Google reply? If it is national security matter? If it is an internal security matter?

Updates: Google reported that in 2011 governments had made 1,007 requests for content removal and had complied with 54% of them. China and Iran are not included because Google does not offer Internet services in those countries. Brazil, for example, made 194 requests removal of posting on Orkut relating to political campaigns.36 The Indian Express, July 8, 2012, reported: 36

Wall Street Journal, June 18, 2012.

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Internet giant Google has said it has logged 255 instances of India asking for online content censorship, marking a sharp rise of 49 per cent in the second half of last year.

India's objections ranged from blockage of 133 YouTube videos, including 10 made on national security considerations and 77 on defamation, besides 26 web searches and 49 blogs, Google said in its transparency report made public yesterday.

After the US, India topped in demand for user data with more than 2,207 requests of which 66 per cent were compiled with by Google. Washington headed the global list with 6,321 requests.

The company said it had received a further 546 informal requests covering 4,925 items, of which it had agreed to 43 per cent of the cases.

Google had also been sued over disparaging content on its Web site.

Protests in India against censorship had increased in India, and The Siasat Daily, July 6, 2012, reported the government’s response: Assuring that government does not plan to censor internet and social media, Law Minister Salman Khurshidon Friday said adequate provisions are already in place and IT Ministry is also holding consultations with various stakeholders to address concerns on objectionable content.

Advanced Technology Laboratories, Inc. 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 20 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 21 and 22 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.

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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, 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.

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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 24.

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.

The issue of the assignment of duty is complex and difficult and is considered in Chapters 21, 22, and 24. The Calabresi and Melamed principles presented in Chapter 14 and applied in Chapter 21 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 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 21 and 22.

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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?

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 19

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 19-1, 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 19-1 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.

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 19-4 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 the Cost is 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.

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.

As indicated in the Chapter Airbus and Boeing have both alleged that the other was violating international trade rules. The United States and the European Union each filed a trade complaint, and the chapter case The Airbus and Boeing Trade Disputes concerns the cases and developments.

The Doha Round WTO negotiations have sputtered for many years and in 2008 they collapsed.

Informal discussions continued, and in 2011 there was an effort to resurrect the Doha Round but the efforts failed. 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.

China initially sought to defuse the solar panel trade cases by stating that Chinese solar panel producers were considering moving some production to other countries including the United States.

One Chinese producer was said to be seeking to have an Oregon company to do the final assembly of its solar panels sold in the United States. China was also considering filing a trade complaint against the United States in retaliation. Speculation was that the case would focus on the export of polysilicon to China.

Cases

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Cemex and Antidumping 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 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

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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 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 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.42 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 42

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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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 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. 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 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?

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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?

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.)

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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 used acceptable procedures, and the duty remained in effect.

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.”

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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.

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 21 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

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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.

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 21 and 22 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

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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.

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 negotiated 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.”43 43

Associated Press Worldstream, January 31, 2007.

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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.”44 He also said, “They are…putting two fingers up to the drug companies and saying, ‘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.’”45 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.

The Airbus and Boeing Trade Disputes Airbus and Boeing have traded allegations of subsidization and unfair competition since before Airbus delivered its first aircraft. After the cancellation of the negotiated accord, it was inevitable that the two companies would come to the World Trade Organization. The stakes are large because of the forecast demand for LCA and new large aircraft were being introduced by the companies.

Subsidization is discussed in the chapter, and economic theory predicts that subsidization in a duopoly can, but does not necessarily, increase aggregate social welfare by lowering marginal cost resulting in greater output and lower prices. As with antidumping the trade agreements, however, are more about fair trade than about social efficiency.

The commercial aircraft industry has economics characterized by large up-front costs (launch costs), a learning curve, economies of scope, and barriers to entry. Both companies have the first, second, and fourth of these characteristics, whereas only Boeing only economies of scope. The European Union has argued that the economies of scope from Boeing’s defense and space business constitute a trade violation. This is an allegation that could be made of many companies in many industries. Note also that exploiting economies of scope improves social welfare.

Airbus may also have economies of scope, since some of its parent companies make military aircraft, and expertise could be transferred from those firms to Airbus.

One interesting feature of the cases is the allegations of what is considered to be a violation of the WTO/GATT agreements. In the United States we seem rarely to think of tax breaks by state and local governments to attract firms and jobs. Nor are research grants for defense, which could have spillovers for commercial aircraft, typically thought of as subsidies. The support under the FSC and ETI do represent export subsidies, but they are available to support a broad range of exports.

44 45

Associated Press Worldstream, January 31, 2007.

Financial Times, January 30, 2007.

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Note that the SCM has two kinds of tests. One is whether the support for the company constitutes a subsidy, and the other is whether the support has had adverse effects on the plaintiff. For example, the WTO panel found support for Boeing to have resulted in trade displacement, suppressed prices, and lost sales. The SCM does not have a social welfare test.

Discussion questions: 1. What are the criteria for a finding of a violation of the SCM? 2. Are the alleged behaviors by the United States likely to be trade violations?

3. Are the alleged behaviors by the European Union likely to be trade violations?

4. Are taking advantage of economies of scope a trade violation?

5. Are these two cases likely to be that last ones between these two companies?

Update: No decision had been rendered on the appeals of the WTO panel decision on the EU case.

The issues are complex and the data are difficult to evaluate, so prediction is difficult.

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Part IV Integrative Case Toys ‘R’ Us and Globalization 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 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 302

greatly among country markets ... (p. 99)”46 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)-by-country 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.

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 46

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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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-by-municipality. 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?

4. How successful is Toys ‘R’ Us likely to be?

Developments

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With respect to Porter’s five forces, the possible threats come from entry by new competitors and from discount stores. One new entrant, Child World, recently went bankrupt, so the principal threat 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 open to foreign investment - Singapore and Hong Kong. One natural expansion strategy is to 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

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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 role. Toy manufacturers will benefit, but most are not located in Japan but instead are located in Hong Kong and South East Asia.

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 or 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

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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?

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?

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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.’”47 “‘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.’”48.

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 47 48

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.’”49 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.50 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.”51 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.’52

49

Japan Economic Journal, April 1990.

Peninsula Times-Tribune, April 6, 1990.

51 The Wall Street Journal, April 9, 1990.

52 Peninsula Times Tribune, April 6, 1990.

50

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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.”53 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.”54 In a breakthrough, Nintendo agreed to supply Toys ‘R’ Us directly but only at a price that was acceptable to other wholesalers.55 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.56 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.

U.S. Ambassador to Japan Michael Armacost attended the opening of the store in Ibaraki 53

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.

54 The Wall Street Journal, October 8, 1991.

55 The Wall Street Journal, October 8, 1991 56 The New York Times, December 21, 1991.

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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%.57 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 regulations might be changed, but Toys ‘R’ Us will not be able to play much of a role in the 57

The Wall Street Journal, April 25, 1995.

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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 store-opening 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 growth rate of toy sales actually increased substantially because of its entry, and manufacturers

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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.”58 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.”59 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.”60 In Germany, Toys ‘R’ Us began advertising heavily and in response the German toy retailers began advertising year-round rather than on a seasonal basis as had been the custom. From 1987 through 1991, toy sales in Germany increased by 50%. Toys ‘R’ Us estimated that it captured one-quarter of the increase and other retailers the rest. Arnt Klöser said, “In the end, everyone benefited.”

The outcome is summarized in toysgermany.ppt and repeated here: • Hired an experienced German retail executive to help implement its integrated strategy.

Familiar with obstacles, local politics, unions/works councils, ...

• Toys played by the local rules –took labor laws, works councils, hours, etc. as given.

• Objective: Get a foot in the door and then go to other cities –dual applications in center of town and meadow –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 purchases for four days. The Competition Center sued C&A and obtained a restraining order 58

The New York Times, August 18, 1991.

The New York Times, August 18, 1991.

60 The New York Times, August 18, 1991.

59

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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.”61 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.”

61

The Wall Street Journal, January 23, 2002.

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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

Japan

Sweden

high

high

high

80

120

8

organization

subsidiary

joint venture

part of UK company

management

German

Japanese

British

per capita income market size (population millions)

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 20 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 23 then presents selected policies implemented by companies in accord with their conception of corporate social responsibility.

Chapter 24 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. See Figure 20-4. 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.

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 quit backstopping the auctions.

Cases The Collapse of Enron: Governance and Responsibility 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 shortly after the Report was released.) It, however, leaves a number of questions unanswered.

Additional information will become available, particularly as lawsuits are prosecuted.

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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 14.) 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 inappropriate about structuring transactions to satisfy the parties’ financial, tax, regulatory or accounting objectives within the relevant rules and standards.”1 1

The New York Times, February 25, 2002.

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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 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

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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.

Wal-Mart: Nonmarket Pressure and Reputation Risk (B): A New Nonmarket Strategy

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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 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.

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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.

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 2

The Wall Street Journal, August 12, 2004.

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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 WalMart 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 18 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 provide in: Emek Basker, “Job Creation or Destruction? Labor Market Effects of Wal-Mart Expansion.” Review of Economics and Statistics, 2005. Vol. 87, 171-183.

In June 2012 the NGO National Guestworker Alliance charged that guest workers in the United States were working under terrible conditions in at least 13 seafood suppliers supplying Wal-Mart.

The NGO disclosed that the suppliers had 644 citations for workplace standards violations and charged that Wal-Mart was failing to live up to its supplier standards. (The U.S. guest worker program issues visas for foreign workers for seasonal work.)

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Facebook and Online Privacy The Brynjolfsson quote sums up the business issue for Facebook: “Their challenge in the coming years is to convert that dominance in time and attention into a bigger share of consumer wallets—a bigger share of money they spend either directly or indirectly through advertising.”3 Getting a bigger share of consumers’ wallets requires knowing individual consumers better, and their activity on the Facebook Web site provides valuable information.

Online privacy in the United State is not regulated although the FTC can act against deceptive practices (see Chapter 10). President Obama has called for a consumer privacy bill of rights, but congressional action is unlikely. Initiatives such as those of Representative Markey and Senators Kerry and McCain have been tried several times in the past and failed. The European Union, however, is on the verge of adopting strong privacy protections.

Facebook’s strategy to know the consumer better seems to be constantly pushing the envelope of responsibility. The company has had a series of privacy breeches, including actions by advertisers on its site, and most of those breeches appear to be intentional. This is a gray area of ethics and social responsibility, and only a quarter to a third of users are “very concerned” about online privacy. Nevertheless, online privacy continues to be a moral and a political issue. One ethics principle that is applicable here is the idea of free consent, which could be implemented through opt out or opt in.4 Facebook and other online companies strongly oppose opt in, since that could severely limit the advertising revenue that could be generated.

The online privacy issue is the focus of NGOs such as EPIC, which monitor companies and their practices. EPIC wrote to the FTC complaining of practices, and the FTC has taken action in the past. Facebook initiatives such as face recognition and Timeline generate complaints. Post-logoff tracking also drew NGO complaints to the FTC, as well as lawsuits and rumblings in Congress.

NGOs have sought a “do not track” option, and the FTC supports it. The FTC, however, embraces stronger self-regulation rather than new legislation by Congress. President Obama has urged Congress to give the FTC authority to regulate, but as Kerry and McCain indicate Congress does not want strong regulation. The Kerry-McCain bill thus does not include opt in or do not track.

Facebook has successfully worked to become a platform for other online businesses and could be responsible for what others do on the platform. Facebook shares data with advertisers and developers, but supposedly no personally identified information is shared.

Facebook has self-regulated with a new privacy policy announced in August 2011, and critics claimed that it was in response to the introduction of Google+. In addition, the IAB has introduced a do not track button. How many users will choose to use it remains to be seen.

3 4

New York Times, September 22, 2011.

Markey’s bill uses opt in, and Kerry and McCain use opt out.

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The issue of children on Facebook is a sensitive one, and many children under 13 were on Facebook in violation of Coppa. Zuckerberg opposes the restriction on children under 13. How Facebook should deal with this issue remains a challenge.

The findings of the Columbia University survey are interesting but their interpretation requires care. If the survey was accurate in the sense that the questions asked were not suggestive, the issue of the direction of causation remains. That is, teens that use social network sites may adopt the reported behavior because of the social networks or teens with those behaviors may also choose to use social networks. The latter may be more likely than the former.

With respect to strategy there is little evidence to suggest that Facebook will stop pushing the envelope of online privacy.

Discussion questions: 1. Why does Facebook have continuing online privacy issues?

2. Should it have changed the default in its December 2009 privacy platform? Why did it do so?

3. Why did give application developers access to its users data?

4. Should Facebook have used opt in for its face recognition feature rather than opt out? Why did it use opt out?

5. Was Marc Rotenberg of EPIC right in his characterization of Facebook’s face-recognition feature?

6. How should Facebook deal with the European Union’s planned revision of its data protection directive? Should Facebook introduce a right to be forgotten for its users?

7. Are congressional efforts to regulate online privacy likely to be successful? Has selfregulation been successful?

8. What are the implications of the findings in the Columbia University survey for Facebook?

9. What guidelines should Facebook use with respect to users’ data for features it introduces in the future?

Developments: The actions by the FTC and the bills introduced in Congress have made it clear that Washington must be given more attention by Facebook. Facebook has used its popularity in attempts to curry favors. For example, it hosted at its headquarters an online town hall with President Obama. In 2011 Facebook spent $1.35 million on lobbying, and in the first quarter of 2012 it spent $650,000.

In comparison Google spent $5 billion in the first quarter and Microsoft spent $1.8 million.

Facebook was concerned about online privacy legislation and also faced an FTC investigation.

This case replaces the DoubleClick case from the earlier editions. Another Facebook case, Facebook in China?, is available in Chapter 2. The Chapter 15 case The European Union Data Protection Directive (B) case considers an important privacy initiative by the European Union Facebook continued to generate protests for its policies. In June 2012 it began suppressing a user’s email address and substituting their Facebook email address @facebook.com. Critics said that

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Facebook was trying to get its users to use its email system, “which until the recent shift most people had no idea even existed despite it launching in late 2010.”5 In June 2012 Apple and Google separately introduced a new 3-D mapping service. Soon thereafter Senator Charles Schumer (D-NY) accused the companies of “an unprecedented invasion of privacy.” Schumer was concerned with the use of “military-grade spy planes” to photograph major cities and the ability to create detailed images of items as small as 4 inches. Schumer wrote to the two companies and then met with them to express his concerns. Both companies denied violating privacy.

In July 2012 Google agree to pay $21.5 million in a settlement of FTC charges of evaded some privacy settings on its Safari web browser.

In an embarrassment to Facebook, General Motors announced that it would no longer advertise on Facebook. The two companies then agreed to discuss resumption of GM advertising.

Facebook went public in an IPO that valued the company at nearly $100 billion, but the share price fell by 25 percent before recovering a portion of the tumble.

5

San Jose Mercury News, June 29, 2012.

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Chapter 21 Ethics Systems: Utilitarianism As indicated in Chapter 20, the content of corporate social responsibility is found in ethics. The purposes of Chapter 21 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 22. A number of the cases in this chapter can be used in conjunction with Chapter 22, 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 utilitarianism 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

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relatively straightforward. (This is the world that Milton Friedman envisions.) The second category 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 21-1 through 21-4. Figures 21-2 and 21-3 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 creative 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 24 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

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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.

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

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and effective birth control device brought to market. The Population Council’s involvement and investment certainly has resulted in a substantial return.

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 22 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

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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 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

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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 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.”6 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 small amounts of silicon were in Norplant, and with the attention being given to silicone breast implants (see Chapter 14), sales of Norplant plummeted.

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 6

New York Times, March 19, 1994. President Clinton fired Dr. Elders shortly after she took office.

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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 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 19) 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

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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 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)

2002

2001

2000

1999

1998

$ 168,979 239,838

$ 151,119 230,631

Costs and expenses Income (loss) from operations Gain on sale of oncology assets Income (loss) before accounting change

385,783

354,458

$ 195,555 247,873

81,007

(120,689)

(52,318)

(70,859)

(79,512)

-

157,771

-

-

-

72,097

51,182

(43,106)

(66,486)

(44,758)

Net income (loss)

$ 72,097

$ 52,271

$ (56,776)

$ (66,486)

$ (44,758)

Revenues

$ 466,790 $ 233,769

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

Exhibit 2 Per Capita Gross National Income in US Dollars, by Country (2003) Country

GNI 2003

Country

GNI 2003

Country

Luxembourg

45,750 Poland

Norway

43,400 Lithuania

Switzerland

40,680 Latvia

Middle income 4,540 Ecuador Colombia 4,420

37,870 Libya

4,400

United States Japan

34,190 Chile

Denmark

33,580 Lebanon

Iceland High income: OECD Sweden United Kingdom

30,910 Costa Rica

High income

28,150

Finland

27,060 Malaysia

Ireland

27,020 Argentina

Austria Netherlands

26,810 Uruguay 26,240 Belize

Belgium

25,760 Grenada

Germany Hong Kong, China

25,270 Botswana Venezuela, 25,110 RB

France

24,750 Dominica

Canada European Union

24,470 Gabon L. America, 22,810 Carib.

Australia

21,960 St. Vincent,

Italy

21,570

Singapore

29,360 Mauritius 28,910 Panama 28,320 St. Lucia Upper middle inc

South Africa 21,410 Turkey

5,280

M. East, N. Africa 4,360 Kazakhstan Bosnia 4,320 Herzegovina 4,310 Albania Belarus 4,100

GNI GNI Country 2003 2003 1,880 Sub-Saharan 510 Africa 1,830 Yemen, Rep. 510 1,830 Papua New Guinea 490 1,830 Mongolia 480 1,810 Vietnam 1,660 Sudan 1,640 Benin 1,590

Comoros 4,040 Samoa 1,540 Low income Tonga 1,510 4,040 Guinea Cape Verde 1,440 4,040 Timor-Leste Egypt, Arab 1,390 3,880 Rep. Uzbekistan Lower 1,370 3,840 middle inc.

Kenya 3,770 Swaziland 1,320 Bangladesh 3,740 Morocco 1,310 Haiti Low & 1,250 3,690 middle inc.

Mauritania 3,530 Vanuatu 1,150 Zambia Syrian Arab 1,120 3,470 Rep. Nigeria Paraguay 1,110 Kyrgyz 3,380 Republic 3,340 China 1,100 Lao PDR Turkmenistan 1,090 Sao Tome, 3,310 Principe East Asia & 1,090 3,250 Pacific Ghana Philippines 1,060 2,850 Togo 2,800 Ukraine 970 Tanzania

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480 460 440 440 440 430 420 420 400 400 400 390 380 350 340 340 330 320 310 310

Honduras

Spain

17,040 Jamaica

2,780

Israel New Zealand High inc: nonOECD

2,760 Armenia Djibouti 2,610

Greece

16,240 Brazil Russian 15,530 Federation Europe & 14,370 C. Asia Marshall 14,230 Islands 13,230 Maldives

Korea, Rep.

12,050 Fiji

Cyprus

2,580 2,490

Indonesia Sri Lanka

2,300 Bolivia Guyana 2,280

Slovenia 11,870 Romania Portugal 11,810 Tunisia Malta 10,630 El Salvador Antigua and 9,330 Thailand Barbuda Saudi Arabia 9,170 Peru Trinidad and Dom. 7,790 Tobago Republic Seychelles 7,360 Bulgaria Czech 7,190 Suriname Republic Iran, St. Kitts and 6,860 Islamic Nevis Rep. Palau 6,580 Micronesia Macedonia, Hungary 6,360 FYR

2,260 Kiribati 2,240 Georgia 2,220 Azerbaijan Angola 2,190

Mexico

6,290 Algeria

1,930

Estonia

5,380 Namibia

1,930

2,140 Nicaragua Bhutan 2,130 2,120 Cote d'Ivoire Congo 2,080 2,010

Cameroon

1,990 Lesotho Moldova 1,980 Solomon Islands Senegal

960 Burkina Faso 950 Mali 950 HIPC* 940 Least developed 930 Cambodia 920 Madagascar 890 C. African Republic 880 Gambia 840 Uganda 820 Chad 760 Nepal 750 Tajikistan 720 Mozambique 670 Rwanda 650 Niger 640 Sierra Leone 590 Eritrea 590 Malawi Guinea560 Bissau 540 Congo, Dem. Rep. 540 Liberia 520 Ethiopia

300 300 300 300 300 290 270 270 250 240 240 210 210 210 200 190 160 160 140 100 100 90

Croatia 5,370 Guatemala 1,910 India World 5,520 Jordan 1,910 Pakistan Slovak Serbia, 4,970 1,900 Republic Montenegro South Asia 520 Burundi 90 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. * HIPC: “Heavily indebted poor countries.”

Source: World Bank, http://www.finfacts.com/biz10/globalworldincomepercapita.htm (October 26, 2006).

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GILEAD SCIENCES (B): IMPLEMENTING THE GILEAD ACCESS PROGRAM FOR HIV DRUGS 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.”7 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 AND AXIOS (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.8

7

“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).

8 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.9 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.10 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, 9

Interview with Gregg Alton, senior vice president and general counsel, Gilead Sciences, September 27, 2006.

Subsequent quotes from Alton are taken from this interview.

10 “Gilead launches Access Program,” loc. cit.

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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.

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:

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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 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.11 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

11

“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).

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step, Gilead decided to concentrate first on 15 so-called “focus” countries in the PEPFAR program and then expand gradually to the other nations.12 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

12

Botswana, Cote d’Ivoire, Ethiopia, Guyana, Haiti, Kenya, Mozambique, Namibia, Nigeria, Rwanda, South Africa, Tanzania, Uganda, Vietnam, and Zambia.

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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.’

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

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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 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.”13 The article only 13

Paul Elias, “Gilead Faces Criticism Over Drug Access,” Associated Press Newswire, June 4, 2006.

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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.”14 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…”15 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 God-given 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 14

Sabin Russell, “International AIDS Conference, A Look at HIV  Where Are We Now?,” San Francisco Chronicle, August 13, 2006.

15 Steve Johnson, “Gilead Lets 8 More Indian Firms Make Generic HIV Drug,” San Jose Mercury News, September 23, 2006.

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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: 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

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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.

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.

Updates: In 2012 an FDA panel voted approval for Gilead’s Truvada as the first drug for the prevention of HIV. Approval by the FDA was pending.

Gilead’s strategy of patenting Viread in India and licensing it broadly ran into a hurdle. The Indian Patent office rejected Gilead’s patent application on the grounds that the innovations were obvious.

(A number of other major drug companies also had complaints about the Indian regulator and its practice of declining to prohibit generic versions of drugs while the patent review was in progress.)

Viread has been granted patent protection in a large number of countries. Gilead has licensed

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Viread to 13 companies in India. The price in India is as low as $8.50 a month, whereas the price in the United States is $400 a month.

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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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 than the harm done by the side effects. This might be a small percent, probably 1 percent or less when the severity of the symptoms are 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 improve the information available to people through its marketing and advertising campaign,

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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 legs. Steven Woloshin and Lisa Schwartz of the Dartmouth University Medical School, who had

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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.”16 Woloshin argued that the disorder was not very prevalent and prescribing strong drugs was not warranted.

16

New York Times, July 19, 2007.

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Chapter 22 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 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 distinctions between deontological and consequentialist systems can be made by distinguishing between intrinsic and instrumental rights. Figures 22-2 and 22-3 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. A lecture on Kant’s system could 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 22-5 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.

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 22-6 and 22-7.

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

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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.

Higher order moral standards and how utilitarianism, moral rights, and Rawls’s theory of justice meet those standards should be discussed in a lecture and can also be useful for reviewing the moral foundations for the three ethical systems considered in Chapters 21 and 22.

Gert’s principles for reasoning about injustice 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.

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.

Disparate Impact versus Disparate Treatment In 1995 26,000 people took the examination to become a firefighter in Chicago. The city stated that anyone scoring above 65 was “qualified,” but it chose the new firefighters from those who were “well qualified, those scoring 89 or better. After many years a lawsuit was filed on behalf of the 6,000 black applicants who had taken the test alleging disparate impact. The city claimed the lawsuit had not been filed in a timely manner, but in a 9-0 vote the U.S. Supreme Court held that the case could proceed. In 2011 the U.S. Court of Appeal for the Seventh Circuit ruled that the city had to hire 111 of the black applicants and pay tens of millions of dollars in damages.

Cases Genetic Testing in the Workplace 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 21 and 22, 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 357

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 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 22 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. An important part of any testing program is to keep the results of the test private.

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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 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 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

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(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?

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? .

Chipotle Mexican Grill and Undocumented Workers Chipotle Mexican Grill was a hot company in 2011. It was opening new restaurants at a rapid pace, and its share price was increasing in a sluggish stock market. The company planned to broaden its

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scope by opening a new line of restaurants—ShopHouse Southeast Asian Kitchen. The company, however, faced a nonmarket challenge to its employment practices for potentially many of its employees. ICE had investigated Chipotle’s operations in Minnesota and found 400 undocumented workers at its restaurants. The workers fired in Minnesota as a result of the ICE investigation represented more than half its employees in the state. If this ratio is representative of other states, the number of undocumented workers in its 26,000 person workforce is huge.

Chipotle surely was aware of its employment of undocumented workers, and the question is why it was employing them given its code of ethics for the CEO that includes, “Comply with rules and regulations of all U.S. and non-U.S. governmental entities and other private and public regulatory agencies to which the company is subject, …” The answer must be that it is able to hire workers more easily at the wage it pays, and if it hired only documented workers, it would have to increase the wage it pays or use labor saving technology both of which would result in lower profits and perhaps slower growth.

The ICE investigation in Minnesota and the one in Washington, DC and Virginia led to a criminal investigation of the company. Criminal charges could be brought against the company and its executives and management. What is unknown is whether there is a paper trail within Chipotle that would indicate that management was aware of the undocumented workers and intentionally ignored the issue.

The issues surrounding illegal immigration and undocumented workers are controversial, and students are likely to be divided on the broader issue of illegal immigration. In discussing the case it is important to distinguish between the term “illegal immigrant” and the term “undocumented worker.” ICE refers to “illegal entry” and stated that the objective of its policies is “to reduce the incentive for aliens to come to, and enter and remain unlawfully.” An illegal immigrant thus can be thought of as a person who comes to, enters, and remains unlawfully in the country. The term “undocumented worker” can be thought of as referring to a person employed without documentation that he or she is eligible. Such people are illegally employed under U.S. law. Both the Bush administration and the Obama administration have enforced the law, but their measures differ. The Bush administration’s policy was to arrest undocumented workers found to be in the country illegally and deport them. The Obama administration uses only silent raids and neither arrests nor deports undocumented workers found to be in the country illegally. The apparent rationale for the Obama administration’s policy is that preventing illegal immigrants from working will “reduce the incentive for aliens to come to, and enter and remain unlawfully.” Since illegal immigration is a delicate political issue, both the president and his Republican challenger have avoided discussing the issue, and when they cannot avoided the issue, they have been cautious in their statements.

The justice concern is that firing undocumented workers could drive them into the underground economy where they could have lower compensation, fewer benefits, and worse working conditions. This would be consistent with ICE’s policy of reducing incentives. One argument is that the Obama administration’s policy of not deporting undocumented workers found to be in the country illegally is justified on the grounds that they will be better off than if they were deported.

A concern for ICE then is to prevent the exploitation of undocumented workers in the underground economy, as in the case of Chun’s Mesquite Broiler.

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With respect to rights, the maximum to be evaluated might be formulated as: Persons have the right to live and work anywhere they choose. This is not a Kantian right, since it does not treat the citizens of a country as autonomous ends who can freely choose the conditions for immigration. If those residents choose to limit immigration, they have exercised their free will. This is also consistent with Nozick’s philosophy that individuals can join together for their mutual benefit and protection.

With respect to utilitarianism, is societal welfare maximized by allowing undocumented workers or illegal immigrants to remain in and work legally in a country? One argument is that the workers are productive and contribute to the economy. In particular, they do work that Americans do not want to do. The citizens of the United States, and any other country with illegal immigrants, are thus better off economically. The counter argument is two-fold. First, if undocumented workers were prohibited from being in and working in a country, wages would rise for the jobs they would otherwise hold and would rise to the point such that those jobs whose value exceeds the higher wage would be filled and those whose value is not that high would not be filled. (Wages are already rising for agricultural labor in parts of the country.) Second, if the country would benefit from undocumented workers, it can allow them to work in the country legally by issuing them visas. In the United States, this is done with H1B visas for highly skilled workers, and through guest worker programs for seasonal work. If the country wanted more such workers, it could simply increase the number of visas issued to the level that maximized the social welfare of its citizens.17 (Note that the guest workers are better off or else they would not have accepted the employment.)

The broader issues of what should be done about illegal immigrants with respect to amnesty, social services, and citizenship are beyond the scope of Chipotle’s autonomy and choice.

Discussion questions: 1. Was Chipotle likely aware that it was employing a large number of undocumented workers?

2. Why was it employing so many undocumented workers?

3. Should Chipotle have fired the undocumented workers in Minnesota and Washington, DC? 4. Should the company use E-Verify for its hiring of new employees for its Chipotle restaurants?

5. Should the company use E-Verify to check the documentation of its current employees?

6. What are the possible implications of criminal charges against the company and possibly its executives?

7. Should it use E-Verify for all the hiring for its ShopHouse restaurants?

8. What type of termination policy should the company have for workers that it has to fire?

What guidance do justice considerations have for its policy?

9. Are silent raids and the firing of undocumented workers consistent with U.S. law?

Update: In May 2012 the company disclosed that it was under investigation for possible criminal charges on a different but related matter. Chipotle spokesperson Chris Arnold said, “It appears that 17

Another utilitarianism argument could be made that the analysis should be carried out at the world level, but this seems far removed from the actuality of countries, all of which control immigration.

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the Department of Justice and the Securities and Exchange Commission are both focused on our disclosures regarding work authorization compliance, both in our SEC filings and in our other communications with investors. We believe we have been open and transparent with investors on these issues.” (Wall Street Journal, May 23, 2012) The media reports of the investigations of Chipotle do not mention any termination policy for undocumented workers whom the company fires.

Chipotle now uses E-verify to screen out undocumented workers in its hiring, but there is no indication that it has used it for its existing workers.

Despite its problems with the federal government Chipotle continued to open new restaurants at a fast pace, and its same store sales were up 11 percent from the previous year. Its share price had increase by 40 percent over the past year. (Wall Street Journal, May 23, 2012) In June 2012 the NGO National Guestworker Alliance charged that guest workers in the United States were working under terrible conditions in at least 13 seafood suppliers supplying Wal-Mart.

The NGO disclosed that the suppliers had 644 citations for workplace standards violations and charged that Wal-Mart was failing to live up to its supplier standards. (The U.S. guest worker program issues visas for foreign workers for seasonal work.)

Environmental Injustice?

The disparities in who lives near facilities that emit toxics have been well documented. The poor and minorities are overrepresented among people living near toxic emissions. These emissions are legal and meet EPA and state standards, but they still generate concerns among residents and advocates for the poor and minorities. The issue in the case is whether this situation represents environmental injustice, and if it does, does it place any duty on the companies generating the emissions?

One part of an answer to these questions depends on causation. Did companies locate their facilities in communities in which the poor and minorities are located or did the poor and minorities locate where facilities that generate toxic emissions were already located. Wolverton’s study provides clear evidence on this issue. She studied the location decision for the facility; i.e., she studied the time at which the location for the facilities was determined. Her study was intended to identify whether the location decision was made on economic criteria and whether the owners sought to avoid posing a risk to people. She found no evidence that facilities were located where blacks or foreign born residents were overrepresented. The facilities were located in lower income communities, perhaps rural areas where people have lower incomes than in urban areas, but they were less likely to be located in communities with people in poverty. The facilities were located based on economic variables. The facilities were also located where people were better prepared to protest, so either the protest failed to materialize or they were ineffective. The conclusions from her study are that facilities locations were based on economic factors and that companies sought to

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avoid areas were people were in poverty and where black and foreign born people lived. Once the facilities were built, land prices remained low, which attracted disproportionately the poor and minorities.

Wolverton conducted a statistical study, and it does not mean that every company behaved as explained by the regression. Also, it was based on one geographic area, and extrapolation to others must be done with caution, but there is little reason to believe that the area was unrepresentative of other areas. Her study suggest that companies take into account the communities in which facilities might be located but do not do so based on race, foreign born, or poverty. It is important to note that she also found that at present the poor and minorities are disproportionately represented in communities with facilities that generate toxic emissions. This confirms the other reports.

Now, is the situation unjust? From a time slice theory such as Rawls’ the answer could be yes because of the presence of the poor and minorities. This could call for compensation or perhaps reductions of emissions in facilities where the poor and minorities are overrepresented. The past, however, seems to be important here as Nozick argued, since firms were unlikely to have located their facilities where the poor and minorities are overrepresented. Indeed, the evidence available suggests that they may have avoided such areas. Taking into account the history behind the present situation indicates that the people who selected to locate near a facility where toxic facilities were already located benefitted from low land and housing costs.

Moreover, as Nozick argued in his theory, justice requires free consent and the people chose to locate there. Facilities that emit toxic emission are not present in most communities, so choices were likely available to the people. Some communities may have been too costly for low income people, but that does not seem to be an issue of environmental injustice.

Discussion questions: 1. Are the toxic emissions of concern illegal? Are the toxic emissions likely harmful?

2. Do firms take economic factors into account in making location decisions?

3. Do firms intentionally locate facilities that emit toxic emissions in communities where the poor and minorities are located or overrepresented?

4. What are the implications of Wolverton’s study? Are there weaknesses in it?

5. Is a time slice theory appropriate for answering the question of whether an environmental injustice is present in the location of facilities with toxic emissions? What might Rawls’ theory conclude?

6. Does history and causation matter in assessing whether an environmental justice is present?

7. What might Nozick’s theory of justice conclude?

8. As a firm with a facility that generates toxic emissions are their actions that you should take in light of the UCC 2007 study?

With respect to question 8 a firm might identify the characteristics of the community at the time it located there to see if the poor and minorities were overrepresented. If so, it might assess whether there is any likely harm, and if so, discussing the situation with community leaders would be appropriate. It might also prepare for private politics challenges to its operating there.

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Chapter 23 Behavioral Ethics, Individuals, and Management Chapter 20 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 difficult one, however, since it must be implemented by individuals. Behavioral ethics is concerned with how people behave in settings in which moral concerns are present. This chapter focuses on one part of behavioral ethics—the understandings that can be obtained from controlled laboratory experiments. Laboratory experiments represent a vast literature focusing on human behavior, and much of that is conducted by psychologists and organizational behavior scholars.

Some of the experiments discussed come from that line of research, but many of the experiments discussed were conducted by economists interested in behavior in settings in which moral behavior can be exhibited. The experiments discussed all deal with moral issues, and some speak directly to moral philosophy as discussed in Chapters 21 and 22. The experiments provide insight into whether individuals are altruistic or self-interested and the types of situations in which each type of behavior is likely to be exhibited.

Students like to play games and take surveys, and a survey of the type discussed in the section entitled “Overconfidence in One’s Self” is a useful exercise. The types of games discussed in the chapter can be played online and outside of class time, and some games are available on the Internet. Otherwise, some programming and debugging may be required.

The chapter also identifies a set of implications for management in dealing with issues pertaining to moral or immoral behavior. For example, one experiment focuses on moral rebels who do the right thing when everyone else is not doing so. Moral rebels can be ostracized or worse by the other people, and this has implications for the design of whistleblowing policies.

The chapter also discusses the challenge of corporate social responsibility and the implementation of ethics principles systems by examining a set of corporate policies intended to guide managers in addressing issues involving responsibility and ethics. An example of the difficulty in establishing social responsibilities in Citigroup is discussed, and as indicated in other chapters these efforts have not been very successful as the company has been involved in a series of incidents and scandals.

This is reflected in shareholders voting against Citigroup’s compensation program in a say-on-pay advisory vote. Johnson & Johnson’s Our Credo is presented and discussed, and the chapter concludes with a brief discussion of some of the factors that can lead to unethical behavior.

Cases Denny’s and Customer Service (A)

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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) 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:

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 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.18 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.”19 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.”20 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 18

Flagstar News Release, July 1, 1993.

Flagstar News Release, July 1, 1993.

20 Flagstar News Release, July 1, 1993.

19

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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.21 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.22 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.”23 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.”24 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.”

21

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.

22 Flagstar is the largest franchisee in the Hardee’s system, which is owned by Imasco Limited.

23 Newsweek, July 19, 1993.

24 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.25 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.

Insider Trading Raj Rajaratnam’s success as an analyst for the semiconductor was built on a set of contacts he cultivated and with whom he exchanged information. When he established Galleon in 1996 he became more active in soliciting information and in building a network of sources. How large that network was will never be known, but it certainly was extensive with 51 people having been convicted or pleaded guilty. He undoubtedly developed contacts at individual companies, but it was probably more efficient to use intermediaries such as consultants, independent board members, and expert networks companies for information about companies. Expert networks companies are organized as networks of independent people who provide expertise and consulting services to clients. But, it is clear that at least Primary Global Research was involved in gathering and providing non-public information about companies obtained through its network and distributing it to clients and others such as Rajaratnam. Winifred Jiau was reported to be one of the best at obtaining non-public information and was paid directly by Galleon. She was convicted and given a 4-year sentence.

Part of the class discussion could focus on whether insider trading is a good or bad thing. One central issue is why the inside information was not made publicly available by the company. This could be because the information was valuable to competitors which would mean that disclosure would be at least a private bad for the firm. It also could be because executives at the firm want to 25

The Wall Street Journal, June 15, 1994.

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trade on the information. For example, if the firm had a bad quarter, executives would know that when the earnings report was released the share price would fall, and they could sell shares in advance of the release, obtaining a private gain. Although the selling of their shares moves the share price in the right direction, it is hard to see why the executives should be compensated in this manner, even if the pay of the executives were reduced by the gain they had obtained.

The principal argument against insider trading is that it lessens confidence in the market. It is easy to see why? An investor considering buying or selling shares may well be concerned that the person on the other side of the trade has inside information allowing that person to gain at the expense of the investor.

The case of Rajat Gupta is interesting since it could have been the case that the two friends were simply sharing information about what was going on. Even casual sharing without any payment for information should be of concern and is possibly a violation of the law.

Discussion questions: 1. Is insider trading a bad thing or does it help to improve market efficiency by moving share prices in the direction of their equilibrium values?

2. Why did Rajaratnan engage in insider trading? What motivations might he have had? Was it greed? Was it the recognition that comes with managing a very successful fund?

3. Is an 11-year sentence too harsh, too lenient, or about right for a white collar crime?

4. Was Rajat Gupta just having a conversation with a friend (Rajaratnan) and discussing “what was going on”?

5. Has Rajat Gupta done anything wrong, given that he was not paid for the information he provided?

6. Should Rajat Gupta be prosecuted?

7. What is the role of expert networks in insider trading?

8. Are expert networks companies socially valuable or are they inevitably going to be engaged in illegal or suspicious activities?

Developments: Rajat Gupta was found guilty of insider trading. The Wall Street Journal wrote, “Mr. Gupta was convicted on three counts of securities fraud and one count of conspiracy for passing along confidential boardroom information about Goldman to a hedge fund that earned millions of dollars trading on his tips. He was acquitted of two counts of securities fraud, including the only one relating to P&G.” The WSJ also stated that he “was motivated not by quick profits but rather a lifestyle where inside tips are the currency of friendships and elite business relationships.”26 Rajat Gupta’s legal bills were believed to be $30 million, and Goldman Sachs had picked up the bulk of the cost with Procter & Gamble covering the rest. Gupta had made an agreement with Goldman Sachs that if he were found guilty he would pay the legal bills, but Goldman Sachs and Procter & Gamble were responsible for the costs until all appeals had been exhausted.27 26 27

Wall Street Journal, June 16-17, 2012.

New York Times, June 19, 2012.

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Fresenius Medical Care in China This case may also be used in conjunction with the discussion of human rights in Chapter 16 or with Chapter 24, which addresses ethics issues in international business.

Fresenius Medical Care (Fresenius) is a German company formed at the time of the acquisition of National Medical Care from W.R. Grace. Along with the acquisition came the Nanfang dialysis center. The Nanfang facility had a capacity of 40 patients. Fresenius had plans to expand beyond Europe and the United States, and Latin America and Asia provided the greatest opportunities.

Fresenius provided dialysis care and sold dialysis products for treatment of chronic kidney failure.

The only available treatments are a kidney transplant or ongoing dialysis. Many individuals with chronic kidney failure sought a transplant, but there was a shortage of organs.

The Nanfang dialysis center was run locally, and Fresenius had only one employee stationed in China—in Hong Kong. Fresenius’s principal interaction with the facility was the supply of filters to it. The facility was located adjacent to a military transplant hospital, but the Nanfang facility was not involved in the transplants. It only provided dialysis treatment for patients, some of whom were awaiting a transplant.

Allegations of the sale of human organs harvested in China had persisted for some time. Amnesty International estimated that 4,300 prisoners a year were executed and their organs harvested. The usual method is a bullet in the head unless the corneas are to be harvested. The FBI sting revealed that harvested organs were offered for sale, and hospitals in China would perform the transplants.

These sales were necessarily arranged in advance, and the implication was that sales would be made and the transplants scheduled. Then, the needed number of organs would be obtained, presumably by executing prisoners and harvesting their organs.

The Chinese government stated that organs were harvested only with written permission of the prisoner. The statements by Dr. Phaibul Jitpraphai of Thailand, who had made an inspection visit to China were reported in Stern. “First, I believed that the prisoners voluntarily agreed to donate their organs. But then we found out that no consent forms from the prisoners existed … They were simply shot in the head and then disemboweled.”28 Teaching the case: The following questions can be used to guide the discussion.

1. After the ABC Primetime Live broadcast what should Fresenius do?

2. After the FBI sting what should Fresenius do?

3. On what basis should Fresenius make its decision about what to do? What if it were unable to gain access to the military transplant hospital?

4. Fresenius was asked by Stern for interviews in conjunction with its forthcoming article on organ harvesting in China. Should it agree to the interviews?

28

San Jose Mercury News, March 8, 1998.

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5. With the article scheduled to appear next week in Stern, what should Fresenius do regarding the reports and what its internal investigation has revealed?

6. To what extent should a company go to ensure that its operations in China are being conducted according to appropriate standards?

Outcome: After the report on ABC Primetime Live Fresenius began an internal investigation of allegations about the Nanfang facility being used in conjunction with patient tourism and the sale of kidneys from executed military prisoners. The military hospital was closed to Fresenius, so its investigation had to focus on patients’ medical records at its dialysis center. The investigation revealed that foreign patients had visited the facility for short-periods of time, and the only reasonable conclusion for traveling to China for dialysis treatment was that they were there for a kidney transplant. Fresenius was unable to obtain any information about the transplants themselves.

The FBI sting accelerated the issue, and Fresenius had been contacted by Stern for interviews for its forthcoming article, but its executives declined to be interviewed. Fresenius knew when the Stern article was scheduled to appear and had to face the immediate problem of what to do about the article but more importantly about the Nanfang facility. It had no direct evidence that kidneys were being harvested from executed prisoners or that foreign patients were receiving kidney transplants. Putting the information from its investigation with the published information, however, left little doubt.

Fresenius decided that the right action was to withdraw from the Nanfang facility and leave China.

On the eve of the publication of the article in Stern Fresenius announced that it was leaving China because its internal investigation had indicated that foreign patients may have been “receiving kidney organs harvested from executed Chinese criminals.” A Fresenius spokesperson said, “We disapprove of the Chinese practices in connection with kidney transplants that recently became known and expressly distance ourselves from them.”

The issue of organ harvesting in China remained of concern in the United States and elsewhere.

Although the numbers are apparently small, Americans are reportedly increasingly traveling to China for organ transplants, particularly kidneys. When they return to the United States, they need follow up care that is paid by medical insurance, including Medicaid or other government programs. Some argued that providing follow-up treatment means that the United States is condoning the transplants. Most of the kidneys and other organs come from executed prisoners.

According to the United Network for Organ Sharing, there were 78,350 Americans awaiting transplants in 2001. (See The New York Times, November 11, 2001.)

One reason for using organs from executed prisoners is that traditional Confucianism requires preserving the body. Consistent with this, Chinese law does not provide for individuals to donate organs upon their death, except apparently for research purposes. (See The New York Times, December 5, 2001.)

In May 2005 Fresenius announced that it would acquire its U.S. rival Renal Care Group for $3.5 billion. This made Fresenius the largest provider of renal care in the United States and in the

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world. After the acquisition was completed Fresenius would operate 2,055 clinics worldwide and have revenue of $7.5 billion.

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Chapter 24 Ethics 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.

In a number of countries, facilitating payments to government officials are commonplace. In some cases, these payments are simply grease that causes 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 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.”29

29

Wall Street Journal, February 16, 1999.

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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 Siemens: Anatomy of Bribery chapter case.

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 14 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.30

Cases Google Out of China This case follows on the Chapter 16 case Google in China, which considers Google’s decision to set up its search service in China. The company had reservations about entering China in the first place, and it entered with a limited set of offerings so that it could avoid be put in a position in which was forced to provide information on its users. For example, Google did not offer G-mail in China. When Google announced its decision to enter China, it expressed its reservations about censorship and notified users when they searched for a term that was censored. All of this angered the Chinese government, and Google had poor relations with the government throughout its stay.

The nature of censorship in China is discussed more thoroughly in the Google in China case.

The sophisticated and broad cyber attack was the straw that broke the camel’s back. Google tried to negotiate with the government, but China does not negotiate on censorship. China requires firms to abide by its laws.

Ending its self-censorship and moving its servers to Hong Kong was consistent with the law and was not challenged by the Chinese government. The government criticized Google but took no action.

30

Business Week, May 23, 2005.

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Serge Brin appears to be the lead executive on the China decisions, and his experience in the Soviet Union may have shaped his views on censorship and human rights.

Moving to Hong Kong was potentially very costly to Google. It has steadily lost search share and advertising revenue to Baidu, partners have abandoned it, and other companies have hired away some of its employees. Although at the time of the decision, Google’s revenue and profits in China were modest, the market is huge and growing rapidly, and incomes are rising quickly. The market potential is very large, and Google is losing the opportunity. Moreover, domestic companies have filled the spaces left open by Google.

Google was careful to praise China for its economic progress and the higher standard of living for tens of millions of people. Google did not accuse China of conducting the cyber attack. Although censorship had been relaxed leading up to the Beijing Olympics, it had subsequently gotten worse.

The cyber attack was found to have originated at two schools in China suspected to be connected to the military.

The ethics rationale for leaving China is based on rights considerations. The right to free speech, and the other side of the coin the right to free inquiry, is clearly violated by Chinese censorship. In its decision to enter China, Google made a utilitarianism argument that its presence would do more good than harm because it had a superior search technology and would censor less than its competitors. The cyber attack may have changed that calculation.

Discussion questions: 1. Why does China censor the Internet?

2. How is Internet censorship implemented in China? What is Google required to do?

3. How much is Google sacrificing in its decision to move its search business to Hong Kong?

4. Did Google’s decision to move its search business to Hong Kong just substitute government censorship for self-regulation by Google?

5. What ethics principles are likely to have guided Google’s decision?

6. Is the decision to move to Hong Kong a compromise of principles?

7. What would you have done? Use principles of utilitarianism, rights, and justice in answering.

Developments: Google reports regularly on the number of government requests for information on users in the countries in which it operates. It does not report on China or Iran where it does not operate.

De Beers and Conflict Diamonds (A) 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

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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 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.

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 Kimberley Process that established a system, the Kimberley Process Certification System (KPCS), that certifies that diamonds are conflict free. The formation of the Kimberley Process began in 2000 with a meeting in Kimberley, 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 Kimberley 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 Kimberley Process also collects data to track the effects. More details can be found at www.kimberleyprocess.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.

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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 development of retail stores was hampered by antitrust class-action lawsuits in Europe and the United States.

De Beers is owned 40 percent by Anglo American PLC, 45 percent by the Oppenheimer family, and 15 percent by the government of Botswana.

De Beers and Conflict Diamonds (B) This case is not about De Beers but instead is about the Kimberley Process created to govern conflict diamonds. The Kimberley Process was established to stop the use of diamonds to finance conflict against a government. It did not cover the funding of conflict by the government. The concern of the human rights NGOs was that the government of Zimbabwe was committing human rights abuses in the Marange diamond mines and that it would use the sale of diamonds to fund human and civil rights abuses leading up to the elections anticipated in 2012. (The situation in Zimbabwe is discussed in Chapter 17.) Zimbabwe strongman Robert Mugabe controlled the police and military and was widely viewed as having stolen the 2008 election. African nations forced Mugabe to enter into a power sharing arrangement with the principal opposition party, and that party and Mugabe’s Zanu PF party. Western countries opposed Mugabe’s continued control of the government.

The threat to the Kimberley Process resulted from an impasse between the NGOs and western countries on the one hand and on the other hand a number of African countries that sided with Zimbabwe if not Mugabe. The Chairman broke the impasse in June 2011, and the NGOs and western countries walked out in protest. From their perspective the Kimberley Process should, as Ganesan said, “ban the sale of all blood diamonds, not just some.”

Discussion questions: 1. Why did the chairman lift the ban on diamonds from the Marange mines?

2. Should the Western countries and NGOs withdraw from the Kimberley Process?

3. Should the Western countries negotiate with Mugabe over conditions in the mines?

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4. Will consumers care about the diamonds from Marange, given that they will be certified by the Kimberley Process?

Developments: After negotiations between the European Union and Zimbabwe, the Kimberley Process members approved exports from the mines, which were expected to generate $3 billion a year for the Zimbabwe government. Zimbabwe pledged to respect human rights and inspectors were allowed at the mines. “Zimbabwe's state-owned Herald newspaper said the lifting of the ban heralded a ‘decisive victory in the struggle against Western economic hegemony’.”31 “The Kimberley Process has effectively given up on Zimbabwe,” said Alfred Brownell, President of Green Advocates, Liberia. “KP member governments and the diamond industry seem ready to turn their back on the interests of Zimbabwe's citizens, the public good and the principles on which the Kimberley Process was founded.”32 “It’s a pure business deal that leaves out key concerns of Zimbabwe’s civil society: that is protection of the locals from human rights abuses in and around Marange and ensuring that Marange diamonds are properly accounted for, for the benefit of the suffering Zimbabwean people,” Farai Maguwu said from New York where he is being honoured with Human Rights Watch’s Alison Des Forges Award for Extraordinary Activism for his work in the Marange diamond fields. 33 Global Witness quit the Kimberley Process in December 2011 as a result of the decision to lift the ban. Western countries participating in the Kimberley Process continued to allege that the military was committing human rights abuses.

The outcome of the Marange diamond mines issue remains uncertain, and it is likely to depend on the upcoming election in Zimbabwe, which is now expected to be in 2013. If there is no violence and the elections are fair, the Kimberley Process will likely continue as it is. Otherwise, the Process itself may be in jeopardy.

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.

31

BBC News Africa, November 2, 2011.

Global Whitness, November 2, 2011. Accessed at globalwitness.org, July 14, 2012.

33 Global Whitness, November 2, 2011. Accessed at globalwitness.org, July 14, 2012.

32

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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.34 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 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 34

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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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.”35 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.

35

Wall Street Journal, July 30, 2008.

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Part V Integrative Case GlaxoSmithKline and AIDS Drug Policy 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.

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 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.

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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 be 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  Price drugs at market in rich countries

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 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 does 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 suggest that the pharmaceutical companies provide their drugs at cost.

The second issue discussed here is an integrated strategy for GSK. 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) » R&D support for drugs for pandemics 387

–

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.

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 sub-Saharan 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 pressure 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 an 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?

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?

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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

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.”36 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 has not increased. Critics argue that the industry focuses on lifestyle drugs that can be sold in developed countries at high prices.

36

The New York Times, June 3, 2005.

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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 acknowledge 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 solution.”37 This comment is surprising, since early on GlaxoSmithKline fought hard against the efforts of the activists for lower prices and greater access.

37

Wall Street Journal, June 18, 2007.

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The following is a note on AIDS and the pharmaceutical industry written in 2003. Chapter 23 provides more current information.

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NOTE ON AIDS AND THE PHARMACEUTICAL INDUSTRY38 HISTORY OF A MODERN EPIDEMIC 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, PCP, and rare infections in the homosexual male population.

By 1982 this 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.

38

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.39 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.40 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.41 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. 42 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.43 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.

39

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.

41 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.

42 Ibid. pp. 30-32.

43 Bethany McLean, “Generic Drugs: Don’t Get Hooked,” Fortune, Oct 30, 2000.

40

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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 HIV-positive 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 an 0.8 percent annual decrease in per-capita income in sub-Saharan Africa.44 Employers faced mounting direct benefits costs for HIV/AIDS. The cost of such benefits was estimated at 7 percent of salary in 1995 and was expected to increase to 18 percent in 2005.45 Sub-Saharan African countries were among those least able to absorb this impact, with a per-capita GNP of less than one-ninth the world average and three out of four people living on less than $2 per day in 2001.

44

Dr. Rene Loewenson, “HIV/AIDS Implications for Poverty Reduction,” United Nations Development Programme, June 2001, p. 3.

45 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 AIDS THERAPIES IN THE 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.46 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.47 These figures were much lower than the $1,500 or more spent by countries in Western Europe and North America. Sub-Saharan 46 47

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.48 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.49 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.50 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.51 The causes were many and complex, but the factor most 48

Ibid.

The PANOS Institute, Beyond Our Means?, 2000 50 Ibid.

51 Joint UNICEF-UNAIDS Secretariat-WHO/HTP-MSF Project, Sources and Prices of selected drugs and diagnostics for people living with HIV/AIDS, May 2001 49

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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.52 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.53 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 1998.54 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 IN DEVELOPING 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.55 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 concentrated in the United States and Europe. As with most drugs the multinational pharmaceutical companies, such as GlaxoSmithKline, Bristol-Myers Squibb, Pfizer, and Roche, owned the rights to manufacture and sell ARVs. 52

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 54 UNAIDS/WHO, Affordable prices: Annual cost per person for triple therapy in Africa, February 2002 55 IMS Health Drug Monitor, http://www.ims-global.com/insight/insight.htm 53

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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 abusing its rights by declining to supply the product. In these cases, TRIPS allowed 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. Developing countries argued that they should be able to protect the public health 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.56 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 patients globally. Various initiatives 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 56

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 countries should not “have to go without medicine they so desperately need.” The Clinton 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.57 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 57

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

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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.58 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?

58

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 AIDS Region

Adults and Children

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

29.4M 0.55M 6.0M 1.2M 1.5M 0.44M 1.2M 0.57M 0.98MM .015M

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59

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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