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M IUMASS BOSTON C0ursePack MBA MGT 660 Business and its Environment Instructor Nardia Haigh PhD Table of Contents Chapter 2 How Markets Work pg 1 Chapter 1 Globalization and its Discontents pg 26 Urbanizing China pg 37 Chapter 7 Business Interest Groups and Political Influence pg 60 Chapters 1 amp 8 Hybrid Organizations pg 88 PepsiCo s Turning Point pg 106 Nestle A Social Media Nightmare Cases A and B pg 123 MBA MGT 660 UMASS Boston Nardia Haigh PhD MBA MGT 660 UMASS Boston Nardia Haigh PhD Planned interventions disturb nature in the course of her operations on human affairs and it requires no more than to leave her alone and give her fair play in the pursuit of her ends Little else is required to carry a state to the highest degree of af uence from the lowest barbarism but peace easy taxes and a tolerable administration of justice all the rest being brought about by the natural course of things Adam Srnithl anagers have to work with and through many inarketsminarkets for labor raw mater ials capital and other inputs as well as markets for their output Most core courses in the management functions for example finance personnel or marketing teach students how to deal with one or more of these specific markets Any overarching analysis of how public policy in uences the varied markets that business people confront is often missing in specialized manageinent courses Government intervention in say the capital labor or consumer markets has important effects on firms strategic options and performance Business Government Society tries to fill that gap to explore systematically how and why public policy constrains private management decision making Before we can examine the place of public policy in the business environment we need to anchor ourselves with a good understanding of how markets work That is the purpose of this chapter Thus we begin with a discussion of political economy and the idea that there are both economic and political markets The rest of the chapter reviews elementary ideas about economic competition Advanced students can scan this material as background for subsequent chapters Students who are not well grounded in introductory microeconomic theory will need to read the next sections more carefully for the ideas presented here are the base on which this book s analysis rests Particular attention should be paid to the issue of market failure which is the basis for government economic intervention THE MARKET Anyone with an interest i11 improving a country s material well being must understand the workings of the market The market singular not plural is a system of social coordination It is a network of 1 Quoted by jacob Viner Adam Smith and Laissez Faire 1927 reprinted in Essays on the Intellectual History of Economics ed Douglas Irwin Princeton Princeton University Press 1991 p 87 13 14 CHAPTER 2 institutions within which people buy sell and rent Whenever the term market appears by itself in this book the reference will be to this network The market is made of individual markets plural f1gurative places where people gather to exchange particular commodities Markets exist for cars houses stocks and bonds and potentially anything else that people can buy and sell As most Americans are taught markets do remarkably well in bringing together the efforts of hosts of self serving individuals More than ever governments are trying to extend the scope of markets in their economies Around the world programs are underway to allow firms and consumers greater freedom to make economic decisions Yet paradoxically governments are trying simultaneously to correct more perceived defects in the market system Today s managers must have a good grasp of what markets can and cannot do or they will not be able to understand the role public policy plays in helping or harming private enterprise POLITICAL ECONOMY To make sense of business changing environment markets and public policy it helps to have a consistent way of thinking a lens to bring the issues into focus We will rely throughout this book on political economy a theory for understanding the links between economics and politics Political economy can be useful in clarifying public policy and the business environment Americans have learned to think that the private sector and the public sector are opposites In the popular culture business represents mostly positive values efficiency productivity innova tion and so forth Government is usually portrayed in a more negative light embodying incom petence waste and wellmeaning but futile efforts to interfere with business to promote social goals These polar descriptions of business and government are useful mainly as debating points not as accurate depictions of reality By typecasting the two sectors they probably confuse more than they enlighten The truth is business and government are more alike than most people realize As Lester Thurow former dean of management at the Massachusetts Institute of Technology observes one reason for black and white thinking about business and government is the Cold War The Soviet Union exempli ed all that was wrong with having too little private business and too much government Communis1n s failures were seen as proving the view that politics and econo1n ics do not 1TiIlX Another reason for seeing business and government as antithetical is the way universities have divided up the social world for study Different specialties have evolved to ask how business on the one hand and government on the other operate Economics and business management focus on the private sector political science and public administration concentrate on the public sector This division of intellectual labor evolved over the last hundred years and would have been surprising to scholars writing at the start of the industrial era They practiced a more universal science they called political economy3 They centered on the ties between civil society and the state the private and public sectors in today s terms The goal of political economists through the 19th century was to uncover policies that would best augment the community s wealth ronghly 2 Lester C Thurow Head to Head The Coming Economic Battle Among japan Europe and America New York Morrow 1992 3 The first known English use of this term was in 1767 with the publication of Sir Iames Steuart s Inquiry into the Principles of Political Economy The term had appeared the previous century in France Political economy fell out of fashion in the late 1800s and was replaced by the modem label economics For a history of the origins of political economy see Terence Hutchison Before Adam Smith A History of Political Economy Oxford Basil Blackwell 1988 HO 7MARKETSNORK 15 equivalent to what we now know as the gross national product or GNP Adam Smith author of the classic treatise An Inquiry into the Nature and Causes of the Wealth of Nations 1776 was typical of this focus on economic development through good government We will return throughout tl1is book to Smith s keen insights many of which retain their validity today Later in history political economy became associated with Marxism and riveted on the deeper structure of society and how the distribution of property affected power This comprehensive way of looking at business and government largely died out and got replaced by the more specialized fields of study familiar today Critics of political economy came to believe that values tainted that discipline rendering it unscienti c Yet in recent years political economy has made a comeback After all people undertake economic and political actions for much the same reasonwto get things they want Because material goods are always limited compared to potential demand people have to make hard choices about how to expend their energy But their motive is constant in both the political and economic realms As the title of Harold Lasswell s famous government text 1936 put it politics is about who gets what when4 The same title could easily be used for an economics text Feeling confined by the limits to the usual disciplines many social scientists and some practitioners have started to take a fresh look at political economy especially as practiced by the pre MarXist or classical political economists The result is a renaissance in studying political and economic events as more of a whole The so called new political economy seeks broad knowledge about socioeconomic facts and tries to put back together what social science has pulled apart This approach lends well to a complicated subject like business and its environment a subject that draws many variablesmmsocial economic cultural technological legal to name a few into its orbit Modern political economy is diverse As mentioned above there are Marxist and conservative wings for example5 We will borrow freely from all branches of the discipline What unifies them is the idea that economics and politics business and government cannot be understood in isolation The two realms are seen to be intimately linked Not everyone agrees that commercial and public life can be fused so easily The late Jane Jacobs for example argued that society has evolved two radically different systems of values One system the commercial orientation stresses qualities like work honesty and thrift The other morality the more political one shuns trading and exalts ostentation and H giving among other things to be esteemed6 People in other words are motivated and guided by conflicting values This is an old and evident truth Political economists are prone to play down the inconsistencies in human motivation They like to think that people respond predictably to rewards and punishment Scratch a business person or a civil servant the political economist argues and you will find that both are competing for resources Only the rules for competition are not the same Business and government are arranged differently and these different arrangements create different incentives for action To explain human behavior the place to start is with organizational structures and the inducements they spawn The result is a unified approach to behavior that can help managers interpret and even forecast events across the spectrum of their organizations environment Political economy cannot answer all questions about public policy satisfactorily Like all schools of thought it can mislead if pushed too far Yet if used prudently political economy is a fertile source of wisdom about the environment of modern business 4 Harold D Lasswell Politics VVho Gets What When How New York P Smith 1936 5 For attempts to untangle the definitions see Martin Staniland What is Political Economy New Haven Conn Yale University Press 1985 and Barry Clark Political Economy A Comparative Approach New York Praeger 1991 6 Jane Jacobs Systems of Survival A Dialogue on the Moral Fouinclations of Commerce and Politics New York Random House 1992 16 CHAPTEB2 THREE WORKING ASSUMPTIONS Let us look at the new political economy s assumptions Following mainstream economics most olitical economists take for ranted three im ortant oints that are familiar to an one who has P 3 P P Y taken a firstyear economics course 0 Individual people should be the first unit of analysis To explain the action of big social units say a company or a public agency political economy starts at the bottom with the people working there It builds up from each person s motives a11d Way of acting to understand the larger groups they form This assumption is known formally as methodological individualism 0 People are strongly marked by selfinterest They are driven by what Smith called the desire for betterment What this assumption means is that people usually look out for themselves They prefer to do things they like and avoid things they dislike What they like most of all what gives them the greatest utility is money 0 People are rational They are goal oriented and act purposefully not randomly in trying to advance their welfare They learn from their mistakes and attempt to do things they think will give them the greatest bene t at the least cost In the somewhat abstract language of political economy people are utility inaximizzers This trio of assumptions individualism selfinterest and rationality are the building blocks for political economy Writers often speak of economic man as a shorthand way to denote the view that in the marketplace people are purposeful agents the defenders of personal gain The novelty of political economy is to extend the logic of economic man to political and social affairs Whether one looks at the profitmaking the voluntary or the govern rnent sectors people are presumed to be similar in thought and deed Economic man is a metaphor Like any metaphor it is not to be taken literally Critics including many political economists themselves point out how one sided even degrading it is as a model for human behavior People are moved by purposes other than egoism their actions are not always deliberate and directed toward particular goals Coercion and ideology culture and morality can be as important stimulants as self interest7 Consider for example the person who leaves a tip in a roadside restaurant to a stranger whom he or she will never see again Others routinely give away their blood Such acts of generosity cannot be explained through individual economic calculation and must be driven by ethical considerations As Smith himself observed How selfish sovever man may be supposed there are evidently some principles in his nature which interest him in the fortune of others 8 People are guided by and sometimes live up to standards of benevolence and self sacrif1ce They do not always have ulterior motives for acts of seeming generosity Other pragmatic and philosophical objections to the rational actor model have been offered To fix on individuals can be to mislead for instance since the whole society is more than the sum of its parts people Logicians call this mistake the fallacy of composition N o man is an island the 7 See for example Amitai Etzzioni The Moral Dimens239on Toward a New Economics New York Free Press 1988 8 Adam Smith The Theory of Moral Sentiments 1790 Oxford Clarendon 1976 p 9 Also see Steven Homes The Secret History of Self Interest pp 267 86 in Beyond SelfInterest ed Jane Mansbridge Chicago University of Chicago Press 1990 HOW MARKETS WORK 17 saying goes and one person s wellwbeing usually is in uenced by his perception of people around him and whether they are suffering or content A Also self interest and utility are very elastic notions and can be used to explain almost every behavior Did Mother Theresa work with Calcutta s homeless from selfinterest as she defined it VV as she maximizing her utility through personal denial One could argue yes but that is stretching self interest and utility so far they lose much meaning Rationality also has limits for people can hold contradictory preferences Consider a cigarette smoker who buys a cigarette pack every day who also pays to join a program to quit smoking What is his or her real preference to smoke or to quit As these examples suggest the economic model is not meant to give a plausible account of all human behavior just a lucid one Much gets left out Of course humans can be generous and self destructive impulsive and erratic It is fortunate for business and for society that human motivation is complex Were we not able to mix selfish and sel ess behavior for instance economic teamwork and group loyalty would not occur the way they do making it much harder to organize for economic activities9 No society can reduce every interaction to a cash transaction though some people in the United States would like to try Reducing esh and blood beings to economic man is being simplistic on purpose The object is to gain in clarity what is lost in accuracy Rich insights come from supposing that much of the time humans try to promote their well being as they see it In particular the rational actor model of human behavior gives a coherent picture of how markets and governments work and why they sometimes falter ETHICAL CONCERNS Due to the flaws in the economic man model only modest claims will be made for it in this book Economic rationality is not a prototype for everything people do It is a convenient fiction for explaining and predicting many business and society relations We will use the economic model of behavior with proper caution Still it is a safe bet that in commerce and politics people do tend to seek advantage for themselves Students also should keep in mind that political economy as used here does not recommend how people should behave In the language of philosophy political economy is a positive theory based mainly on observation not a normative one having more to do with values The rational actor framework tries to predict behavior rather than to prescribe it In depicting what people in industry and government tend to do it does not necessarily make a judgment about what those people ought to do While the framework does presume that managers public servants consumers and other economic actors are likely to put self interest first this presumption is not intended as advice There are many other values like altruism selfsacrifice fairness respect for rights that have a legitimate claim to take precedence over selfinterest Some political economists it is true do make a strong ethical argument for self interest as a supreme value Unregulated pursuit of individual ambition in their view is likely to help society as a whole As the tycoon Gordon Gecko said in the Academy Awardwinning film Wall Street 9 Amartya Sen On Ethics and Economics Oxford Basil Blackwell 1987 pp 221 10 Robert Kuttner Everything For Sale The Virtues and L239mits of Markets New York Alfred A Knopf 1997 11 For a cogent argument see Milton Friedman Capitalisin and Freedom Chicago University of Chicago Press 1982 18 CHAPTER 2 I987 Greed for lack of a better word is good Creed is right Greed works Greed clarifies cuts through and captures the essence of the evolutionary spirit Smith who held a chair in moral philosophy would have found such claims self serving and overstated He asserted in his largely forgotten tract The Theory of Moral Sentiments 1767 that ambition can have hurtful consequen ces for others Untamed by scruple or by law greed is not good V Thinking back on the concept of social capital introduced in Chapter 1 it is apparent that voluntary co operation underlies all organized activity even that which occurs within a profit seeking company Any company whose einployees always act as independent agents and care solely about their own advancement will not last long Successful organizations build a sense of loyalty among their employees or members and use that commitment to reduce cost and encourage innovation The current trend toward job hopping workers who feel they owe nothing to any larger organization is unlikely to produce positive economic effects regardless of the good things its boosters say about this development13 The need to step beyond economic man to take a broader and more morally satisfying view of human behavior has given birth to the field of business ethics Business ethics call for managers and organizations to heed carefully thought out rules of moral philosophy Ethical behavior in business goes beyond making a profit or obeying the law and requires conformity to higher standards of professional duty and obligation to others How THE MARKET IS SUPPOSED TO WORK The critical feature that allows markets to meet people s needs is that when they are working right markets are voluntary Everybody is a willing participant Individual buyers and sellers come together and trade resources because they want to The stress must be on voluntary exchanges As we will see shortly when markets involve people without consent they break down By interacting in a market buyers and sellers combine inputs or factors of production land labor capital to make outputs useful goods and services that can be consumed or used for further production Individual rewards and penalties primarily financial gains and losses deter mine what gets produced and how Political economists have long noticed the unintended social benefit of these individual incentives Each person s quest for his or her profit when taken altogether leads to goods and services that improve everyone s position A private vice greed transforms into a public benefit consumer choice This positive result comes about without anybody s conscious intent Smith was among the first to point out how the market channels human energy toward socially useful ends In a celebrated passage at the beginning of The Wealth of Nations he asserts that It is not from the benevolence of the butcher the brewer or the baker that we expect our dinner but from their regard to their own interest Smith develops the argument more fully later He any participant in the economy generally indeed neither intends to promote the public interest he intends only his own gain and he is in this as in many other cases led by an invisible hand to 12 For revisionist commentaries that stress the altruistic side of Adam Smitlrs thinking see Patricia Werhane Adam Smith and His Legacy for Modern Capitalisin New York Oxford University Press 1991 and jerry Z Muller Adam Smith in His Time and Ours New York Free Press 1993 13 Daniel H Pink Free Agent Nation New York Warner Books 2001 HOW MARKETS WORK 19 promote an end which has no part of his intention By pursuing his own interest he frequently promotes that of society more effectually than when he really intends to promote it stress added 14 The Invisible Hand was a powerful metaphor for a striking observation the market can spontaneously serve the society s interests Through commercial activities people unknowingly promote social welfare Smith s insight has led many people to advocate laissez faire government policies toward business Taken from the French term for leave alone laissez faire doctrine holds that an economic system works better the less government intrudes The natural economic order that is one left undisturbed by man made restraints or support is seen to meet the needs of both individuals and society We will see throughout this book that Smith never pushed this doctrine to its logical extreme to make a blanket rejection of government A sophisticated thinker he was no libertarian or anarchist and he credited public policy with a critical role for supporting commerce Unlike some economic fundamentalists today Smith did not hold that the best economic policy is in effect always to have no policy at all Historically laissez faire was a reaction against mercantilisin a system where states tried to control industry and foreign trade to make their countries rich These wellintended actions could backfire and hold down living standards Laissez faire became the dominant theory less the reality of public policy in the United States after the Civil War 186165 It was also prominent in Britain then Later laissez faire fell from fashion for being a simplistic doctrine Hands off policies work best for exchanges that lack major implications for third parties Frequently third parties are implicated a point we will return to in Chapter 3 By the 1930s and into the postWorld War II period government activism and interventionism became the conventional wisdom in the North a loose geographically inaccurate term that covers Western Europe North America Australia New Zealand and Japan Since about 1980 laissez faire has reappeared as a serious guide to public policy partic ularly in Anglo Saxon countries16 Ronald Reagan in the United States Margaret Thatcher in Britain and David Lange in New Zealand are among the many leaders who came to power during that decade praising the benefit of unregulated economic competition These ideas have universal appeal Developing countries in Africa and Latin America have followed a similar approach often reluctantly and under pressure from Northern governments and international financial institutions Transitional countries from the former soviet empire have followed similar ideas This open market approach has not been notably successful in the developing world however and has generated a political backlash among sectors that are left behind Business students seldom question pro market values and ideas though the pro and con arguments are more subtle than they generally recognize Let us look more carefully at the case for leaving the market alone 15 4 14 Adam Smith An Inquiry into the Nature and Causes of the Wealth of Nations 1776 reprint New York Modern Library 1965 pp 14 423 15 See Andrew Shoniield Modem Capitalisrn London Oxford University Press 1965 15 Daniel Yergin and joseph Stanislau The Cormnanding Heights The Battle Between Government and Marketplace that is Remaking the Modem VVOrlcl New York Simon and Schuster 1998 20 CHAPTER 2 ADVANTAGES OF DECENTRALIZED DECiSl0N MAKING AND INDIVIDUAL CHOECE av Consumsas iN 0RGANlZNG AN ECONOMY Efficiency Markets allow mutually satisfactory exchanges among consenting individuals and thus promote social welfare Innovation Markets force companies to innovate Liberty Markets are desirable because they permit voluntary cooperation and are not binding ABGUMENTS FOR LAISSEZ FAIRE The case rests on three claims Unregulated markets are said to be efficient innovative and liberating See Table 21 Efficiency By saying the market is efficient political economists are usually thinking mostly aboutthe best mix of goods sometimes called allocatzive efficiency Their meaning is not the everyday notion of efficiency which refers to producing goods at low cost also known as productive efficiency Markets do encourage companies to be businesslike and productive too for reasons we will explore in the next section on innovation First we discuss efficiency in the allocative sense By allocative efficiency political economists mean the market theoretically can produce a desirable social outcome by serving out the economic pie in a way that suits everyone given their income The distribution of income is of course uneven since people have uneven skills ideas strengths and inherited wealth they can offer for exchange People may be unhappy with the initial hand they are dealt Still within that constraint the market parcels out goods and services so that everyone gains and no one loses How does this efficient pattern of exchange happen If people are economically rational and V nothing impedes their actions efficient results are certain People will trade until a balance is reached where no one could be made better off without someone else being made worse off It should be clear immediately that many things can hamper an exchange leading to inefficient results When people share the slices of the economic pie the way they want given their income they obviously will stop trading with each other17 Should an imbalance occur where someone thinks he can improve his wellebeing through a voluntary exchange with some else the resulting transaction automatically removes the imbalance In this sense the market is said to be self correcting It adjusts for any source of instability such as a change in someone s tastes or needs Using the language of political economics the market tends toward equilibrium a resting point Proponents of the efficiency argument acknowledge that no society ever reaches an equilibrium at which everyone s Welfare is as great as possible without hurting anyone else To get to that happy point requires socalled perfect competition The following ideal conditions must be in place 17 The technical term for this balance point where all possible mutually beneficial exchanges have occurred is the Pareto Optimuin named after the Italian economist and sociologist Vilfredo Pareto 1848 1923 who discovered it HOW MARKETS WORK 21 o All rms are small and there are lots of them so no buyer or seller can influence prices through independent action 0 Entering or leaving the market is easy 0 Consumers act to maximize utility and firms act to maximize pro ts Production technology has constant or decreasing returns to scale the rate of output stays the same or falls as inputs are added 0 Buyers and sellers have full knowledge available at no cost about the performance and quality of items being traded o The offerings of sellers are identical in all respects 6 Prices of goods and services are not sticky and move up or down quickly and they reflect full costs Finally the cost to penalize cheating by either party and to protect their property is zero Why think about such unrealistic market conditions Nowhere do we see hordes of small competitors unrestricted entry perfectly informed buyers and homogeneous products The answer is that perfect competition is not meant to describe actual markets though some agricul tural and financial markets may come close Instead these conditions are put forward as a model against which real markets can be tested The nearer real markets come to the ideal the better Admirers of markets find many rough analogues to perfect competition in the real world They argue that partly competitive markets are usually better than the alternative allowing government to allocate resources A case in point is the former Soviet Union Government planners created a warped economy with an overdeveloped military sector and an underdeveloped civilian sector Had producers and consumers been given more range to choose the economy would have made more butter and fewer guns Witli greater freedom of choice soviet society would have come much closer to meeting society s wants than it ever did under the commissars Market competition it must be stressed never produces the best possible distribution of resourcesmjust the best distribution given the pattern of wealth and income Thus market competition can have dreadful results in unequal societies Many famines for example take place when there is enough food to go around People starve to death not because of absolute shortages but because the food that is available is unevenly distributed Hoarding high prices and poverty make it impossible for some people to buy the nourishment they need to live18 The play of supply and demand produces this outcome but it is only something a sadist or masochist would freely choose 4 lnnova on Competition figures in the second argument for laissez faire too This argument holds that free markets are unparalleled for promoting innovation By making firms compete markets not only squeeze out waste what we called productive efficiency above but they also stimulate new techniques and new products Whereas allocative efficiency refers to the best way to hand out the slices of a given economic pie the innovation argument is based on the idea that people 18 Amartya Sen Poverty and Famine Oxford Clarendon Press 1982 22 CHAPTER 2 are made happier by baking a bigger and tastier economic piemthat is by creating more and improved goods Companies must innovate to create more and improved goods Laissez faire advocates think the best spur for innovation is competition In a market economy companies are forced to reduce production cost or risk being replaced by rivals who can develop and use less costly methods They have to try new methods of organizing motivating and training Should they not someone else will Companies are made to respond to their customers needs on penalty of being driven out of business The result is a flow of improved low priced merchandise Lack of competition has the opposite effect It allows firms to turn lazy and insensitive If they have captive customers they are apt to give up the quest for new and better ways to produce value Refusal to change or listen to customers are charges frequently made against monopolies large companies that dominate their market and do not have to compete For proof defenders of laissez faire again point to the old Soviet Union Soviet enterprises were monopolies undisciplined by the need to compete They were notorious for being lax and unwilling to change They made shoddy goods that people often did not want In a market economy these dinosaurs would have quickly become extinct Because capitalism is decentralized it is good at conducting experiments They can be con ducted on a small scale and be repeated The cost of failure is not great to society Successful experiments can produce large rewards and are a signal for others to follow That a decentralized economic arrangement works is sometimes surprising Emile Durkheim 18581917 the famous French sociologist is reported to have been motivated to study society by his wonderment that he could open the back door of his apartment every morning and find a bottle of milk waiting and he did not even know the milkmanlg This remarkable degree of coordination happens with no central blueprint along soviet lines Liberty Competition is also part of the third rationale for markets that they encourage human freedom A most powerful appeal of a market exchange is that it is based on compromise and agreement Neither party is forced to enter the deal the parties get together because each sees a gain Haggling may result but the outcome is by definition mutually acceptable since the parties have alter natives People are freed by having other buyers and sellers to whom they can turn and by having money making opportunities they can choose to exploit The old Soviet Union is the paradigm for how lack of markets restricts freedom There government tried to ration many goods in roughly equal amounts It also refused to give consumers many products they wanted and tried to get them to accept products government thought they should have By cutting down on people s economic choices the Soviet system exercised economic tyranny Milton Friedman the 1976 Noble laureate economist is among the writers who extends the freedom argument from the economy to the political realm He asserts that the liberty of capitalism and democracy are strongly linked The links are easy to see There is a natural parallel between choice in the marketplace and choice in elections and both business and government leaders 19 Cited in Adam Przeworski Democracy and the Market Cambridge Cambridge University Press 1991 105 20 See Friedman Capitalism and Freedom 10 HOW MARKETS WORK 23 depend on freedom of information to know what customerscitizens want In each realm the economic and the political competition checks power from amassing On the other hand the free market can create economic inequality that subverts the political equality on which democracy is based The biggest inequality is often the gap between the owners of capital and wage earners From this viewpoint capitalism and democracy are contradictory Also the freedom of the market is but one of several types of freedom that philosophers have identified We will look at these issues more closely in Chapter 4 A further shortcoming of markets is that voluntary exchanges will not do for every social task Even if the market does tend toward an equilibrium from which no possible movement would make everyone better off there are times when it is preferable to impose a loss on some people The United States is better off today for having forcibly freed slaves whose owners were not paid for the property they lost Similarly japan and South Korea are richer because 50 years ago US occupiers took land from unwilling landlords and gave it to peasants None of these events happened voluntarily As Charles E Lindblom former president of the American Political Science Association points out Insofar as markets can organize only voluntary mutually advantageous acts of coordination it will be necessary to find non market alternatives 2l Society sometimes needs coercion THE PRICE MECHANISM Thus far we have reviewed three good things the market can prornote efficiency innovation and freedom For the market to do these good things its participants need knowledge Prices provide that knowledge In Lindblom s words prices are a device for declaring in standardized form the terms on which exchange is offered or consummated 22 The total of all prices is a kind of intelligence network for the market Prices thus play a central part in the laissez faire argument They reveal what the best use of resources is where workers can get the best wage where investors can get the highest returns where consumers can get the lowest price and so on They also warn which goods and services are scarce high priced and which are plentiful low priced Prices convey an enormous amount of information in very compact form and do so swiftly Absent that information the market s ability to correct itself is impaired When a price is right that is when it reflects an item s true value to people it clears the market Demand meets supply and buyers and sellers both get the best deal they can from their noncompulsory exchange Alternatively when a price is too high an unwanted surplus results In a smooth running market buyers and sellers will bid the price down until the surplus goes away Something similar happens if a price is too low A shortage develops and market forces will drive the price up until the shortage or the waiting line of customers disappears The result is a system of profit and loss for companies In 2003 AOL Time Warner announced an annual loss of 987 bz39llion the largest dollar loss in history and an amount approximately equal to the gross national product of Israel Consistent losers are punished in the financial markets and face eventual bankruptcy or absorption by a competitor Some 500000 businesses fail in the United 21 Charles E Lindblom Politics and Markets The World s Political Economic Systems New York Basic Books 1977 p 81 22 ibz39d p 31 11 24 CHAPTER 2 States each year However another 600000 new businesses are formed putting some of those lost physical and financial assets back to better use Scarcity Pricing Marketclearing prices are sometimes called scarcity prices because they match the assessment of both parties buyers and sellers of an item s scarcity or abundance They also are known as efficiency prices because they aid efficient or mutually agreeable exchanges When the amount of money charged for something is not based on mutual agreement that is it does not reflect the interplay of supply and demand it is called an arbitrary price One reason laissez faire advocates do not like government to intervene in the economy is that arbitrary prices often result An illustration of how scarcity pricing allows markets to self regulate is the 19703 energy crisis An oil shortage arose then largely because oil producing countries got together to restrict produc tion The price of oil went up to reflect this artificial shortage Expensive oil in turn got American consumers to buy smaller cars insulate their homes install woodburning stoves and take a thousand other steps to cut down their use of oil products and save money Expensive oil also got oil producers to explore for more oil open new oil reserves and find other energy sources Here lower demand and greater supply eventually drove the price of oil back down When adjusted for in ation the cost per barrel was lower in the late 1990s that it had been 25 years earlier The rise in energy prices in 2000 set off a parallel sequence of conservation and expanded production Price Controls If government starts to set prices it ends by distorting them Economic planners can never keep up with shifting supply and demand In the Soviet Union planners had to track 24 million separate prices23 Inevitably the wrong signals about surplus and shortage value and waste are given Resources do not get pulled to their best use Innovation slows We can use the 19703 oil crisis again to illustrate To protect consumers the US government put a ceiling on gasoline prices These prices were too low they did not re ect the true scarcity of oil Motorists saw the bargain and rushed out to fill their tanks Car lines began to form around the pumps Forced to give away gasoline at discount prices service stations soon began to run out Since they could not charge motorists more service stations started limiting the volume of sales to preserve their dwindling stocks Each driver was allowed only a few gallons at a time The lines got longer Motorists ended up paying with time and aggravation for gasoline s artificially low price During more recent oil shocks gasoline prices have been allowed to rise and fall freely and no lines formed at the pumps The year 2001 saw a sharp run up at the pump but they settled back by summer as refiners increased stocks in response to higher prices To sum up a working price mechanism both signals scarcity and allocates resources As a resource gets used up its price rises The higher price in turn motivates buyers to conserve the resource and find cheaper substitutes and it encourages suppliers to figure out less expensive ways to provide the resource One advantage of organizing an economy around scarcity prices is that the supply and demand for goods and services tend to balance themselves automatically The result is an agreeable compromise for the participants for it meets their needs as much as possible given the availability of resources and the way they are allocated from the start 23 Nikolai Shmelev and Vladimir Popov The Turning Point New York Doubleday 1989 p 170 12 HOW MARKETS WORK 25 How MARKETS CAN FAIL Public goods Markets do not provide education public health services infrastructure and other public goods in ample quantity due to the problem of free riding Example Private companies may choose not to train their workers for fear they wilt iose any trained workers to competitors Externalities Markets do not protect people from the actions of others Exarnpie Second hand smoke inflicts cost on non smokers who had nothing to do with the purchase or sale of cigarettes Monopoly Due to obstacles to free entry economies of scale and other factors markets may be dominated by one or a few companies that may try to take advantage of consumers Example Airlines charge very high fares in outoftheway communities where they face little competition information asymmetry Markets cannot work well when consumers are ignorant Example Lacking scientific knowledge consumers can be enticed to buy dangerous patent medicines Agent misdirection Agents need not act in their principals best interest in a market Example Brokers sometimes mislead elderly clients into making highrisk investments that are not appropriate for their investment goals Social goals Markets may not promote social goals like providing merit goods Example Real estate developers do not build homes for the indigent Inequality Markets may be inequitable Exampiez People with inherited wealth get to live extravagantiy without working while many hardworking people live in poverty Economic instability Markets may not provide full employment stable prices or economic growth Example The transition to a market economy in Russia is accompanied by a loss of jobs and a collapsing currency MARKET FAILURE The market under ideal conditions does a good job of allocating resources to their best use Yet there is a catch Economic exchange works best where everyone involved is a willing participant but of course many exchanges do not work that way They involve people without their consenflkor know ledge Often faulty prices are to blainewthey mislead people into inef cient exchanges When exchanges are involuntary or ill informed the Invisible Hand falters In the real world buying and selling can fall well short of What would happen in the utopian world of perfect competition Prices do not re ect all available information and unregulated market activity does not efficiently organize production or allocate goods and services to consumers in a Way that is socially or morally preferable These market failures as they are known formally are built into the Way many markets actually work Market failures have little to do with and should not be confused with a company failing When a company loses market share or goes out of business that may be a sign that the law of supply and demand is working Under competitive conditions inefficient or poorly managed companies should cease to function so their assets can be put to better uses As bad as an individual company s failure may be for the Workers who lose their livelihood or the shareholders who lose their investments it may on balance be desirable for the larger society if it leads to a more robust industry overall Market failure is a different phenomenon Where the forces of supply and demand produce net undesirable effects for society not just for people directly affected Political economists have found several sources of market failure 4 The more important market failures relevant for managers are listed in Table 22 They are discussed in the sections that follow When the market fails government intervention may be called for to correct the failure 24 Similar lists are standard in any welfare economics text An early framework is Francis M Bator The Anatomy of Market Failure Quarterly journal of Economics vol 72 no 1 1958 351 79 13 26 CHAPTER 2 Public Goods Adam Smith understood the need for government to intervene in economic life He proposed three duties of the sovereign three jobs for government on which almost everyone agrees Because of market failure none of these items is provided by the market in the right amount They are first the duty of protecting the society from the violence and invasion of other independent societies secondly the duty of protecting as far as possible every member of the society from the injustice or oppression of every other member of it or the duty of establishing an exact administration of justice and thirdly the duty of erecting and maintaining certain public works and certain public institutions 25 The events of September 11 2001 have been a horrifying reminder of how important national defense and public safety are to the economy The country was plunged into a recession as consumers and companies pulled back in the uncertain times that followed There was an unspoken agreement that government should expand its powers to provide a higher level of security no one looked to the private sector to meet this collective need for emergency and military personnel and services Why is this Smith s three duties of government to defend against foreign attack to protect life and property and to maintain public works and institutions all share aspects of what political econ omists call public goods These are items both tangible and intangible that people use together Public goods have value that spills over onto people without their assent or awareness Decentralized competitive markets simply do not produce as many public goods as people want or need The reason is because in Smith s words they are things which it can never be for the interest of any individual or small number of individuals to erect and maintain because the profit could never repay the expense to any individual or small number of individuals though it may frequently do much more than repay it to a great society 2396 In other words the profit sector which focuses on its bottom line is never going to pay for the number of police officers fire fighters or public health workers that society must have to function efficiently Since they is a major rationale for government involvement in economic life let us look at public goods more closely How do they differ from private goods Political economists identify two attributes of goods to judge how they should be provided through the market or through government These attributes are excludability and subtractability27 Excludability refers to the degree to which a potential user of a good can be excluded from its use by a potential supplier While people can be excluded from using many items public goods are not that way They are products that are hard to render inaccessible to provide them for one person is to provide them for all Take national defense and the legal system both public goods singled out by Smith in The VVealth of Nations Each is low on excludability they cover eveiyone living in a territory whoever they are Nobody can be blocked from that coverage Not even people who object on principle to military spending or to the legal system can escape Some public works lighthouses are a classic example are similar in affecting many people s lives with or without permission A lighthouse owner has no say over the use of his service every ship that passes by benefits 25 Smith Wealth of Natioris p 651 26 Ibid 27 The pioneering analytical thinking on public goods was by Paul Samuelson The Pure Theory of Public Expenditure Review of Economics and Statistics vol 36 no 1 1954 387189 14 HOW MARKETS WORK 27 Subtractability also called rivalness refers to the extent to which one person s consuming a good subtracts from another s ability to use the good without raising production cost Like exclud ability subtractability is relative Goods have greater and lesser degrees of rivalness of consumption A When an item is high on subtractability two or more consumers cannot use the item at the same time Many consumer goods are this way By contrast when something is low on subtract ability many people can use it without depleting it or lessening each other s use of it Again national defense and the legal system are good examples After an immigrant moves to a new country his or her being there does not mean less national defense or justice to go around for everyone else Communication facilities can be similar Take the lighthouse again or a television transmitter Extra users do not detract from others enjoyment of the good The lighthouse beam or the television signal does not get used up by more consumption The two types of course blend into each other At the extremes few pure public or pure private goods exist Many private goods have a public side or externality to them Externalities are the nonpriced element in a transaction We shall discuss them shortly The types refer to central tendencies not mutually exclusive categories Political economy sees little reason for government to produce most private goods which business will provide itself But government must take steps to assure the supply of public goods because the market will not This does not mean that government has to take on the role of producer and supply all such items itself but it does need to act as a buyer promoter guarantor or regulator to encourage private sector suppliers and to prevent abuses by companies delegated these responsibilities Problems of Collective Action Public goods are valuable even indispensable for civilized life Why is the market unable to produce enough of these useful items A major reason is free riding The impracticality to exclude means people have access without paying Those who have paid for the good or service cannot prevent those who have not paid for it from benefiting as well Few investors will want to go into the venture of making or selling something people have no reason to purchase Most profit will be captured by wouldbe consumers who can share the good for free for example the lighthouse mentioned earlier The inability to divide collectively consumed goods into units for individual use also deters investors by making it difficult to sell the goods and recover cost Consumers may need the good but they have too little pecuniary incentive to get together themselves to provide it The paradox of collective inertia may result where no one seems able to cooperate despite widespread agreement that group action is needed to get to a common goal28 The freerider problem is illustrated by public television broadcasting in the United States It is a nearly pure public good anybody can watch for free at no harm to anyone else People who watch agree that the news and entertainment on PBS is excellent and viewers like that they are not subjected to the tedium of advertising breaks Yet most viewers do not donate money to public broadcasting despite regular appeals to the audience s conscience during fund raising drives During these drives the stations even offer private goods coffee mugs tee shirts program guides as an incentive to contribute The government sweetens the offer by making it tax deductible Still too much free riding or shirking takes place for the stations to support themselves and public 28 On the difficulty of organizing to provide public goods see Mancur Olson r The Logic of Collective Action Cambridge Mass Harvard University Press 1965 15 28 CHAPTER 2 broadcasting has to rely on government for much of its funding The British solve the problem by charging people an annual fee for the right to have a television antenna the proceeds of which help support the BBC Free riding is related to the issue of transaction cost which is the cost of specifying and enforcing contracts A transaction cost does not directly benefit either party to an exchange it makes the exchange more laborious and less attractive It is the parallel to friction in mechanical systems Perfect competition takes place in an imagined world of frictionless exchange but trans action cost is not trivial in the real world According to one effort to measure its size in the United States 45 percent of national income goes to pay for transacting banking insurance legal services accounting services and the like30 High transaction cost can encourage free riding People might agree in principle that they need something to use collectively Yet if they are a large group getting organized to provide the public good carries a high price All parties need to invest time and effort to make the deal happen The nego ations are apt to collapse before everyone can reach agreement on their individual contribu tion and compensation many groups do not get off the ground to provide public goods The failure of private action to supply public goods is strong ground for having the government supply them Coercion is imperative for the benefit of all all are forced to buy public goods with taxes levied on the community We extract money for people to pay for the Army Navy Coast Guard Border Patrol police fire fighters and other providers of public services Witli private goods where private incentives do function and free riding does not happen a presumptive case exists for letting the market do the job A major difficulty with government providing any goods is too little feedback from consumers There may be a bias toward overproduction as opposed to the underproduction that distinguishes the free market situation We will return to the problem of providing the right amount of government services repeatedly in later chapters The appropriate policy may be a mix of public and private enterprise for instance charging user fees for the good or licensing a private company to supply it Public goods should not be confused with publicly provided goods or services The two need not be the same for governments often provide private individually consumed goods to people Examples include food stamps social security payments and individual health care treatments From the political economists vantage point these examples are mainly private goods because they can be divided up and restricted to certain individuals though health turns into a public good when communicable disease is involved in the interest of avoiding wider infection people may be treated and quarantined against their will Alternatively private foundations and charities may supply public goods such as new technology or knowledge everyone can share Even companies may do this sometimes inadvertently as their novel products or ideas are copied by others The defining trait of economic goods is not where the items come fromu the public or the private sectorbut how they are consumed However the bulk of critical public goods probably come from government Externalities or Neighborhood Effects For many transactions the cost or benefit spills over onto third parties who are not directly involved in the transaction Alfred Marshall in 1890 began to call these spillovers externalities because they 29 On the problem of transaction cost see Oliver E Willianison Marlcets and Hieraroliies New York Free Press 1975 30 Douglass C North Institutions Institutional Change and Economic Performance New York Cambridge University Press 1990 p 28 16 HOW MARKETS WORK 29 are external to market exchanges and thus do not figure in producers and consumers internal accounting They also are called neighborhood effects Externalities lead to prices that do not reflect a good s full social cost or benefit The market misfires Without accurate price signals private producers will make too many goods with external costs and too few goods with external benefits A classic example of an external cost is pollution If a power plant produces soot as a by product of making electricity that soot imposes a cost on people in the neighborhood They have to spend money to clean their windows more often repaint their houses and so forth The neighbors of the power plant do not normally get compensated by the utility company for these costs Because the company does not need to consider its neighbors cleaning and painting costs it charges a lower price for electricity than it would otherwise This lower price in turn invites users of electricity to use more than they would if they had also to pay for damages to the utility s neighbors In a world of perfect competition the victim of an externality could bargain with its perpe trators31 In such a world for instance the utility company s neighbors would simply go to court to recover the damages caused by pollution These civil suits also would encourage the utility company to cut back its harmful emissions by raising the tangible cost of dirtying the environment Alas bargaining this way is not feasible in the real world The transaction cost is too high Most people do not have the time and patience to pursue legal action against polluting companies Instead we call on government to play the part of regulator and stop pollution at its source External benefit also known as positive externality is similar Smith gives an excellent example He singled out education as a critical duty of government At first glance education seems a typical private good it is individually consumed markets exist for it and so forth Yet a large social gain also is associated with the solitary act of getting educated The higher the average level of educa on in society the more apt that society is to be productive to be adaptable to be capable of governing itself Smith recognized that education had too many public side effects to be left a private voluntary affair So compelling is the community s stake in education government everywhere supplies it routinely Most countries consistent with Smith s logic give consumers little choice and make education compulsory Careful readers will see a link here with the definition of public goods made earlier In fact another way to define public goods is that they are items with large positive externalities The internal cost of producing public goods is too high for individuals to bear because it is impossible to charge third parties for their full gain from the public goods In sum external effects are a deficiency in the market that often attracts government action3 The solution is for government to tax or regulate activities creating negative externalities and subsidize activities creating positive ones Officials for instance may order the power company to cut emissions or offer tax breaks to educators to open private schools 2 Monopoly and Imperfect Competition Not all real markets are competitive Often one seller or a few sellers plotting together is large enough to dictate terms to buyers to try actively to in uence prices rather than taking them as given A single seller is called a monopoly Because it is unchallenged in the market a monopoly can 31 This is the point of the Coase theorem proposed by Ronald Coase the 1991 Nobel prize winner in economics 32 An early attempt to use externalities as the basis for a theory of the state is William Baumol Welfare Economics and the Theory of the State Cambridge Mass Harvard University Press 1952 17 30 CHAPTER 2 restrict its production or sales in an arbitrary way To make the most profit a producer in this position is tempted to make artificial shortages of things buyers want and sell them at in ated prices Consumers have no other choice and the resulting consumption pattern is far from optimum Sometimes monopolies are simply the winners in the market One firm drives its rivals out of business by being the best Other times monopolies get their position by unfair means One firm conspires with others to stop competing and combine forces In ether case government often intervenes to make sure large companies play by the rules and do not use their market power to crush potential rivals and cheat consumers Situations exist when having one supplier is just the obvious way to provide a service at the least cost Monopoly in other words can be the best way to organize some industries So called natural monopoly situations are created when fixed cost is very high Public utilities gas electricity local telephones cable television and mass transit trains trolleys fall into this last category of monopoly All face large fixed cost constructing and maintaining sewer lines utility poles rightsof way and so forth Think of the extra expense of having two competing gas companies each with its own network of tanks and gas mains or two subways each maintaining a separate tunnel system Under these conditions competition may raise not lower the cost to provide a service Having a solo company allows fixed cost to be spread out Governments either own these natural monopolies outright the preferred public policy in most of the world or they set up public service commissions to make them provide good service and stop them from charging too much for doing so common in the United States Limited or Lopsided Information Efficient exchange presumes equal access to information Yet information about the quality of goods is not evenly distributed in real markets leading to mistaken transactions With so many different items for sale in a modern economy and so many sales taking place infrequently buyers cannot be well informed across the range of purchases Ignorance is not bliss when one is dealing with complex potentially dangerous items machines medicine and so on and when consumers for one reason or another have difficulty making informed choices as happens to minors illiterates and so on To compensate for this obstacle to efficient exchange people have mobilized to get public officials to help Government may order that commodities be tested for safety and effectiveness It may set standards for labeling It may restrict sales to trained people It may force manufacturers to recall products that prove hazardous In the unreal world of perfect competition such actions would be redundant in the real world of poorly informed harried consumers they are a way to screen people from making dangerous or costly mistakes Market participants have an economic incentive to use their access to information in oppor tunistic ways Producers or sellers are apt to know more about the things they sell than their customers do They make the product and deal with it everyday Customers especially in consumer markets rarely have as deep Contact with the product and are less familiar with it To the extent that producers are selfinterested they also may be tempted to conceal some information and exploit the consumers ignorance Political economists label the result adverse selection An interesting illustration is the market for health insurance Paul Krugman and Robin Wells describe the situation as follows 18 HOWVMARKETSINORK 31 Imagine an insurer who offered policies to anyone with the annual premium set to cover the average person s health care expenses plus the administrative costs of running the insurance company Who would sign up The answer unfortunately is that the insurer s customers wouldn t be a representative sample of the popula on Healthy people with little reason to expect high medical bills would probably shun policies priced to reflect the average person s health costs On the other hand unhealthy people would find the policies very attractive You can see where this is oin The insurance com an would uickl find that because its 3 8 P Y I Y clientele was tilted toward those with hi h medical costs its actual costs er customer were 3 P much hi her than those of the avera e member of the o ulation So it would have to raise g g P P premiums to cover those higher costs However this would disproportionately drive off its healthier customers leaving it with an even less healthy customer base requiring a further rise in premiums and so on33 Note how the price mechanism fails to allocate resources appropriately in this case Again government often enters the picture to try to level the field of play between buyers and sellers simply insuring everyone for health problems Only the United States government among advanced capitalist countries does not take this step Another information problem that leads to negative outcomes is moral hazard This is a term that describes situations where one side of the market cannot observe the actions of the other The party whose actions are hidden has a perverse incentive either through acts of commission or omission to behave in a detrimental way To continue with the example of health insurance people who have health insurance may subsequently take less care of their physical condition Why would they act carelessly Because insured people know the insurance company will bail them out of any health problems that result As Malcolm Gladwell puts it Insurance can have the paradoxical effect of producing risky and wasteful behavior Insurance is an attempt to make human life safer and more secure But if those efforts can back re and produce riskier behavior providing insurance becomes a much more complicated and problematic endeavor 34 The insurance company cannot tell which of its policy holders are acting recklessly Therefore it has to raise insurance rates on everyone deterring some safetyconscious people from taking out insurance shrinking the insurance pool and driving premiums up still further One public policy solution to this failure in the health care market would be simply to eliminate the insurance and force people to take responsibility for their actions and pay directly for medical treatment But that would have even more severe social consequences Agency Problems Information asymmetries touch on another market failure the principalagent problem35 In complex societies we often have to rely on someone an agent to act on our behalf We the principals in these transactions delegate decisionmaking authority to the agent Agency relations pervade economics and politics The link between client and attorney shareholder and manager citizen and bureaucrat are illustrations 33 Paul Krugman and Robin Wells The Health Care Crisis and What to Do About It New York Review of Books March 23 2006 34 Malcolm Gladwell The Moral Hazard Myth New Yorker August 29 2005 35 For a review of the literature see Barry M Mitnick The Theory of Agency and Organizational Analysis in Ethics and Agency Theory Norman E Bowie and R Edward Freeman New York Oxford University Press 1992 19 32 CHAPTER 2 N o real life agent is completely impartial of course Their interests and those of their principals may diverge Being economically rational they are not going to surrender their welfare to someone else and this is a source of market failure If agents have some hidden information they may use it to mislead the person they are supposed to oblige A stock broker for instance stands to make commissions by churning a client s the principals portfolio though a buy andhold strategy might better serve the client There are subtle pressures on the broker to misrepresent the facts To put it differently the principal can see what the agent is doing but is too ignorant to judge whether it really is advantageous There is a monitoring problem that leads to adverse selection Government tries to offset agent misdirection by introducing rules to punish agents for acting against principals interests There are public policies that penalize lawyers brokers accountants and other professionals who make undue gains from their privileged position These professionals often are compelled to take extra care to divulge information to their clients to give them extra time to reconsider decisions and to do other things to insure impartiality and fairness Public policies to curb agency abuses are not awless but they do inhibit the worst misconduct To illustrate the Securities and Exchange Commission SEC enforces rules against insider trading of stocks and bonds See Box 21 Insider trading is the practice of obtaining information from inside a company and using it for personal financial gain Managers and consultants are in the best position to take advantage of such information especially during corporate mergers though it hurts small investors ImClone Systems founder Sam Waksal was sentenced to seven years and three months in prison for selling stock in 2000 ahead of a drug non approval by the Food and Drug Administration This insider trading scandal also ensnared Martha Stewart and her home decorating empire Insider trading refers to unlawful buying or sell ing of securities by persons who have material nonpublic information about a company Material information is information that could have a substantial impact on the price of particular stocks or bonds In the United States people who have inside knowledge that could a fect security prices may not profit from it They also have a duty to refrain from divulging confidenw tial information to someone else Anyone receiv ing a tip about say a proposed merger or acquisition is barred from using it too These legal demands are covered by the Securities and Exchange Act of 1934 They are part of the larger e fort to improve the market for stocks and bonds that followed the financial bust of 1929 The penalties and classes of securities that can be considered in legal action have been expanded in the Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 Violators risk heavy fines and jail time The United States has unusually strict insider trading rules Several famous Wall Street figures went to prison for insider trading associated with the merger boom in the 1980s Many other nations have no such public policies against trading securities based on privileged information or they are less vigorous in enfor cing the policies that are on the books 20 HOW MARKETS WORK 33 Social Goals Markets can be de cient by generating unpopular results Some products of unregulated exchanges are going to be viewed at certain times and in certain places as immoral Professor Ravi Kanbur of Cornell University calls these obnoxious markets 36 Gambling alcohol narcotics prostitution pornography birth control and abortion are all examples of goods and services tl1at people some times have condemned While no one denies these products meet a real demand their sale provokes misgiving and indignation Thus governments are called on to license or regulate the trade in goods and services that offend customary ethical standards Public policies run the gamut from sin taxes on tobacco products to Malaysia s death penalty for small time drug smugglers Banning or regulating a market does not eliminate the forces that created that market in the first place and such action may even intensify the demand for the illicit product These are underground or illegal markets which are engaged in the buying and selling of goods and services in violation of legal restrictions We find them for most questionable goods Not all societies share the same social views or want to expend as much energy shutting down obnoxious markets This can create ethical dilemmas in the international arena Poor people in developing countries for example may wish to sell live exotic animals or the byproducts of endangered species such as the horns of rhinoceroses or ivory for which there is ready demand in richer countries There is a cruel and exploitative tourist traffic in sex with underage girls or boys In China human organs are available for transplant to the right buyer Humans themselves continue to be bought and sold as slaves in Sudan and Mauritania There are international treaties banning many of these obnoxious markets but enforcing them is not easy Alternatively markets may not produce and distribute enough merit goods mbasic needs such as water food clothing shelter and health care These items are the reverse of the morally suspect items just mentioned Conventional morality decrees that people as a matter of right ought to be able to eat put a roof over their heads and so forth Not everyone in society can afford or even wants merit goods Yet these goods are considered so important that government acting for society often steps in to provide them to citizens irrespective of ability to pay This market deficiency is the rationale behind the modern welfare state the social insurance system of food stamps public housing family assistance and free medical care for the poor Not only does the government secure these goods for people it may even force people to consume them For instance there are people who with some reason prefer to sleep on the street rather than in shelters for the homeless provided at public expense Legal powers exist to declare some of these people mentally incompetent and to compel them to enter institutions A national welfare state in America dates from the New Deal Food aid using surplus commodities and subsidized public housing both began in 1933 Two years later the government created unemployment insurance Social Security and gave aid to children The welfare state surged again under the Great Society proposed by President Lyndon johnson 196369 That period saw the start of the Food Stamp program vouchers for basic items and limited public health insurance for the elderly Medicare and the poor Medicaid The bargain among workers managers and civil servants that was implicit in the welfare state had pluses for business By guaranteeing people s income the welfare state made it easier for companies to reduce their labor force to adjust to changing market conditions The welfare state also relieved companies of pressure to provide fringe benefits to their employees since the 36 Ravi Kanbur On Obnoxious Markets in Stephen Cullenberg and Prasanta Pattanaik Globalization Culture and the Limits of the ZVIarket Essays in Economics and Philosophy New York Oxford University Press 2004 21 34 CHAPTER 2 government was already doing it Finally making workers feel more secure helped nullify any radical menace to the private enterprise system Despite these advantages for business during the 19703 most rich countries started having second thoughts about their welfare states Having government play this guarantor role is expen sive VVith the surge of world economic competition many wondered whether rich countries could afford to be so generous Companies and factories in the less developed countries did not have the same costs Did not social programs tie up too many resources and handicap welfare states on world markets The answer seems a partial yes37 The major negative economic effects of the welfare state are said to be 0 It hurts investment The welfare state diverts resources from production to consumption making it harder for business to update its facilities and compete o It creates ine iciency The welfare state stops or slows resources especially labor from moving to industry that earns the highest reward on the international market o It saps motivation The welfare state weakens the incentive for employees to work innovate and cooperate with management Many countries notably the United States and Great Britain tried to hold down or out back social spending in the 1980s These efforts may have kept the welfare cost in the United States and Britain below the costs of their European competitors but social spending continued to creep upward every where38 Inequality and Unfairness Related to the problem of merit goods individuals share of income in the market mirror to a degree the assets they hold before they enter the market Wealthy people have the edge one that is often thought unfair People born into poverty have fewer chances to get ahead Limited education lack of personal contacts and isolated neighborhoods rig the odds against them Since people do not get to buy their parents there is a clear market failure here Adam Smith had a concern for equity No society can surely be ourishing and happy of which the far greater part of the members are poor and miserable he wrote It is but equity besides that they who feed clothe and lodge the whole body of the people should have such a share of39the produce of their own labor as to be themselves tolerably well fed clothed and lodged Governments can take the rough edges off the income distribution through transfer payments the social welfare programs just mentioned and through progressive taxes high rates for richer people Several specific arguments can be made favoring economic equality Sharing between the haves and the havenots has been interpreted as a kind of public good It enhances the utility of the rich by satisfying their sense of fair play Leveling the economic pyramid also may add to collective efficiency given that the economic principle of diminishing returns implies that a poor person gets more benefit from an extra dollar than a rich person does Equality may reduce the threat to social 37 See for example Alfred Pfailer et al eds Can the 39Welfare State Compete Houndsrnill UK Macmillan 1991 38 Margaret S Gordon Social Security Policy in Indusmal C39oLmtrz39es Cambridge Cambridge University Press 1988 p 15 39 Smith Wealth of Nations Book I Chapter 8 39 22 HOW MARKETS WORK 35 stability a main cause of riots and revolution is people s sense that they are deprived compared to others Equality may enhance productivity by reducing the stress and resentment felt by people at the bottom More equal societies like Germany and Japan tend to have the fastest productivity and income growth All governments intervene to change income distribution Controversial is how far they ought to go Conflicts arise because different people put forth conflicting claims on the economy s benefits and burdens In the 18005 for instance in uential Social Darwinists said no even to minimal help from government Let the fit survive they argued and allow others to perish Under no circum stances should anyone interfere with the market s process of natural selection Most Americans disagree with such a severe position and feel that justice dictates a safety net be created to save people from cold and hunger Few Americans go to the opposite extreme and say justice demands complete equality Most of us think work ought to be rewarded more highly than idleness The gap between rich and poor is widening in the United States Real incomes of America s poor have been sinking for two decades driven by changes in technology and competition from developing countries that have made demand for unskilled workers drop US public policy has abetted these trends by encouraging a flexible labor market see Chapter 12 Inequality is widening in other developed countries too but not as fast They have done more to offset economic forces with powerful labor unions centralized wage bargaining and high minimum wages see Chapter 6 These social and economic trends may come back to haunt American business Chapter 18 Economic instability The market is prone to boom and bust As part of the business cycle the market s downside serves the useful purpose of clearing out inefficient firms But it also imposes pain on people who lose their investments or their jobs While idle resources can and should move to better uses they do so with friction Some individual people never recover from economic downturns Worse the Great Depression of the 19303 hinted that the market could get stuck at the bottom of the business cycle The selfregulating mechanism did not seem to work as expected In the United States GNP went into a free fall between 1929 and 1933 dropping 30 percent It barely budged for several following years Economies need not rebound on their own or at least not fast enough to avoid social unrest I John Maynard later Lord Keynes 1883 1946 the most famous economist of the 20th century identified the problem as the paradox of thrift This paradox is another example of rational individual behavior leading to bad social outcomes When people think their jobs are at risk it makes sense for them to cut back expenditures and put more money aside Unfortunately when everyone spends less people really do lose their jobs It is a selffulfilling prophecy The answer Keynes showed is public borrowing and spending fiscal policy to get the economy going again According to the precepts of Keynesian economics in a weak economy with idle workers the government should spend to put them back to work The military buildup for World War II for example was what finally pulled the United States out of the Great Depression To be a stimulus such spending must be financed by borrowing One factor in the Great Depression was that the government did not borrow Faced with falling tax receipts the consequence of rising unemploy ment federal and state authorities cut spending rather than go into debt Keynesian theory holds 40 See for example Ted R Gurr Vi72y Men Rebel Princeton N Princeton University Press 1970 23 36 CHAPTEB2 that the governments response was backward from what needed to be done and that it prolonged the 1930s crisis needlessly Since the 19405 American and other national governments have taken seriously the role of managing the economy They self consciously try to keep people worldng hopefully without allowing the general level of prices to rise Following Keynes ideas they often resort to de cit public spending to fight economic slowdowns Governments are not always good in this role of economic manager The early 1980s were a period of stag ation in many countries marked by rising unemployment and in ation Today s governments are prone to run de cits even in good times When President Reagan took office in 1981 the govern ment owed 26 for every 100 of GNP when President Clinton took over in 1993 the level was twice as high 49 for eveiy 100 of GNP No nation can inde nitely increase its debt faster than its abilityto produce income As the government goes deeper into the red it needs more receipts to pay back earlier loans Business leaders have long professed that deficit spending has gone too far in the United States Public borrowing absorbs private saving saving that financial markets would otherwise make available to business Thus US companies may have a hard time raising the funds they need to buy new factories and machines The gravity of the crowding out effect of public borrowing is controversial but it may raise the cost of borrowing42 More clearly deficit spending has led to borrowing from foreigners who do have extra savings which has added to the oountry s inter national trading woes see Chapter 1343 Debt also means that our elected officials have less leeway than before to use Keynesian techniques to revive a stalled economy Under President Clinton these processes were reversed Taxes were raised and the federal government began to run a surplus taking in more money than it spent By the end of Clinton s administration the federal debt load had dropped back to 35 for every 100 of GDP This created the political maneuvering room for a major tax cut by President George W Bush when he took office in 2001 It is always far less difficult politically to cut taxes than to raise them History quickly repeated itself and by 2005 the public debt was back up to 40 dollars for every 100 of GNP and headed Skyward Ironically business leaders are partly responsible for the fiscal problem Public indebtedness has not stopped them from lobbying for policies to help their particular companies policies that add to public spending We explore that subject in Chapter 8 CONCLUSION We have introduced the theory of political economy and its core insight that despite appearances business and government are closely integrated Political economy lets us understand how markets work and more importantly for public policy how they sometimes fail It also gives us a basis for interpreting how public policy is made through a kind of market for political in uence see Chapters 8 9 and 10 The juncture of the private and public sectors of market and non market forces is the unifying thread for the rest of this volume 41 On the recurring controversy over public borrowing in the United States see james D Savage Balanced Budgets and Amerzbcm Poliitics Ithaca Cornell University Press 1988 42 A reassuring View of the national debt is Robert Eisner The Misunderstood Economy Boston Harvard Business School Press 1994 43 For a discussion of the international rami cations of public indebtedness see David P Calleo The Bankruptcy of America New York William Morrow 1992 24 HOW MARKETS WORK 37 We also have probed the basis of free market or capitalist economies and identified several scenarios where the Invisible Hand of competition produces desired outcomes Under the right conditions laissez faire policies work the best for all They create a process akin to natural selection in biology through which only the fittest rms making things people Want survive There is much to the point often made by former US President Ronald Reagan that the market is miraculous It is a Wonder that self interested beings can work together without conscious knowledge in the complex and large scale job of producing distributing and consuming wealth The linking of individual and social benefit through the Invisible Hand makes laissez faire a hardy and appealing doctrine Yet conditions are not always so favorable for the competitive market The Invisible Hand cannot be counted on to move resources to their best use all the time In these cases what might be called government s Visible Hand is needed We probe deeper into government intervention in Chapter 3 25 9Z CHAPTER I THE PROMISE OF GLOBAL INSTITUTIONS NTERNATIONAL BUREAUCRATSTHE faceless symbols of the world economic order are under attack everywhere Formerly uneventful meetings of obscure technocrats discussing mundane subjects such as concessional loans and traded quotquotas have now become the scene of raging street battles and huge demonstrations The protests at the Seattle meeting of the World Trade Organization in 1999 were a shock Since then the movement has grown stronger and the iry has spreadVirtually every major meeting of the Interna tional Monetary Fund the World Bank and the World Trade Organi zation is now the scene of conflict and turmoil The death of a protestor in Genoa in 2001 Was just the beginning of what may be many more casualties in the War against globalization Riots and protests against the policies of and actions by institu tions of globalization are hardly new For decades people in the developing world have rioted when the austerity programs imposed on their countries proved to be too harsh but their protests were largely unheard in the West What is new is the wave of protests in the developed countries It used to be that subjects such as structural adjustment loans the programs that were designed to help countries adjust to and Weather crises and banana quotas the limits that some European countries AZ 4 GLOBALIZATION AND ITS DISCONTENTS impose on the importing of bananas from countries other than their former colonies were of interest to only a few Now sixteen year old kids from the suburbs have strong opinions on such esoteric treaties as GATT the General Agreement on Tarifis and Trade and NAFTA the North American Free Trade Area the agreement signed in 1992 between Mexico United States and Canada that allows for the freer movement of goods services and investment but not people among those countries These protests have provoked an enormous amount of soul searching from those in power Even conm servative politicians such as Frances president Jacques Chirac have expressed concern that globalization is not making life better for those most in need of its promised benefits1 It is clear to almost everyone that something has gone horribly wrong Almost overnight globalization has become the most pressing issue of our time some thing debated from boardrooms to op ed pages and in schools all over the world WHY HAS GLOBALIZATIN a force that has brought so much good become so controversial Opening up to international trade has helped many countries grow far more quickly than they would otherwise have done International trade helps economic develop ment when a country s exports drive its economic growth Export led growth was the centerpiece of the industrial policy that enriched much of Asia and left millions of people there far better off Because of globalization many people in the world now live longer than before and their standard of living is far better People in the West may regard low paying jobs at Nike as exploitation but for many people in the developing world working in a factory is a far better option than staying down on the farm and growing rice Globalization has reduced the sense of isolation felt in much of the developing world and has given many people in the developing countries access to knowledge well beyond the reach of even the wealthiest in any country a century ago The antiglobalization protests themselves are a result of this connectedness Links between activists in different parts of the world particularly those links forged through Internet communication brought about the pressure that resulted in the international landmines treaty despite the opposi THE PROMISE or GLOBAL INSTITUTIONS 5 tion of many powerful governments Signed by 121 countries as of 1997 it reduces the likelihood that children and other innocent vic tims will be maimed by mines Similar well orchestrated public pres sure forced the international community to forgive the debts of some of the poorest countries Even when there are negative sides to glob alization there are often bene ts Opening up the Jamaican milk market to US imports in 1992 may have hurt local dairy farmers but it also meant poor children could get milk more cheaply New for eign firms may hurt protected state owned enterprises but they can also lead to the introduction of new technologies access to new mar kets and the creation of new industries Foreign aid another aspect of the globalized world for all its faults still has brought benefits to millions often in ways that have almost gone unnoticed guerrillas in the Philippines were provided jobs by a World Bank f1nanced project as they laid down their arms irrigation projects have more than doubled the incomes of farmers lucky enough to get water education projects have brought literacy to the rural areas in a few countries AIDS projects have helped contain the spread of this deadly disease Those who vilify globalization too often overlook its benefits But the proponents of globalization have been if anything even more unbalancedTo them globalization which typically is associated with accepting triumphant capitalism American style is progress devel oping countries must accept it if they are to grow and to fight poverty effectively But to many in the developing world globaliza tion has not brought the promised economic benefits A growing divide between the haves and the have nots has left increasing numbers in the Third World in dire poverty living on less than a dollar a day Despite repeated promises of poverty reduction made over the last decade of the twentieth century the actual num ber of people living in poverty has actually increased by almost 100 million This occurred at the same time that total world income increased by an average of 25 percent annually In Africa the high aspirations following colonial independence have been largely unfulfilled Instead the continent plunges deeper into misery as incomes fall and standards of living declineThe hard won improvements in life expectancy gained in the past few decades SZ 6 GLOBALIZATION AND Irs DISCONTENTS have begun to reverseWhile the scourge of AIDS is at the center of this decline poverty is also a killer Even countries that have aban doned African socialism managed to install reasonably honest gov ernments balanced their budgets and kept in ation down find that they simply cannot attract private investorsWithout this investment they cannot have sustainable growth If globalization has not Sld1EEZ t C3w IlMlW1MI1 reducing poverty neither has it HgEabmW Crisewilsllin Asia and in Latin Ammwelfica the stability of all developing countriesThere are fears of financial contagion spreading around the World that the collapse of one emerging market currency will mean that others fall as well For a while in 1997 and 1998 the Asian crisis appeared to pose a threat to the entiremworld economy 39 Globalization and the iritf6 d ttio oquotf aTiW i lE f 39 quoti c quotE quot i iomy has not produced the promised results in Russia and most of the other economies making the transition from communism to the market These countries were told by the West that the new economic sys tem would bring them unprecedented prosperity Instead it brought unprecedented poverty in many respects for most of the people the market economy proved even Worse than their Communist leaders had predicted The contrast between Russ1a s transition as engineered by the international economic institutions and that of China designed by itself could not be greaterWhile in 1990 Chinas gross domestic product GDP was 60 percent that of Russia by the end of the decade the numbers had been reversed While Russia saw an unprecedented increase in poverty saw an upnprewcwpedented decrease The critics of globalization accuse Western countries of hypocrisy and the critics are right The Western countries have pushed poor countries to eliminate trade barriers but kept up their own barriers preventing developing countries from exporting their agricultural products and so depriving them of desperately needed export income The United States was of course one of the prime culprits and this Was an issue about which I felt intensely When I was chair man of the Council of Economic Advisers I fought hard against this hypocrisy as had my predecessors at the Council from both partiesrlt not only hurt the developing countries it also cost Americans bil lions of dollars both as consumers in the higher prices they paid and THE PROMISE or GLOBAL INSTITUTIONS 7 as taxpayerskto finance the huge ppag igultiralsWup i gly1gsThe struggles v39m39v ov were all too often unsuccessful Special commercial and financial interests prevailed and when I moved over to the World Bank I saw the consequences to the developing countries all too clearly But even when not guilty of hypocrisy gejest has drivepmpllg globalization agenda ensuring that it garners a disprtiidortimoniatie share l ilbenel ts at the expense P s t thaltmthe lmiore advanced indiistrial Fw open up their markets to the goods of the developing countriesmfor instance keeping their quotas on a multitude of goods from textiles to sugar vvhile insisting that those countries open up their markets to the goods of the wealthier countries st that the more advanced industrial countries continued to subsidize agriculture making it difficult for the developing countries to compete while insisting that the developing countries eliminate their subsidies on industrial goods Looking at trade the prices which developed and less developed countries getfor the products they produce after the last trade agreement in 1995 the eighth the net effect was to lower the prices some of the poorest countries in the world received relative to what they paid for their imports The result was that some of thpgppoorest the2 Z I 39l i quot l e actu qY allywnpgrfgigl M iggrseMn ia iwe Western banks benefited from the loosening of capital market controls in Latin America and Asia but those regions suffered when inflows of speculative hot moiiey money that comes into and out of a country often overnight often little more than betting on whether a currency is going to appreciate or depreciate thatwhgdpgiiigdinto countries suddenlym abrupt outflow of money left nos mltm a xigaaa O 39Wldwehindwclollapsed I currencies and weakened banking systems The Uruguay Round also strengthened intellectual property rights This eighth agreement was the result of negotiations called the Uruguay Round because the negotiations began in 1986 in Punta del Este Uruguay The round was 39 concluded in Marrakech on December 15 1993 when 117 countries joined in this 39 trade liberalization agreement The agreement was finally signed for the United States by President Clinton on December 8 1994 The World Trade Organization p came into formal e ect on January 1 1995 and over 100 nations had signed on by 0 7 July One provision of the agreement entailed converting the GATT into the WTO me 5 i SZ 3 GLOBALIZATION AND Irs DISCONTENTS American and other Western drug companies could now stop drug companies in India and Brazil from stealing their intellectual prop erty But these drug companies in the developing world were making these life saving drugs available to their citizens at a fraction of the price at which the drugs were sold by the Western drug companies There were thus two sides to the decisions made in the Uruguay Round Pro ts of the Western drug companies would go up Advo cates said this Would provide them more incentive to innovate but the increased pro ts from sales in the developing world were small since few could afford the drugs and hence the incentive effect at best might be limitedThe other side was that thousands were effec tively condemned to death because governments and individuals in developing countries could no longer pay the high prices demanded Lathe sass 9 eventually agreeing to lower their N p the drugs iiilate 2001 But the underlying prob lems the fact that the intellectual property regime established under the Uruguay Round was not balanced that it overwhelmingly reflected the interests and perspectives of the producers as opposed to the users whether in developed or developing countries rernain Not only in trade liberalization but in every other aspect of globalization even seemingly well intentioned efforts have often backfired When projects whether agriculture or infrastructure rec ommended by the West designed with the advice of Western advis ers and nanced by the World Bank or others have failed unless there is some form of debt forgiveness the poor people in the devel oping world still must repay the loans If in too many instances the bene ts of globalization have been less than its advocates claim the price paid has been greater as the environment has been destroyed as pohtical processes have been cor rupted and as the rapid pace of change has not allowed countries time for cultural adaptation The crises that have brought in their wake massive unemployment have in turn been followed by longer term problems of social dissolution from urban violence in Latin America to ethnic conflicts in other parts of the world such as Indonesia These problems are hardly new but the increasingly vehement THE PROMISE or GLOBAL INSTITUTIONS 9 worldwide reaction against the policies that drive globalization is a significant change For decades the cries of the poor in Africa and in developing countries in other parts of the world have been largely unheard in the WestThose who labored in the developing countries knew something was wrong when they saw financial crises becom ing more commonplace and the numbers of poor increasing But they had no way to change the rules or to influence the international financial institutions that wrote them Those who valued democratic processes saw how gonditionaliw Wthe conditionpsmthat intgrna L eir national sovereignty But until the protestors came along there was little hope for change and no outlets for complaint Some of the pro testors went to excesses some of the protestors were arguing for higher protectionist barriers against the developing countries which would have made their plight even Worse But despite these prob lems it is the trade unionists students environtriiltntalists oijdiriarquoty wpitizfngwmarching in the streets of Prague SeattleWashington and Genoa who have put the neEgLf9L f9ii m93E1Q 2igeI3 i21rgfwglgg sisrsloped Wedd R iisleieiiiglobahzation in a very different light than the tream sury secretary of the United States or the nance and trade ministers of most of the advanced industrial countriesThe differences in views are so great that one wonders are the protestors and the policy rnakm ers talking about the same phenomena Are they looking at the same data Are the visions of those in power so clouded by special and par ticular interests What is this phenomenon of globalization that has been subject at the same time to such vili cation and such praise Fundamentally it isNM integration of the countries panwdwpmemoples of the world v r which has been bioughtj about by the enormousppr duction of costs of I v pranspoi tquotafion and w down of G to q eattent gt borders Globalization has been accompanied by the Eireiation of t that have joined with existing ones to work across borders In the arena of interna tional civil society new groups like the jubilee movement pushing for debt reduction for the poorest countries have joined long 09 IO GLOBALIZATION AND ITS DISCONTENTS established organizations like the International Red Cross Globaliza tion is powerfully driven by international corporations which move not only capital and goods across borders but also technology Globalization has also led to renewed attention to longestablished international irztergovemmental institutions the United Nations which attempts to maintain peace the International Labor Organization ILO originally created in 1919 which promotes its agenda around the world under its slogan decent work and the World Health Organization WHO which has been especially concerned with improving health conditions in the developing world Many perhaps most of these aspects of globalization have been welcomed everywhere No one wants to see their child die when knowledge and medicines are available somewhere else in the world It is the more narrowly de ned economic aspects of globalization that have been the subject of controversy and the international institu tions that have written the rules which mandate or push things like liberalization of capital markets the elimination of the rules and reg ulations in many developing countries that are designed to stabilize the flows of volatile money into and out of the country To understand what went wrong it s important to look at the three main institutions that govern globalization the IMF the World Bank and the WTO There are in addition a host of other institu tions that play a role in the international economic system a num ber of regional banks smaller and younger sisters to the World Bank and a large number of UN organizations such as the UN Develop ment Program or the UN Conference on Trade and Development UNCTADThese organizations often have views that are markedly different from the IMF and the World Bank The ILO for example worries that the IMF pays too little attention to workers rights while the Asian Development Bank argues for competitive plural ism whereby developing countries will be provided with alternative views of development strategies including the Asian model in which governments while relying on markets have taken an active role in creating shaping and guiding markets including promoting new technologies and in which rms take considerable responsibility for the social welfare of their employeesmmwhich the Asian Develop THE PROMISE OF GLOBAL INSTITUTIONS 11 ment Bank sees as distinctly different from the American model pushed by the Washingtonbased institutions In this book I focus mostly on the IMF and the World Bank largely because they have been at the center of the major economic issues of the last two decades including the financial crises and the transition of the former Communist countries to market economies The IMF and the World Bank both originated in World War II as a result of the UN Monetary and Financial Conference at Bretton Woods New Hampshire in July 1944 part of a concerted effort to finance the rebuilding of Europe after the devastation of World War II and to save the world from future economic depressions The proper name of the World Bank the International Bank for Recon struction and Development re ects its original mission the last part Development was added almost as an afterthought At the time most of the countries in the developing world were still colonies and what meager economic development efforts could or would be undertaken were considered the responsibility of their European masters The more difficult task of ensuring global economic stability was assigned to the IMF Those who convened at Bretton Woods had the global depression of the 19303 very much on their minds Almost three quarters of a century ago capitalism faced its most severe crisis to date The Great Depression enveloped the whole world and led to unprecedented increases in unemployment At the worst point a quarter of America s workforce was unemployed The British econom mist john Maynard Keynes who would later be a key participant at Bretton Woods put forward a simple explanation and a correspond ingly simple set of prescriptions lack of sufficient aggregate demand explained economic downturns government policies could help stimulate aggregate demand In cases where monetary policy is inef fective governments could by increasing expenditures or cutting taxes While the models underlying Keynes s analysis have subsequently been criticized and refined bringing a deeper understanding of why market forces do not work quickly to adjust the economy to full employment the basic lessons remain valid L9 I2 GLOBALIZATION AND ITS DISCONTENTS another global Wpdwe pie i oWn It would do this by putting international pressure on countries that were not doing their fair share to maintain gl9lLgggm1 1 g by allowing their own economies to go into a slump When necessary it would also provide liquidity in the form of loans to those countries facing an economic downturn and unable to stimulate aggregate demand with their own resources In its original conception then the IMF was based on a recogni tion that markets often did not work well that they could result in massive unemployment and might fail to make needed funds avail able to countries to help them restore their economiesThe IMF was founded on the belief that there was a need forcollettiigegction at the just as the g founded on the belnilefithat there was a need for collective action at the global level for political is a public institution established with money provided by taxpayersmaround the worldThis is important to remember because it does not report directly to either the citizens who finance it or those whose lives it affects Rather it reports to the ministries of finance and the central banks of the governments of the world They assert their control through a complicated voting arrangement based largely on the economic power of the countries at the end of World War IIThere have been some minor adjustments since but the major developed countries run the show with only one countrythmWgWnited Statesthaving e ec Pa this sense it is similar to the UN where a historical anachronism determines who holds the veto the victorious powers of World War II but at least there the veto power is shared among five countries Over the years since its inception the IMF has changed markedly On the b611615athat1Ia1Cl 1SQft 1 worked 0 badly it now market Supremacy 0 i solotw Poun i E1ii i5f1 r the belief that there is alnleed for internationlalnilpressiirfe on countries to have more expansionary economic policies such as increasing expenditures reducing taxes or lowering interest rates to stimulate the economy today the IMF typically provides funds only if coun tries engage in policies like cutting deficits rgising taxes or raising A quot vquot imAw i Mm V THE PROMISE or GLOBAL INSTITUTIONS 13 jlnterest rateswthat lead to a contraction of the economy Keynes would be rolling over in his grave were he to see what has happened to his child The most dramatic change in these institutions occurred in the 19805 the era when Ronald Reagan and Margaret Thatcher preached free market ideology in the United States and the United KingdomThe IMF and the World Bank became the new missionary institutions through which these ideas were pushed on the reluctant poor countries that often badly needed their loans and grants The ministries of finance in poor countries were willing to become con verts if necessary to obtain the funds though the vast majority of government officials and more to the point people in these coun tries often remained skeptical In the early 1980s a purge occurred inside the World Bank in its research department which guided the Banks thinking and direction Hollis Chenery one of America s most distinguished development at Harvard who had made fundamental contributions to research in the economics of development and other areas as well had been Robert McNamara s confidant and adviserMcNamara had been appointed president of W J fR9 r1w39x F sI r f the World Bank in 1968 Touched by the poverty that uliewsawl Third World McNamara had redirected the Bank s effort at its elimination and Chenery assembled a first class group of economists from around the world to work with him But with the changing of the guard came a new president in Cwlapmsgn and a new chief economist Ann Krue gMgr an international Wfrade specialist best known for her 0 seeking how special interests use tariffs and other protectionist measures to increase their incomes at the expense of othersWhile Chenery and his team had focused on how markets failed in developing coun tries and what governments could do to improve markets and reduce poverty Igrigggggwsgajgymm government as the problemgfree mar kets were the soliition to e developing countries In the new ideological fervor many of the first rate economists that Chenery had assembled left Although the missions of the two institutions remained distinct it was at this time that their activities became increasingly intertwined Z9 14 GLOBALIZATION AND ITS DISCONTENTS In the 19803 the Bank went beyond just lending for projects like roads and dams to providing broad based support in the form of 39 but it did this only when the IMF gave its approval and with that approval came IMFimposed conditions on the country The IMF was supposed to focus on crises but develop ing countries were always in need of help so the IMF became a per manent part of life in most of the developing world The fall of the Berlin Wall provided a new arena for the IMF managing the transition to a market economy in the former Soviet Union and the Communist bloc countries in Europe More recently as the crises have gotten bigger and even the deep coffers of the IMF seemed insufficient the World Bank was called in to provide tens of billions of dollars of ernergency support but strictly as a junior part ner with the guidelines of the programs dictated by the IMF In prin ciple there was a division of labor The IMF was supposed to limit itself to matters of macroeconomics in dealing with a country to the governments budget deficit its monetary policy its in ation its trade deficit its borrowing from abroad and the World Bank was supposed to be in charge of structural issues What the country s government spent money on the country s nancial institutions its labor markets its trade policies But the IMF took a rather irnperialistic view of the matter since almost any structural issue could affect the overall per formance of the economy and hence the governments budget or the trade deficit it viewed almost everything as falling within its domain It often got impatient with the World Bank where even in the years when free market ideology reigned supreme there were frequent controversies about what policies would best suit the conditions of the country ThI 4 wers basicall the same ones for j eyery country didn t see the need for all this discussion and wh e S theWdfldWWEEWk debated what Should be done saw itself as stepping into the vacuum to provide the answers The two institutions could have provided countries with alterna tive perspectives on some of the challenges of development and tran sition and in doing so they might have strengthened democratic processes But they were both driven by the collective will of the G 7 the governments of the seven most important advanced industrial THE PROMISE or GLOBAL INSTITUTIONS 15 countries and especially their nance ministers and treasury secre taries and too often the last thing they wanted was a lively demoera tic debate about alternative strategies ieahalf Ctntuw efist it f9undinsaitiS N in om laW nn Mm W A its Mgrussipn It has not done B waisiimsiipposed to for countries facing an economic downturn to enable the country to restore itself to close to full employment In spite of the fact that our understanding of economic processes has increased enormously during the last fifty years crises around the world have been more frequent and with the exception of the Great Depression deeper By some reckonings close to a hundred countries have faced criseS3 Every major emerging market that liberalized its capital market has had at least one crisis But this is not just an unfortunate streak of bad luck Many of the policies that the IMF pushed in particular premature capital market liberalization have contributed to global instability And once a country was in crisis IMF funds and programs not only failed to stabilize the situation but in many cases actually made matters Worse especially for the poor The A pi abLmw it H in the new missions that it has undertaken such as guiding the transition of CO ntrieS 33 359i 3 3 3339 w393iEi 1E E9ir9 3iYw The Bretton Woods agreement had called for a third international economic organizatior1 ma World Trade Organization to govern international trade relations a job similar to the IllF s governing of international financial relations Beggar thy neighbor trade policies in which countries raised tariffs to maintain their own economies but at the expense of their neighbors were largely blamed for the spread of the depression and its depth An international organization was required not just to prevent a recurrence but to encourage the free flow of goods and serviceSAlthough the General Agreement on These are the United Statesjapan Germany Canada Italy France and the UK Today the G 7 typically meets together with Russia the G8The seven countries are no longer the seven largest economies in the world Membership in the G 7 like permanent membership in the UN Security Council is partly a matter of his torical accident 99 I6 GLOBALIZATION AND ITS DISCONTENTS Tariffs and Trade GATT did succeed in lowering tariffs enormously it was di icult to reach the nal accord it was not until 1995 a half century after the end of the war and two thirds of a century after the Great Depression that the World Trade Organization came into beinggl MuHt phquot the markedly different from the other two orga nizations not setrules itself rather it provides a forum in rg rwva M I which trade p goon and it ensures that its agreements are The ideas and intentions behind the creation of the international economic institutions were good ones yet they gradually evolved over the years to become something very different The Keynesian orientation of the IMF which emphasized market failures and the role for government in job creation was replaced by the free market mantra of the 19805 part of a new Washington onsensus a con sensus between the IMF the World Bank and the P about the right policies for developing countries that signaled a radi cally different approach to economic development and stabilization Many of the ideas incorporated in the consensus were developed in response to the problems in Latin America where governments had let budgets get out of control while loose monetary policies had led to rampant in ation A burst of growth in some of that regions countries in the decades immediately after World War II had not been sustained allegedly because of excessive state intervention in the economy Unfortunately the ideas that were developed to cope with problems arguably speci c to Latin American countries were applied to other countries countries with quite different economic structures strengths and weaknesses Policies like capital market lib eralization were pushed throughout Latin America before there was a strong body of either theory or evidence that they promoted growth Even as evidence mounted that such policies contributed to instability these policies were pushed elsewhere sometimes in situaw tions where they were even more poorly suited 39 In many cases the Washington Consensus policies even if they had been appropriate in Latin America were ill suited for countries in the early stages of development or transition Most of the advanced industrial countries including the United States and japanhad built up their economies by wisely and selectively protecting some of THE PROMISE or GLOBAL INs39rIrUr1oNs 17 their industries until they were strong enough to compete with for eign companiesWhile blanket protectionism has often not worked for countries that have tried it neither has rapid trade liberalization Forcing a developing country to open itself up to imported products that would compete with those produced by certain of its industries industries that were dangerously vulnerable to competition from much stronger counterpart industries in other countries can have disastrous consequences socially and economically Jobs have sys tematically been destroyed poor farmers in developing countries simply couldn t compete with the highly subsidized goods from Europe and America before the countries industrial and agricul tural sectors were able to grow strong and create new jobs Even M7v qrsew lre IMF s insistence on developing irw za x tight monetary policies has led 3 interest Z that would j ltraWdeWliberalization occurred before safety nets were P into place lost their jobs were forced into poverty Liberalization has thus too often not been followed by the promised growth but by increased misery And even those who have not lost their jobs have been hit by a heightened sense of insecurity Capital controlsmare another example European countries banned t pit until the seventies Some might say it s not fair to insist that developing countries with a barely functioning bank sys tem risk opening their markets But putting aside such notions of fair ness it s bad economics the influx of hot morigyinto and out of the country that so frequently follows after capital market liberalization leaves havoc in its wakewdWey LQpipgWcpwpgtries are like small 3 boats Rapid capital market liberalization in the manner pushed by fli eWlWME amounted to setting them off on a voyage on a rough sea before the holes in their hulls have been repaired before the captain has received training before life vests have been put on board Even in the best of circumstances there was a high likelihood that they would be overturned when they were hit broadside by a big wave Even if the IMF had subscribed to mistaken economic theories it might not have mattered if its domain of activity had been limited to Europe the United States and other advanced industrialized countries that can fend for themselves But the end of colonialism 179 i8 GLOBALIZATION AND ITS DISCONTENTS and communism has given the international nancial institutions the opportunity to expand greatly their original mandates Today these institutions have become dominant players in the world economy Not only countries seeking their help but also those seeking their seal of approval so that they can better access international capital gmarkets must follow their economic prescriptions prescriptions which reflect their free market ideologies and theories The result for many people has been poverty and for many coun tries social and political chaosThe IMF has made mistakes in all the areas it has been involved in development crisis management and in countries making the transition from communism to capitalism Structural adjustment programs did not bring sustained growth even to those like Bolivia that adhered to its strictures in many countries excessive austerity stifled growth successful economic programs require extreme care in 5equencing the order in which reforms occur and pacing If for instance markets are opened up for com petition too rapidly before strong financial institutions are estab lished then jobs will be destroyed faster than new jobs are created In many countries mistakes in sequencing and pacing led to rising unemployment and increased poverty4 In the 1997 Asian crisis IMF policies exacerbated the crises in Indonesia and Thailand Free mar ket reforms in Latin America have had one or two successes Chile 1S repeatedly cited wbut much of the rest of the continent has still to make up for the lost decade of growth following the so called suc cessful IMF bailouts of the early 1980s and many today have penis tently high rates of unemploymentwin Argentina for instance at doubledigit levels since 1995 even as in ation has been brought downThe collapse in Argentina in 2001 is one of the most recent of a series of failures over the past few years Given the high unemploy ment rate for almost seven years the wonder is not that the citizens eventually rioted but that they suffered quietly so much for so long Even those countries that have experienced some limited growth have seen the bene ts accrue to the well off and especially the very well offwthe top 10 percent While poverty has remained high and in some cases the income of those at the bottom has even fallen Underlying the problems of the IMF and the other international economic institutions is the problem of governance who decides THE PROMISE or GLOBAL INSTITUTIONS 19 what they doThe institutions are dominated not just by the wealthi est industrial countries but by commercial and nancial interests in those countries and the policies of the institutions naturally re ect thisThe choice of heads for these institutions symbolizes the institu tions problem and too often has contributed to their dysfunction While almost all of the activities of the IMF and the World Bank today are in the developing world certainly all of their lending they are led by representatives from the industrialized nations By custom gr tacit agreement the head of the IMF is always ggg wgwuroppewan that of Tiler srashossn behind Closediasorssa and it has never even been viewed as a prerequisite 03 should have any experiencgepipHthe deyelopi nggggyvorldThe institutions the nations they serve i g cc r39Tr W The problems also for the country At the it is rI1i 1it irS and the Central the p p p particular constituencies within their countries The trade ministries reflect the concerns of the business community both exporters who want to see new markets opened up for their products and producers of goods which fear competition from new imports These constituencies of course want to maintain as many barriers to trade as they can and keep whatever subsidies they can persuade Congress or their parliament to give them The fact that the trade barriers raise the prices consumers pay or that the subsidies impose burdens on taxpayers is of less concern than the profits of the producerswand environmental and labor issues are of even less con cern other than as obstacles that have to be overcome The finance ministers and central bank governors typically are closely tied to the nancial community they come from nancial rms and after their period of government service that is where they returnRobert the treasury secretary during much of the period described in this book came from the largest investment bank Goldman Sachs and returned to the rm Citigroup that controlled the largest comm mercial bank CitibankThe number two person at the IMF during this period Stan Fischer went straight from the IMF to Citigroup These individuals naturally see the world through the eyes of the nancial community The decisions of any institution naturally re ect 99 20 GLOBALIZATION AND ITS DISCONTENTS the perspectives and interests of those who make the decisions not surprisingly as we shall see repeatedly in the following chapters the policies of the international economic institutions are all too often closely aligned with the commercial and nancial interests of those in the advanced industrial countries For the peasants in developing countries who toil to pay off their countries IMF debts or the businessmen who suffer from higher value added taxes upon the insistence of the IMF the current system run by the IMF is one of taxation without representation Disillusion with the international system of globalization under the aegis of the IMF grows as the poor in Indonesia Morocco or Papua New Guinea have fuel and food subsidies cut as those in Thailand see AIDS increase as a result of IMF forced cutbacks in health expendi tures and as families in many developing countries having to pay for their children s education under so called cost recovery programs make the painful choice not to send their daughters to school Left with no alternatives no way to express their concern to press for change people riotThe streets of course are not the place where issues are discussed policies formulated or compromises forged But the protests have made government officials and economists around the world think about alternatives to these Washington Consensus policies as the one and true way for growth and development It has become increasingly clear not to just ordinary citizens but to policy makers as well and not just those in the developing countries but those in the developed countries as well that globalization as it has been practiced has not lived up to what its advocates promised it would accomplish or to what it can and should do In some cases it has not even resulted in growth but when it has it has not brought benefits to all the net effect of the policies set by the Washington Consensus has all too often been to benefit the few at the expense of the many the well oif at the expense of the poor In many cases commercial interests and values have superseded concern for the environment democracy human rights and social justice Globalization itself is neither good nor bad It has the power to do enormous good and for the countries of East Asia who have embraced globalization under their own terms at their own pace it has THE PROMISE OF GLOBAL INSTITUTIONS 21 been an enormous benefit in spite of the setback of the 1997 crisis But in much of the world it has not brought comparable benefits The experience of the United States during the nineteenth cen tury makes a good parallel for today s globalization and the contrast helps illustrate the successes of the past and today s failures At that time when transportation and communication costs fell and previ ously local markets expanded new national economiesformed and with these new national economies came national companies doing business throughout the country But the markets were not left to develop willywnilly on their own government played a vital role in shaping the evolution of the economy The US government obtained wide economic latitude when the courts broadly interpreted the constitutional provisioriWthat allows the federal government to regu late interstate comme ge39iTNhie AG imn mtgt wquotquot the financial system set minimum wages and working conditions and eventually A systems to deal with the problems posed by a market systemTwlige A also promoted some industries the first telegraph liinefori t Es T between Baltimore and Xashing ton in 1842 and encouraged others like agriculture not just helping set up universities to do research but providing extension services to train farmers in the new technologies The federal government played a central role not only in promoting American growth Even if it did not engage in the kinds of active redistribution policies at least it had programs whose benefrts were widely shared not just those that extended education and improved agricultural productiv ity wb11talsolan LgI gQ1 that provided a minimum opportunity for all Americans Today with the continuing decline in trajnspjgrjtjatiojn P nicatjiQncgstspand the reduction of manmade barriers to the ow of goods services and capital though there remain serious barriers to the free flow of labor we have a process of globalization analogous to the earlier processes in which national economies were formed Unfortunately we have no world government accountable to the people of every country to oversee the globalization process in a fashion comparable to the way national governments guided the 99 22 GLOBALIZATION AND ITS DISCONTENTS nationalization process Instead we have a system that might be called global governance wifhpgigwgggiiggwif w ggne in which a few institu tions the World Bank the IMF the WTO and a few players the finance commerce and trade ministries closely linked to certain nancial and commercial interests doIninate the scene but in which many of those affected by their decisions are left almost voice less It s time to change some of the rules governing the international economic order to think once again about how decisions get made at the international level and in whose interests and to place less emphasis on ideology and to look more at what Works It is crucial that the successfgl dey elWoWpn3emntgt5 ygp ghgyewsggn in E l mEWquot SlElJ be quot wM Y ma w M achieved elswgggggggg ihere is an enormous cost to continuing global can be reshaped and when it is when it is properly fairly run with all countries having a voice in policies a ecting them there is a possibility that it will help create a new global economy in which growth iswwnptWonly 0D and less volatile but the fruits of this grgwth are CHAPTER 2 ROMISES N MY FIRST day February 13 1997 as chief economist and senior vice president of the World Bank as I walked into its gigantic modern gleaming main building on 19th Street in Washington DC the institution s motto was the first thing without I90 fFiF the Center sm39w w of the thirteenstory atriiiinithere is a statue of a young boy leading an old blind man a memorial to the eradication of river blindness onchocerciasis Before the World Bank the World Health Organiza tion and others pooled their efforts thousands were blinded annually in Africa from this preventable disease Across the street stands another gleaming monument to public wealth the headquarters of the International Monetary Fund The marble atrium inside graced with abundant ora serves to remind visiting finance ministers from countries around the world that the IMF represents the centers of wealth and power These two institutions often confused in the public mind present marked contrasts that underline the differences in their cultures styles and missions ne is devoted to eradicating pyovggwtgbgggrggemgpm rgiaintaining global styabilityWhile both have teams of economists y for three week missions the World 33 HARVARD BUSINESS SCHOOL 9713037 OCTOBER 30 2012 LAKSHMI IYER GA DONOVAN Urbanizing China We have proposed the strategic mission of building a socialist harmonious society with a democratic legal system fairness and justice sincere amicability and great vitality bringing into full play the people39s wisdom and creativity letting all the people share the social wealth created by reform and development forging closer ties between the people and the Party and government and further consolidating the state of stability and unity Accornplishjng this mission will greatly advance the great cause of building a strong prosperous democratic civilized socialist modernized country Premier Wen Jiabao February 7 20051 In 2012 China attained a historic development milestone for the first time more Chinese citizens lived in cities than in the countryside Government figures reported that 691 million people or 5127 percent of China39s population lived in urban areas at the beginning of the year While this milestone had been attained by the UK in 1851 and the US in 1920 China s urbanization had been extremely rapid compared to other emerging markets such as India or Thailand Only about 20 percent of China39s population lived in urban areas when market reforms were first introduced in 1979 By 2030 more than 70 percent were expected to live in cities See Exhibits 1 and 2 China39s rapid urbanization and the accompanying conversion of agricultural land to non agricultural uses led to a number of economic social and political tensions Agriculture constituted 30 percent of China39s GDP in 1980 but only ten percent in 2010 See Exhibit 3 Land use patterns had changed accordingly industrialization and urbanization resulted in the conversion of large swathes of agricultural land to nonagricultural uses For a while bringing new land into cultivation more than made up the difference but by 2003 the government began to recognize that farmland was rapidly disappearing with potential ramifications for China39s future food security Much of China39s breakneck growth had been accomplished at the expense of the quantity and quality of farmland as the country promoted high levels of investment in infrastructure and real estate See Exhibit 4 In many cases these investments had been funded by sales of land use rights by local governments In early 2012 debts incurred by local governments were estimated to be a quarter of China s GDP and Beijing had directed stateowned banks to begin rolling over a portion of local government debt3 Converting agricultural land to nonagricultural uses was the source of considerable con ict in China as farmers were often not compensated adequately when village land was expropriated Land disputes led to public protests and in some places violent unrest as farmers took to the street to express their dissatisfaction4 In September 2011 the residents of Wukan village in Guangdong province staged a series of protests against illegal land sales by village officials where the villagers Professor Lakshmi Iyer and APRC Senior Researcher GA Donovan prepared this case IIBS cases are developed solely as the basis for class discussion Cases are not intended to serve as endorsements sources of primary data or illustrations of effective or ineffective management Copyright 2012 President and Fellows of Harvard College To order copies or request permission to reproduce materials call 18005453685 write Harvard Business School Publishing Boston MA 02163 or go to wwwhbspharvardedu educators This publication may not be digitized photocopied or otherwise reproduced posted or transmitted without the permission of Harvard Business School 37 Authorized for use oat by Patrick Kennedy from Aug 12 E to Apr 0 2014 Use outside these parameters is a copyrignt vkxatiors 713037 Urbanizing China chased out Communist Party officials5 A peace agreement with higher level government officials led to protest leader Lin Zuluan becoming Wulltan s new Communist Party secretary The tensions posed by rapid urbanization raised many important questions Could China maintain its food security in View of the sharply rising demand for land for urban development How could it ensure the sustainability of local government finances Were the protests in Wulltan an exception or the harbinger of major changes in China39s political institutions How would the challenges of urbanization affect the business environment for private firms The success and viability of China39s overall growth strategy would be largely determined by its land rights policies China39s Urbanization Process China39s economy expanded rapidly after economic reforms were introduced in 1979 prompting many rural residents to leave their villages in search of opportunity The urban population stood at 172 million in 1970 by 2010 it had increased to 690 million See Exhibit 5 for urbanization trends by province Beijing encouraged the urbanization process by allowing localities to upgrade their status for example from prefecture or county to city or by converting larger villages to townships The number of cities increased from 193 in 1978 to 655 in 2010 while the number of townships grew from just over 6000 to more than 40000 Between 1983 and 1997 Beijing granted city status to thousands of counties based on a formula that took into account metrics such as population density and GDP This program was discontinued in 1997 after it became clear that simply changing a place s designation did little to promote urban planning 6 Nonetheless the government continued to approve the reclassification of prefectures into cities and to promote the development of townships Despite the rise in the number of cities China39s strict household registration or hulltou system served as a check on the urbanization process by making it difficult for Villagers who migrated to cities to obtain official status as urban residents The government believed that allowing vast numbers of rural residents to settle permanently in the city would put a strain on resources ranging from infrastructure to social services As a consequence many rural houses remained vacant as the owners left for the city but were still entitled to hold a share of village land because they were registered village residents The number of migrants traveling outside their place of registration to find Worllt China s oating population was reported to exceed 220 million according to official Chinese media reports7 As the urbanrural income gap began to widen in the 1990s and the 20005 See Exhibit 6 China introduced a series of policies that aimed to improve conditions in rural areas but with mixed results Growing income inequality was an increasingly sensitive topic in China The government did not report an official Gini income coefficient after 2000 when it gave the gure as 0412 This was an increase from the 1990s when official estimates of China39s income Gini coefficient ranged from 035 to 0393 In 2001 the United Nations estimated China39s Gini index was 0447 and in 2005 the Chinese Academy of Social Sciences concluded that the Gini coefficient was nearly 0479 3 China39s five ievels of local government are provincial prefectural county township and village Cities can be designated as provincial level namely Beijing Shanghai Tianjin and Chongqing prefecturallevel or countylevel 2 38 Authorizes for use oraiy by Patricia ttansedy from Aug 32 20 to Apr 0739 2314 Use outside these parameters is a sopyr ght vioiaiion Urbanizing China 713037 Property Rights and Land Ownership in China The Planned Economy Land use in China was governed by complex rules that were a legacy of the country39s communist history After the founding of the People39s Republic of China in 1949 the new government carried out radical land reforms to consolidate its support among poor farmers and check the power of the landowning class Over 40 percent of the country39s arable land was redistributed to poor households between 1950 and 1952 Farmers in some areas were encouraged to join cooperatives but few chose to do so Most rural land remained in private hands This period saw China take the first steps toward a command economy with the establishment of a government grain monopoly Agricultural production rose sharply after 1949 but the anarchy of the preceding War years meant that this was off a relatively low base By 1955 Mao Zedong had become frustrated by the slow pace of rural development That year he launched a campaign to collectivize agricultural production and all farmland became the property of villagelevel collectives Private ownership of rural land was disallowed and land was allocated among members of the collective based on need By the end of 1956 nearly all rural land had been collectivized Henceforth the government encouraged farming collectives to be selfsufficient and provided little in the way of subsidies This hindered development and as a result rural areas remained uniformly poor At the same time that collectivization was revolutionizing the countryside urban areas were being transformed by nationalization as the government set about to create an intensively managed command economy After 1949 the new Chinese government had taken over businesses and factories that had been owned by the previous regime or by families that had ed the country but many other businesses continued to operate under private ownership By 1956 however the remaining private businesses had been nationalized and all urban land taken over by the state The transition to a socialist planned economy was complete Household Responsibility System Agricultural production began to level off after 1956 and then fell by 30 percent as a result of the disastrous quotGreat Leap Forwardquot 19591961 when China experienced What has been called the worst famine in world history Production recovered somewhat in the early 1970s when growth averaged about 3 percent annually but China was still importing millions of tons of wheat each year In late 1978 China39s leaders began the process of quotreform and opening upquot To spur agricultural production they encouraged innovations that gave farmers better incentives and greater autonomy Most rural collectives eventually adopted the practice of contracting small parcels of land to individual households in return for a fixed portion of the harvest This became known as the quotHousehold Responsibility Systemquot HRS Under the HRS collectives remained the legal owner of the land and retained the right to reallocate plots from time to time Most readjustments were based on changes in population or household size although they also occurred when common land was lost through government expropriation which would become more common as China39s development gathered steam Official support for the HRS came in 1980 and the system had spread throughout the country by 198310 Agricultural output surged during this period From 1978 to 1984 production grew an average of 82 percent each year Up to half of this growth has been attributed to the HRS 11 While growth slowed after 1984 it remained impressive at around 4 percent 12 39 Authorized for use eraiy by Patricia tiemedy from Aug 32 2033 to Apr 7 2912 Use outside these parameters is a copyright vioiaiion 713037 Urbanizing China Land Use Rights The government classified land in China into three categories agricultural land construction land and unused land Agricultural land included all farmland orchards pastures and plantation forests Construction land comprised all land in urban areas as well as builtup land in rural areas Unused land encompassed wasteland desert and high mountains See Exhibit 7 for the breakdown of land use in rural areas China39s 1982 constitution specified in law for the first time that rural land was quotowned by collectivesquot and urban land was quotowned by the statequot Usage rights for both rural and urban land were granted by the government for a fixed duration A 1998 revision to the Land Management Law specified that rural land use rights were to be granted for 30 years In urban areas land for business uses was typically leased for up to 40 years industrial or office space for 50 years and residential land for 70 years Subleases were generally limited to a maximum of 20 years A real estate tax system was in place but residential apartments for own use were exempt Rural Land Use Rights Land use rights for rural land were held collectively at the Village level and parceled out to members of the collective V lagers based on household size Most rural land was reserved for agricultural use although some was designated quotrural construction landquot Collectives were allowed to develop rural construction land for three purposes 1 for Township and Village Enterprises TVES but not for private businesses or commercial gain 2 for public facilities and 3 for rural residences The largest portion of rural construction land was used for farmers residences see Exhibit 7 Each household was allowed one plot for housing these sites averaged about half a mu in size 003 hectares Urban residents and businesses registered in urban areas were not allowed to utilize construction land in rural areas Farmers were highly restricted in what they could do with the land assigned to them Rural households were not permitted to lease or sell their houses which were thus considered dead capital With no clear title to the land farmers could not use it as a guarantee for a loan or mortgage In 2002 China enacted the Rural Land Contracting Law which permitted farmers to reassign but not to sell their landuse rights to other parties but land use was still restricted to agricultural purposes Land readjustments the process of reallocating land among village families to account for changing family size migration etc had always been the subject of many complaints from farmers Around this time they became much less prevalent as a matter of local practice Urban Land Use Rights Under China39s socialist planned economy all urban residents were assigned to a quotwork unitquot such as a factory or government department Work units controlled nearly all aspects of an individual39s life and provided housing education medical care and other social services Most urban workers were assigned living space by their Work units but a chrome housing shortage meant that conditions were often poor Young workers typically shared crowded dormitories and could only secure a small apartment after marriage if then Starting in the late 1980s urban work units in many cities started selling their housing units to the current occupants Nearly half of urban households had purchased their dwellings from their work units by 1999 and fully 80 percent of China s urban housing had been privatized by 2005 In this system the state owned all urban land and granted usage rights to individuals and companies on a leasehold basis similar to the system used in many parts of the United Kingdom All 4 40 Authorized for use orsty by atric lt Kennedy from mtg 3932 2013 to Apr 07 2914 Use uutaide these parameters is a capyright vioiation Urbanizing China 713037 urban land was treated as quotconstruction landquot which could be developed for commercial purposes Regulations issued in 1990 allowed for the transfer of urban landuse rights creating a further distinction between urban and rural land Urban land rights that had been purchased from the government could now be transferred sold leased or mortgaged to other parties although land that had been quotallocatedquot without payment such as to a government unit or stateowned enterprise could not As a way to raise revenue and also dampen high property prices trial property tax programs were introduced in Shanghai and Chongqing in Ianuary 201113 Converting Land from Rural to Urban Use Land Use Planning China maintained a substantial bureaucracy dedicated to land use planning The Ministry of Land and Resources MLR exercised primary oversight for land use through subsidiary offices at each level of government In urban areas the Ministry of Construction oversaw land use from a city planning perspective The MLR had the authority to supervise and inspect local governments land management practices and to punish lower level officials who did not follow directives enforce laws or implement central government policies but illegal land acquisitions were commonplace In 2006 official Chinese media reported that in some cities as much as 90 percent of developments had been built on land that was not obtained through legal channels Because of the China s large population and its history of famines and flooding the central government made it a priority to maintain a sufficient amount of farmland to ensure food security By law at least 80 of total farmland had to be preserved as prime farmland dedicated to growing grains and other essential crops The government aimed to preserve at least 120 million hectares or 18 billion mu of prime farmland as the red line the minimum needed to ensure food and social security According to FAO and UN statistics China fell below the 120 million hectare red line in 2008 although official MLR data for that year indicated that China still had 122 million hectares of farmland see Exhibit 8 The MLR specified explicit quotas for the amount of farmland that each province was required to preserve as part of a 15year national plan for land use see Exhibit 9 for provinciallevel agricultural land targets for 2020 Provinces with the largest amounts of prime farmland were given incentives to conserve it including nancial subsidies that were funded by fees on newly builtup land Local authorities adopted a wide array of policies and administrative measures to maintain the farmland quota while at the same time continuing to convert farmland to urban and commercial uses For example authorities in many places but particularly in villages adjoining urban areas reclassified rural construction land as cultivated land by reclaiming traditional farmhouses and moving farmers into apartment buildings nearby This was accomplished by issuing vouchers to farmers who gave up their homes which then could be exchanged for an urban apartment under favorable terms Disappearing Farmland Between 1997 and 2008 China lost over twelve million hectares of cultivated land or an average of one million hectares each year17 It was hard to say exactly how much agricultural land was lost in previous years as China39s first comprehensive land survey was only conducted in 1996 and from that time on government statistics were based on a new definition of arable land However a study of satellite images concluded that the net amount of agricultural land actually increased between 1986 and 2000 as new land especially grassland was brought into cultivation Subsequently China did acknowledge the loss of over a million hectares of farmland each year from 2001 to 2005 At that point 5 41 Authorized far use oniy by tiatrick iienraedy from Aug 32 2013 to Apr 07 2014 use crutaide these parameters is 3 S139 3i Il Jif 3i O 393 73913037 Urbanizing China the government began to be seriously concerned The MLR continued to insist that the amount of prime farmland decreased only marginally in each of the next three years See Exhibit 8 The last year for which authorities released official figures for the amount of cultivated land was 2008 Chinese law allowed for the conversion of rural land to urban uses in the public interest but did not clearly define what that meant In principle conversion of agricultural land to construction land required approval of the provincial government and twothirds of the collective that owned the land in question In addition State Council approval was required to convert any amount of prime farmland more than 35 hectares of nonprime farmland or more than 70 hectares of forest or unused land to other uses Nonetheless in many cases local governments neglected to go through the required legal formalities or to prove sufficient grounds for conversion and took land merely for economic reasons such as urban development The Chinese government acknowledged that many land transactions had not been conducted appropriately If the MLR discovered that land was being used improperly the individuals or enterprises involved could be fined the land confiscated and the government officials involved subjected to administrative penalties Criminal charges could be brought for the most serious infractions The MLR established a State Land Inspection System in 2006 to improve the enforcement of land planning by tracking land use through the study of high resolution satellite photographs If satellite images revealed that more than 15 percent of newly developed land in a locality was illegally converted from protected farmland then the officials responsible were to be punished or dismissed As a Tsinghua university economist related the central government is worried about food security just imagine if collective land is changed to private land business people will try to use it for businesses purposes Local governments do not consider the importance of maintaining farmland as they can just import food from other provinces or overseas However as a country we cannot rely on the international market for food and we must maintain farmland3920 China39s production had fallen behind domestic consumption for a number of key agricultural commodities like soybeans corn poultry and wheat See Exhibit 10 Despite the government39s efforts illegal conversion of rural land remained a major problem Some local officials reportedly went to great lengths to foil the satellites in one case even covering a quarry with green paint so that the land Would appear to be forested when viewed from space An MLR official admitted it is difficult to hold local government leaders accountable for such offenses and hard to put a stop to such violations when key construction projects and use of land for construction purposes are involved 1 In 2009 satellite photos revealed over 34200 cases of illegal land use involving a total of 48900 hectares of land That same year the ministry imposed over 245 billion RMB in fines for illegal land use It also confiscated 292 million square meters of illegal construction and demolished an additional 74 million square meters In 2010 the MLR detected 53000 cases of illegal land use and levied over 25 billion RMB in fines3942 Urbanization and Local Government Finances China39s national government based in Beijing oversaw a vertically integrated political system divided into five levels province prefecture county township and village See map of China39s provinces at Exhibit 11 Local governments dispersed funds for most social services including health care education and culture and also devoted much of their budgets to salaries for civil servants and payments to retirees Taxes were considered budgetary revenue and included valueadded taxes VAT enterprise taxes and business taxes These funds were shared among the Various levels of government according to fixed formulas Prior to 1994 the bulk of tax revenues were retained by provincial and local governments Tax reforms enacted in 1994 increased the central government39s 6 42 Authorizeaj fer use eraiy by Patricia Eienneeiy from Aug 32 ZOE3 to Apr 07 2 4 Use outezde these perametequota as a cspyrigin vioiaiien Urbanizing China 713037 share of revenues from just 22 percent in 1993 to around 50 percent in subsequent years23 These reforms also made local governments prone to frequent revenue shortages and thus dependent on Beijing to balance their budgets Taxes on land and property made up only about 16 percent of local government revenues in 200824 In addition to budgetary revenue localities also had access to extra budgetary revenuesquot including non tax items such as user and license fees which were usually controlled by the government entity that collected it However much of these funds were set aside for specific purposes such as providing services to fee payers A third revenue category sometimes referred to as offbudget funds provided income that did not have to be reported to higher levels and in most cases was exclusively controlled at the local level Under legislation enacted in 1998 income from sales of land use rights called land conveyance fees fell into this category25 Because local governments were not permitted to take on debt they increasingly turned to land sales to finance infrastructure and other construction projects See Exhibit 1225 Land conveyance fees rose dramatically from less than ten percent of total local government revenues in 1999 to 435 percent in 200827 However local governments were prohibited from diverting funds from land sales directly to infrastructure projects China39s central government instead encouraged local officials to form local investment companies LICS also known as local financial platforms In many cases local governments formed LICS by injecting capital typically land into the entity which used it as collateral to obtain bank loans This often meant LlCs had to rely on rising land prices to pay their debt Failure to realize increasing revenue from land sales potentially put the LlCs at risk of default The scale of LIC activities expanded rapidly in the 2000s There were 8221 LICs in China at the end of 2009 of which nearly 60 had been established by countylevel governments LlCs accounted for 48 of all loans issued by the China Development Bank and 10 of the loan portfolio of the four largest state owned commercial banks An estimated threefourths of the government stimulus projects launched after the 2008 global economic crisis were financed by loans from state owned banks to LlCs29 At the end of 2010 Beijing announced that LIC debt totaled 107 trillion RMB US 17 trillion although estimates by western academics and ratings agencies ranged from 142 trillion RMB US225 trillion to 201 trillion RMB US 32 trillion30 Obtaining Landfor Development China introduced an auction process in 2004 for all land opened up for development While rural land could not be auctioned off for development it was common for parcels of rural land to be converted to urban land just before they were put up for auction Plots of land offered at government auctions were classified as for business residential or industrial use Residential land usually commanded the highest prices Bidding for land designated for commercial office or industrial uses was relatively less competitive For each plot the government provided detailed guidelines on how the land was to be used such as the maximum plot ratio and minimum green space Once a parcel of land that had been allocated through the auction process the government rarely approved a change in use for example from industrial to commercial Auctions were usually conducted via sealed bid and only registered real estate companies were allowed to participate Because auctions were held without much advance notice companies had to act quickly A real estate developer from Southwest China s Yunnan province related You need to know in advance which land parcels are slated for development so that you have time to make plans to find out about the condition of the land you need to develop some relationships with government officials 31 43 Authorized for use cmty by F atrilt lt Kennedy from Aug 32 2013 to Apr 07 2514 Use outside these 5gtaaretes 35 a copyright vaoiatstm 713037 Urbanizing China Foreign firms faced particular difficulties meeting the short payment schedule required by the land auction system and obtaining the hundreds of permits that were required before construction could begin Consequently foreign companies that planned to invest in property through the land auction system usually chose to set up a joint venture with a Chinese company first The auctions were initially intended to control spiraling land costs but they failed to achieve this aim and land prices rose exponentially in subsequent years Local officials acknowledged that they earned considerable revenues from land sales but they also recognized that high land prices had helped drive up housing prices and that this was a serious problem Facing public discontent over this issue China39s government frequently announced new regulatory and administrative measures to rein in property prices Compensation and Resettlement In most cases when land was auctioned off people were still occupying it Developers that won a land auction had to compensate and resettle these residents before clearing the site and starting construction Prior to 2008 farmers displaced by development had been entitled to an amount of compensation calculated as a multiple of the land39s annual yield In most parts of the country developers were supposed to pay land compensation of between 6 to 10 times the yield for the most recent three years Additional compensation for resettlement of between 4 to 6 times the most recent three years yield was also required However a 2005 N GO survey found that twothirds of Chinese farmers who lost their land were dissatis ed with the compensation they received Failure to provide farmers with adequate compensation for their land could mean that many were left with no land to grow food on and not enough to eat Local governments relied on offbudget revenue from land sales to promote investment and economic growth and this created an incentive to hold down the compensation paid to dislocated residents The stakes were high in recent years the average compensation paid to farmers in one study of farming households in 17 provinces was 18739 RMB per mu US 17850 per acre while the mean price paid to the government by property developers was 778000 RMB per mu US 740000 per acre33 Additionally many localities tried to keep the price of land as low as possible in order to attract investment Academic Yu Iianrong estimated that from 1990 to 2010 the difference between the land compensation paid to farmers and the market price of the seized land was about 2 trillion yuan 294 billion for 147 million hectares 34 In 2008 some provinces began requiring that compensation be calculated based on a unified pricing system set at the county level and as of June 1 2010 all provinces were required to follow this practice An MLR official stated publicly that this provided between 20 and 30 percent more compensation on average35 In addition to providing land compensation developers were also required to help resettle displaced residents For farmers resettlement usually occurred in one of four ways 1 by resettlement in another agricultural area if land was available nearby 2 by placement in salaried jobs 3 by receiving stock or options in the enterprise acquiring the land or 4 by internal migration to another part of the country such as in cases where large infrastructure projects like the Three Gorges Dam made large tracts of land uninhabitable Farmers were sometimes given a choice among the four options Since 2007 provinces were also required to provide social welfare benefits including pensions to farmers affected by land expropriation In the past such benefits were only afforded to urban residents Both compensation and resettlement were the subject of considerable controversy in China In December 2009 five Peking University law professors published a letter to the central government in the staterun People39s Daily that criticized a 2001 regulation governing demolition and resettlement in 8 44 Authorized for use onty by i atricit Eamedy from Aug 32 2013 to Apr 07 201 Use outside these parameters is a copyright vaoiaiion Urbanizing China 713037 urban areas The professors pointed out that the regulation contradicted Chinese law in a number of places Most significantly the regulation allowed residents to be compensated after demolition had begun instead of at the time the land was requisitioned35 Stories of residents being forcibly evicted from their dwellings were commonplace In 2010 the government announced proposed guidelines that would prohibit developers from using force or compulsion for example turning off the water or power during the relocation process They would also prohibit demolishing properties if a lawsuit challenging the eviction was pending As one Chinese academic quoted in the western media remarked however it is already against the law to use violence and that has not stopped people before 37 Dispute Resolution in China China39s Legal System China39s legal system was organized into four levels national Supreme People39s Court provincial Higher Level People39s Courts prefectural IntermediateLevel People39s Courts and county Basic Level People39s Courts38 Courts were divided into separate divisions for criminal civil economic administrative and enforcement matters Family matters and debt collection constituted more than half of the judiciary s total caseload39 Judges were appointed by the legislative body at the corresponding level for example by the National People39s Congress at the national level and by local people s congresses below4 Former military officers traditionally constituted a large portion of sitting judges although other occupations were increasingly represented The level of educational attainment was relatively low on average A majority of judges had college degrees but many had only the equivalent of a high school diploma or less41 Professionally trained lawyers were rarely appointed to judgeships42 The Communist Party exerted considerable in uence over the judiciary through the process for selecting judges as well as by reviewing cases in progress particularly those related to criminal matters and in instances where the party39s financial interests were at stake This in uence was exerted by the Party Committees at the same level of government as each court Courts were required to report to and seek guidance from their respective Party Committees on a variety of issues including individual cases that had social or political implications At times party organs had reportedly used their power to convince claimants to withdraw cases persuade judges to issue particular judgments and transfer judges who made rulings not to their 1illting43 Most Chinese laws and regulations originated from government agencies that had the power to both write laws and to interpret them The only checks on these powers came from within the bureaucracy itself there was no effective system for enforcing limitations on the lawmaking power When laws come in con ict for example if a local law contradicted a national law the relevant administrative body not the judiciary took action to resolve the problem China39s Administrative Litigation Law allowed citizens to file cases to contest the application of administrative rules but not to challenge the rules themselves The legal concept of property rights was only enshrined in Chinese law on October 1 2007 when the PRC39s Property Law came into effect This was in part a response to the large scale expropriation of farmland and the discontent that it gave rise to 45 Authorized for use nraiy by Patrick Kennedy from Aug 12 20 to Apr 37 2 ilt1 Use outside these parasrtetars is a crspyr ght notation 713037 Urbanizing China Mediation and Arbitration Displaced residents who Wished to dispute the terms of their compensation or resettlement had few options under China s legal system Before filing a legal case they first had to go through a series of alternative dispute resolution procedures The initial step was mediation with the local village head or equivalent serving as mediator If the residents were not satisfied with the result they could approach the local office of the MLR to request arbitration However this office had responsibility for approving land appropriations in the first place If residents were dissatisfied with the arbitration result they could then complain to the local government which had the authority to refer cases to the provinciallevel MLR office Developers that faced pressure from dislocated residents were free to negotiate a settlement with them directly but there was no requirement that they do so Typically 90 percent of these types of cases were resolved through mediation and around 5 percent by arbitration44 In theory farmers could file a lawsuit over the amount of compensation after all other administrative channels had been exhausted but it was very rare for these cases to make it to court45 Moreover it was not possible to file a case on the issue of expropriation which was an administrative matter outside the courts jurisdiction As a consequence most dislocated residents filed petitions to higher level governments or else turned to public demonstrations as a way to secure higher compensation Petitions to Higher Level Governments Petitioning the authorities for redress of grievances Was a longestablished tradition in China dating to imperial times The modern Chinese government institutionalized its own system for dealing with complaints from citizens setting up a ministrylevel agency known as the State Bureau for Letters and Visitsquot directly under the State Council45 The right to petition was also included in China39s 1982 constitution Article 41 Every government office operated 23 Letters and Visits department that reported up to the State Bureau Successful petitioners could have their grievance redressed by administrative measures or alternatively have their case referred to the judicial system Although the government did not provide authoritative statistics on how many petitions were filed reports indicated that the number increased dramatically in the early 1990s when the pace of industrialization and urbanization began to speed up A 2011 report from China39s Academy of Social Sciences reported that 73 percent of petitions and complaints concerned land issues47 The majority of these were related to compensation and associated arrangements after land had been expropriated43 The volume of petitions received by government agencies at all levels reportedly peaked in 2003 at around 12723000 In response to the increasing number of petitions the state petition bureau revised its regulations in 2005 to make it more difficult for petitioners to submit a complaint successfully Local officials were instructed to ensure that the number of petitions was reduced Incidents of intimidation and even detention of individuals who Were known to be planning to submit petitions were widely reported in the media The volume of petitions went down in the years after 2005 but was still estimated at around 10 million annually50 China39s Ministry of Agriculture reported that it received over 200000 registered complaints involving land disputes in 2006 but only 150000 in 2008 Protests against Local Governments The number of disputes demonstrations and in some cases serious unrest related to land use rights began to increase beginning in the 1990s as farmers and residents in many parts of China expressed their anger over losing their land However reliable data on such disputes was generally 10 46 Authorized for use on y by Patrick Kennedy from Aug quot32 ECVE3 to Apr 0 2014 use outside these parasneters is a eeoyrignt v oiatiors Urbanizing China 713037 not available China39s Ministry of Public Security reported that 60000 riots involving more than 3 million people occurred in China in 2006 but in subsequent years the ministry ceased releasing this type of information due to its sensitive nature51 One NGO estimated the number of public protests each year at around 18500052 A survey of published news reports found that more than half of all incidents of mass protest in rural areas were attributed to rural land seizures 55 and Chinese agriculture expert Yu Iianrong quoted in the official Chinese media claimed that 65 percent of all protests in China were related to land issues54 During a dramatic protest in July 2010 thousands of farmers took over a government building in eastern Jiangsu province for five days to protest land seizures that they claimed were unlawful The farmers said they never received promised compensation and were further angered when their former lands lay unused for up to six years55 On September 21 2011 a riot broke out in Wukan a coastal fishing village of about 13000 residents in the city of Lufeng in Guangdong Villagers raided the local communist party office and a police station to protest a land deal that saw their farmland sold to a major mainland developer for over one billion RMB US 150 million55 In many cases the farmers families had worked this land for generations The violence soon escalated with more than 200 villagers vandalizing a local industrial park and blocking roads57 Protest quickly spread to other areas of Guangdong with farmers in one village hiring earthmoving equipment to tear down fences that had enclosed their former fields 53 Within days authorities agreed to investigate the villagers grievances 59 This diffused the situation somewhat although sporadic marches and demonstrations continued 50 IIowever the death in police custody of one of the protestors in mid December sparked new riots Residents took control of the village and the local government officials ed Villagers constructed roadblocks to keep out police who tried to retake the area The standoff continued for ten days and was only ended when provincial authorities promised to investigate the land sale return some of the contested farmland and release villagers who had been detained during the protests In addition they agreed to let villagers elect a new village leader on a secret ballot which was unprecedented in communist China In a special election held March 3 2012 protest leader Lin Zuluan was elected the new village leader replacing the former leader who had held his post since 1970 This dramatic result gave rise to speculation that China had begun to take a new approach to resolving these issues Implications for Private Businesses in China The nature of the land system and the con icts it created posed a number of potential risks for firms that sought to acquire land for business purposes The experience of Finnish paper company Stora Enso typified the challenges of acquiring land in China In 2002 Stora Enso set up a plantation company in southern China39s Guangxi province with the aim of developing eucalyptus plantations to supply raw material for a planned paper and pulp production facility in the province The company planned to spend 18 billion Euros to acquire a total of 120000 hectares 18 million mu of forest land The company worked with local governments which in turn gave lower level officials strong incentives to procure land for Stora Enso At the prefectural municipal level officials set up an LIC specifically for the purpose of acquiring land that would then be transferred to Stora Enso The LIC was responsible for securing leases from the collectives that owned the land or in some cases from businesses or other individuals who held existing leases granted by the collectives After securing use rights to the forest land the LIC planted eucalyptus trees to Stora Enso s standards and then turned the plantation over to the company 11 47 Authorized far use omy by Patricia Kennedy frean39A1gz 32 2013 to Apr 07 2014 Use outside these parazneters is a copyright vioiatien 713037 Urbanizing China An NGO survey conducted in 200910 revealed widespread irregularities and abuses in the land acquisition process Government coercion was frequently mentioned as a factor For instance one county specified land quotas for each township and required township leaders to post a deposit If they met their quota the deposit would be returned and the leaders would get a monetary reward raise or promotion If the quota was not met the deposit would be forfeited and they could be demoted In three villages compulsive measures such as these prompted violent clashes between farmers and government officials including armed police Because the government LIC acted as a middleman in all the land transactions Stora Enso had little oversight or control over the process Many farmers who lost their land were unhappy about the compensation they received In several cases collectives approved the transfer of land to the company without consulting individual farmers who possessed valid land use certificates from the county government Shadow middlemen were occasionally used to disguise transactions in areas where there was opposition to granting land to the company Adding to Stora Enso s difficulties it sometimes received false or incomplete information about conditions on the ground Unbeknownst to the company farmers who lodged complaints were cut off from receiving rental yield payments until their case was resolved Once the Stora Enso became aware of these problems it set up a hotline for farmers to call with questions or complaints However the only response the hotline could offer was to refer the caller to the official dispute resolution system The company also held town meetings for farmers to air their grievances but these were of little help to farmers who had lost their livelihoods Stora Enso had devoted considerable resources to building a strong Corporate Social Responsibility Program It now needed to decide the best strategy to address the farmers grievances and also to acquire the rest of the land It was keenly aware that competitor firms who did not bother with niceties like CSR managed to get similar projects up and running much faster Land Issues in China39s Urban Future Looking ahead the key question for the Chinese government was how best to reform its land use policies Around the country planners had begun to advocate the sale of land use rights to fac itate largescale farming or agribusiness development and financial institutions had been encouraged to develop new products aimed at rural communities such as insurance covering farmers who were unable to work due to illness54 Officials at the MIR were investigating how to unify the existing two tier ruralurban system of land management including ways to allow rural residents to rent out their houses and obtain mortgages China39s urbanization process was likely to significantly shape the business environment for private firms Could China successfully institute political and institutional reforms to ensure the sustainability of its economic growth strategy 12 48 Autnurizeu for use on y by Patr ek Kennedy 3m Aug 32 20 to Apr 07 2814 Use outside these parameters is a mpyrignt vio aiiers Urbanizing China Exhibit 1 Urban Rural Population Distribution in China 19802020 713037 100 75 50 25 9 3 39e Q3 b Qt gt o zwrtsan K Rurai Source China National Bureau of Statistics Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat World Population Prospects The 2008 Revision and World Urbrmization Prospects The 2009 Revision http wwwunorg esa popu1ation accessed March 2012 Exhibit 2 Percent of Population in Urban Areas China and Selected Countries 19602020 100 80 mw F G 6O au onto quotquot 40 H ise g mm waamww O 5 E 2 E E E I I I E i 5 J J J J J J J J lt3 lt3 J lt3 lt9 0 Brazil China m m India United States Thailand Germany Source Population Division of the Department of Economic and Social Affairs of the United Nations Secretariat World Population Prospects http esaunorgwup2009unup accessed March 2012 Figures after 2010 are projections The 2008 Revision and World Urbanization Prospects The 2009 Revision 49 13 Authorized for use on y by Patrick Eieamedy from Aug 32 2013 to Apr 07 2s39 I i Use outside these parazrsetars is a sopyright v oiai on 713037 Urbanizing China Exhibit 3 Composition of China39s GDP by Sector 100 80 60 40 20 0 933 3 3 Agricztftare P Bzdustry Services Source China Statistical Yearbook various years China National Bureau of Statistics http WWWstatsgovcn eng1ish statistica1datayear1ydata accessed March 2012 Exhibit 4 Share of Total Investment and Investment in Residential Property in China s GDP 50 1490 1200 4amp1 6 0L 1900 39 800 28 600 I1OI 19 200 8 000 i 9 lt9 9 Q Q lt30 V V30 T3 95 9 gt 539 quotgt5quot 9 0 0 Tote mvestme at investment is Resicfentiai Property right scaie Source China Statistical Yearbook various years China National Bureau of Statistics http WWWstatsgovcn eng1ishstatisticaldatayearlydata accessed March 2012 14 50 20 id Kennedy from Aug 12 2013 to Apr 7 eae parasrsetars s a cogzyright vioiat on Author zed for use om by Pair Use outside th Urbanizing China 713037 Exhibit 5 Urban Population as a Percentage of Total Population by Province 19902009 1990 1999 2009 Hebei 142 203 387 Shanxi 217 286 400 Inner Mongolia 316 386 528 Liaoning 426 491 601 Heiiongjiang 430 487 602 Jilin 390 451 535 Jiangsu 194 316 615 Zhejiang 162 231 380 Anhui 138 205 292 Fujian 170 230 457 Jiangxi 177 237 341 Shandong 137 283 442 Henan 124 189 283 Hubei 194 299 528 Hunan 146 209 285 Guangdong 230 349 718 Guangxi 132 182 236 Hainan 199 269 487 Chongqing NA 219 409 Sichuan 144 189 336 Guizhou 122 151 209 Yunnan 124 155 194 Tibet 131 139 202 Shaanxi 181 234 369 Gansu 164 195 300 Qinghai 294 282 364 Ningxia 240 303 471 Xinjiang 296 387 504 Note The municipalities of Beijing Shanghai and Tianjin are not included Chongqing was split off from Sichuan province and became an independent administrative unit in 1997 Source China Premium Database CN Population By Census and CNPopu1ationUrban CEIC accessed March 2012 15 51 Authorized for use on y by Patricia Kennedy from Aug 12 2013 to Apr 07 2014 Use ouiaide ineae parameters is a copyright vioiation 713037 Urbanizing China Exhibit 6 Per Capita Annual Expenditures of Rural and Urban Households RMB 19902010 29000 18000 16000 14000 1 2000 10000 8000 6000 4000 2000 0 1998 1995 2000 2009 2010 E Urban Hoasehoids Rzzrai Househoic s Source China Statistical Yearbook 2011 Tables 105 and 1018 China National Bureau of Statistics http wwwstatsgovcn eng1ish statistica1datayear1ydata accessed October 2012 Exhibit 7 Rural Land Use in China 2007 H0U35n8 and Cuitivate Land CommeciaE 13 3 Other Rurai Use 3 Transport and Other 1 Orchards 1 Source 2007 Report of the Ministry of Land and Resources PR C In Chinese http wwWmlrgovcn zwg1lttjxx200912t20091215699754htm accessed March 2012 16 52 Authorized for use onty by Patr ck Kennedy from Aug 32 2013 to Apr 37 2314 use outside these parameters is a capyright vioiaiion Urbanizing China Exhibit 8 Total Cultivated Land in China Official Statistics 19962010 130 125 120 Million Hectares 115 Q b ca 0 3 99 gt 49 ltgt SQ an W Q90 713037 Source Annual Report of the Ministry of Land and Resources PRC various years in Chinese httpWWWm1rgovcn zwgktjxx accessed March 2012 No official data on the total amount of cultivated land is available after 2008 53 17 Authorized for use my by Patrick anrzady from Aug E2 20135 E0 Apr 37 2014 Use outside these paraenetera is a copyright v o ai en 7213037 Exhibit 9 Province Level Quotas for Agricultural Land 0 million hectares 2020 target 2010 estimated 2005 actual Beijing 021 023 023 Tianjin 044 044 045 Hebei 630 633 641 Shanxi 400 405 408 inner Mongolia 698 705 710 Liaoning 406 408 409 Jinan 552 553 554 Heilongjiang 1158 1163 1167 Shanghai 025 026 027 Jiangsu 475 476 480 Zhejiang 189 192 195 Anhui 569 572 573 Fujian 127 132 135 Jiangxi 281 283 286 Shandong 748 750 752 Henan 790 791 793 Hubei 463 466 468 Hunan 377 379 382 Guangdong 291 291 295 Guangxi 421 421 425 Hainan 072 072 073 Chongqing 217 222 226 Sichuan 589 595 600 Guizhou 437 444 451 Yunnan 598 605 609 Tibet 035 036 036 Shaanxi 389 399 409 Gansu 465 466 467 Qinghai 054 054 054 Ningxia 109 109 110 Xinjiang 403 405 406 Total 12033 12120 12208 Source National Imzd Use Plan 20062020 in Chinese People39s Daily http po1iticspeop1ecomcn GB 1026 8222549htm1 accessed March 2012 Urbanizing China October 24 2008 18 54 AmtE1orEzea forise outr by Patrick Remedy from aug 32 2013 to Apr 07 2014 use ouiside these paraneiers is 9 copyright vioiation Urbanizing China 713O37 Exhibit 10 China39s Production and Consumption of Key Agricultural Commodities 19902012 million metric tons 130 125 120 115 110 105 100 95 90 85 80 CDVirl 39Q39L LDlOOO39CJrIrT 39LnKOfOO0 nClfl O aCDOChOWO39O1ChOO nCJOOOOOOOOOrquotlquotiquot1 OEOEOWOWOWOTOWOEONOVOOOOOOOOOOOOD HHHHHHHHHHNNNNNNNNNNNNN umeProduction X Consumption 80 Sobeans 70 y 60 50 40 30 20 O i ifiiit E3llE i3 CIquotI lfY3939lt L LDfOOO1OI 1CJfY39 quotLOkOfOOChOr39irl ChCDO3030301ChOCDO1000CJCDOCDOOOItiI OWOKOWOWOSGWOWOWOWOHOOOOOOOOOOOOO I1ixlr rixIrir rr4rlrClf J llClfllflClClrl Production asatconsumption Source US Department of Agriculture Foreign Agricultural Service Production Supply and Distribution Database http WWWfasusdagov psdonl139ne psdgrainspu1sescsvzip and httpwwwfasusdag0Vpsdonlinepsdoi1seeds csvzip accessed October 2012 55 19 Authorized for use oniy by Patrick E ersnedy from Aug 12 2013 0 Apr 7 2314 Use outside ihese parameiars is 3 sopyr ght vioiaiicm 73913037 Urbanizing China Exhibit 11 Map of China Inn ggzsgutnia Source Wikimedia Commons http co1nmonswikimediaorg Wi1lti FileMapofPRCWithprovincenamesensvg accessed April 10 2012 Exhibit 12 Total Value of LandUse Rights Purchased Annually in RMB billions 2010 J 200 400 600 800 1000 Source China Statistical Yearbook various years China National Bureau of Statistics http wwwstatsgovcn eng1ish statistica1data year1ydata accessed March 2012 20 56 Auihoz zed for use 053 by Patrick Kennedy from Aug 2 2013 to Apr 97 2914 Use ouissde these parazneters is a copyrigiwt vioiaticm Urbanizing China 713037 Endnotes 1 Text of Premier Wen Jiabao s Chinese New Year address 7 February 2005 Text of report by official Chinese news agency Xinhua BBC Monitoring Asia Pacific February 7 2005 accessed via Factiva April 2012 2 Jamil Anderlini China s City Population Outstrips Countryside Financial Times January 18 2012 3 Beijing tells banks to roll over local government debt China Economic Review February 13 2012 4 Beijing battling protest fires on all fronts The Australian June 15 2011 5 Michael Wines A Village in Revolt could be a Harbinger for China New York Times December 25 2011 http wwwnyti1nescom 2011 12 26 World asia in chinathewulltan revoltcouldbea harbingerhtmlpagewantedall accessed February 2012 5 Lixing Li The Incentive Role of Creating quotCitiesquot in China China Economic Review Volume 22 Issue 1 March 2011 p 172 7 China39s oating population exceeds 221 million Chinadailycomcn February 28 2011 http wWwchinadailycomcn china 201102 28 content12091797ht1n accessed April 2012 8 Dwayne Benjamin Loren Brandt John Giles and Sangui Wang Income Inequality during China39s Economic Transition in China39s Great Economic Transformation edited by Loren Brandt and Thomas G Rawski New York Cambridge University Press 2008 p 758 9 Fang Xuyan and Lea Yu China refuses to release Gini coef cient Caixin Online January 19 2012 http 1englishcaixincom201201181100349814html accessed March 2012 10 Barry Naughton The Chinese Economy Transitions and Growth Cambridge The MIT Press 2007 p 89 11 Huang Otsuka and Rozelle quotAgriculture in China39s Developmentquot in China39s Great Economic Transformation edited by Loren Brandt and Thomas G Rawski New York Cambridge University Press 2008 p 490 12 Huang Otsuka and Rozelle p 478 13 Shanghai Chongqing launch property tax Xinliua January 28 2011 14 John Meligrana Zhijian Li and Zhiyao Zang Resolving Land Disputes in China An Analysis of a Method of Dealing with Citizen Complaints Environment and Urbanization Asia 2011 2 253 15 China tightens land supply to curb economic overheating Xinhua September 5 2006 16 Wen Yan and Yueming Xu Exchange of Rural Residential Land in China Asian Social Science 66 2010 17 Xinhai Lu and Shanlin Huang Barriers and Solutions to China39s Cultivated Land Protection International Journal of Environmental Studies 672 2010 223 13 Xiangzheng Deng Jikun Huang Scott Rozelle and Emi Uchida quotCultivated Land Conversion and Potential Agricultural Productivity in China Land Use Policy 23 no 4 July 2006 372384 19 Wang Qian quot73 officials blamed in illegal land grabs China Daili July 8 2011 p 3 20 Interview with Professor Cai Jiming October 25 2010 21 A growing land problem China Daily January 26 2011 92 2009 figures from Toh Han Shih Corrupt local officials one step ahead in illegallandsale game South China Morning Post January 29 2011 2010 figures from Wang Qian China vows tough measures to curb illegal land usequot China Daily January 21 2011 23 Dennis Nitikin Chunli Shen Janey Qian Wang and Ileng fu Zou Land Taxation in China Assessment of Prospects for Politically and Economically Sustainable Reform Annals of Economics and Finance 132 2012 499 24 Joyce Yanyun Man Local Public Finance in China An Overview in China39s Local Public Finance in Transition edited by Joyce Yanyun Man and YuHung Ilong Cambridge Lincoln Institute of Land Policy 2011 p 10 25 A pilot program to allow selected municipalities to issue shortterm bonds was only announced in 2011 Li Han and James KaiSing Kung Urbanizing China The Changing Fiscal Incentives of Local Governments 21 57 Authorized for use only by Patrick t fermedy from Aug 12 20i3 to Apr 07 20 EltE use ouieide ttaoae oarasriotera as a copyright violation 713037 Urbanizing China March 8 2011 Conference paper for Public Finance Issues in China 2011 Tsinghua University Beijing June 2728 2011 26 Wei Tian Direct Debt for Local Governments Xinhua http newsxinhuanetcom enqlish2010 china 201110 21 c 131203831htm accessed March 2012 27 Joyce Yanyun Man p 12 23 The four big banks are the Industrial and Commercial Bank of China China Construction Bank Agricultural Bank of China and Bank of China See Yoshiaki Azuma and Jun Kurihara Examining China39s Local Government Fiscal Dynamics With a Special Emphasis on Local Investment Companies LICs Cambridge Gazette PoliticoEconomic Commentaries No5 January 2011 29 Victor Shih Local Government Debt China Economic Quarterly June 2010 p 26 30 Pan Kwan Yuk China let a hundred muni bonds bloom beyondbrics blog Financial Times October 20 2011 http blo gsftcom beyondbrics 2011 10 20 chinaletahundredmunibonds blossom axzz1oVCWtUhm accessed March 2012 31 Interview with chairman of property development company Kunming October 27 2010 32 Zhu Keliang and Li Ping Rural Land Rights under the PRC Property Law China Law 62 Practice November 2007 p 23 33 Landesa Summary of 2011 17Province Survey s Findings April 26 2012 http wWwlandesaorgchina survev6 accessed June 2012 34 Rural land disputes lead unrest in China China Daili November 6 2010 35 Increased Compensation for Requisitioned Land to have Small Impact on Land Prices in Chinese Beijing Sina Net July 28 2010 http neWssinacomtw article 20100728 3557028html accessed October 8 2012 36 Guo Shaofeng Five Beijing University Scholars Advice the National People39s Congress to Review Demolition Ordinance Said to Con ict with Cons tution in Chinese ChinaNeWsCom December 8 2009 http WWwchinaneWscom gn news 2009 1208 2004896sht1nl accessed September 30 2012 37 Geoff Dyer China Shakes Up Land Seizure Rules after Outcry at Violent Evictions Financial Times January 30 2010 38 Stanley B Lubman Bird in a Cage Legal Reform in China after Mao Stanford Stanford University Press 1999 p 251 39 Lubman p 252 40 Lubman p 256 41 Lubman pp 253254 42 Lubman p 256 43 Lubman p 263264 44 Move to minimize disputes over land use China Daily December 23 2008 http WWwchinaorgcn government news 200812 23 content16992944htm accessed June 2012 45 Author39s interview with Bureau of Agriculture Lijiang City Yunnan Province October 28 2010 46 Government of the People39s Republic of China State Bureau for Letters and Visits http english govcn 200510 02 content 74182htm accessed March 2012 47 He Dan Land battles most dire rural issue Report China Daili December 16 2010 48 John Meligrana Zhijian Li and Zhiyao Zang p 255 49 John Meligrana Zhijian Li and Zhiyao Zang p 256 50 Complaint bureau busiest office in Beijing Xinhua September 2 2007 51 RDI Website http Wwwrd and org regions china accessed October 2010 52 Landesa Rural Development Institute Findings from Landesa s Survey of Rural China Published http Wwwlandesaorg news 6thchinasurvey accessed March 2012 53 Chihjou Jay Chen Growth social protests and the changing statesociety relations in China Working Paper Institute of Sociology Academia Sinica 54 Rural land disputes lead unrest in China China Daily November 6 2010 55 Rona Rui Tens of Thousands in Standoff with Police in Eastern China Epoch Times July 19 2010 22 58 Authorized for use oer by Patricia Eiennedy from Aug 12 2013 to Apr 87 28 Use outside iheae oarasneiers is a copyright vio aiion Urbanizing China 713037 56 Stephen Chen angry Villagers riot over land grab Residents raid police station in Lufeng block roads and clash with officers in row over cadres selling land to rm without their knowledge witnesses say South China Morning Post September 23 2011 p 8 See also Protesters riot in China city over land sale BBC News September 23 2011 57 Gillian Wong Hundreds of villagers in southern China riot clash with police over land dispute Associated Press September 23 2011 58 Choi Chiyuk Rural land grab protests spread Violence in Wukan stirs nearby village to force way back to farmland officials hold urgent meeting South China Morning Post September 25 2011 p 3 59 Leo Lewis Protesting Chinese villagers win inquiry into suspected land grabs thetimescouk September 25 2011 accessed Via Factiva 60 Protesters in China march against 39dictatorship39quot November 21 2011 A gence France Presse 51 Li Ping and Robin Nielsen A Case Study on LargeScale Porestlanal Acquisition in China The Stora Enso Plantation Project in Hepu County Guangxi Province Washington DC Rights and Resources Initiative 2010 p 20 62 Li Ping and Robin Nielsen p 22 53 Li Ping and Robin Nielsen p 19 64 Iames Kynge Seeds of Change Look Poised to Transform Rural Chinese Lifequot Financial Times October 8 2009 23 59 Authorized for use oniy by Patriot Etsrmetiy from Aug 3912 2023 to Apr 07 2334 Use autside these parameters is a aopyr ght vioiation The most common and durable source of factions has been the various and unequal distribution of property Those who hold and those are without property have ever formed distinct interests in society The regulation of these various and interfering interests form the principal task of modern legislation James Madisonl usiness competes in a political marketplace just as it competes in the more familiar economic marketplace Since the modern state s birth companies both collectively and individually have sought public policies that enhance their material gains while dimin ishing their losses As government has grown in scale and scope in recent decades business has redoubled its effort to sway policy its way According to a Conference Board report one third of 185 chief executive officers CEOS questioned spent 2550 percent of their time trying to in uence legislation and to comply with regulation At the same time other groups have organized for policies that are costly to business leading to con ict in the political market place The ways in which business goes about competing in politics its strategies and tactics are the subjects of this chapter There are several contrasts with ordinary economic competition The political marketplace gives companies far more chances to form alliances with other like minded companies to seek shared advantage Compared with many business activities political action thus can be more cooperative Yet the political marketplace simultaneously creates strife While private economic exchanges are apt to be mutually beneficial and thus done freely public economic transactions often involve the unwanted transfer of resources from one party to another There are winners and losers and depending on the stakes the losers may choose to fight back The result is that political competition sometimes makes companies clash with other sectors of the business community as well as with labor groups consumer organizations and other organized stakeholders To understand business and political competition we start by discussing the idea of the public interest We look at the status of business in modern democracies and how companies organize themselves into interest groups that contest in the political arena for favorable public policies We then turn to techniques used by interest groups to raise money and exercise in uence followed by a brief review of proposals for making political competition more fair and open I The Federalist Max Beloff 2nd ed 1787 88 Oxford Basil Blackwell 1987 p 43 V 2 Gordon Donaldson and Jay Lorsch DecisionMaking at the T op New York Basic Books 1983 p 13 60 120 CHAPTER 7 THE PUBLIC INTEREST Politics is about making Social or collective choice it is the way society chooses public policy including public policy toward business Yet society is an abstraction it does not think and act in unison In democratic States the foundation for public decisions is supposed to be the individual citizen Democracy S main tenet is that citizenS and their voluntary asSociationS Should select their leaders and hold them to account for public policies The stated goal of policy making is invariably to serve the public interest that is to advance the general welfare of the population People defend or oppose policies in regard to their impact on the public interest and it seems obvious that public policy should further the good of the whole The trouble is that the public interest is a theoretical construct to which different individuals and groups lay claim to legitimize their policy preferences People disagree often Strongly on what government should and should not do but they rarely see themselves working against the public interest It is far more likely for people to convince themselves that their policy choices are the best for everyone There is no obvious way to separate the claims and counterclaims and to find a transcendent public interest that exists apart from the declared preferences of the people who make up society Business is not exempt Adam Smith argued long ago The proposal of any new law or regulation of commerce wliich comes from this order dealers in trade or manufactures ought always to be listened to with great precaution It comes from an order of men whose interest is never exactly the same as the public who have a general interest to deceive and even oppress the public and who accordingly have upon many occasions both deceived and oppressed it3 The implication of Smith s observation is that firms will make expenditures to seek government failure so they can capture the benefits Since no policy ever gets unanimous support in a nation some method must be found to choose among the options Most business people like people in general would agree that majority rule is the right way to settle policy disputes Through debate and compromise interested parties recon cile their disagreements to arrive at a course of action that is acceptable to most The public interest is what a majority wants Yet as MIT S Kenneth Arrow proved individual preferences need not yield consistent social choices His impossibility theorem shows that the wishes of the majority can be cyclical given certain reasonable assumptions about individual s deSireS4 The public interest cannot be found by adding up private interests to find the most widely acceptable alternative Arrow s theorem has bleak implications If there is no clear majority interest let alone public interest the rules for choosing among policies get foggy Policy making can become a question of might more than right of who gets to control the policy agenda and what alternatives are considered BUSINESS AND DEMOCRACY Business is one participant in policy making and corporate leaders help frame the issues that come up for public debate Their ample resources and pivotal place in the economy give corporations 3 Adam S1nithAn Inquiry into the Nature and Origins of the Wealth of Nations 1776 reprint New York Modern Library 1965 p 250 4 Kenneth Arrow Social Choice and Incliiviclual Values New York john Wiley 1951 61 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 121 leverage over public policy Even in a liberal democracy such as the United States where citizens have wide latitude to press demands business is apt to have lopsided advantages in being heard and getting its way Business people seldom see things this way and feel they are fighting an uphill battle According to a recent study Executives believe that corporations are constantly under attack primarily because government simply doesn t understand that business is crucial to everything society does but can easily be crippled by well intentioned but unrealistic government policies A widespread View among the business people interviewed is that far and away the vast majority of things that we do are literally to protect ourselves from public policy that is poorly crafted and nonresponsive to the needs and realities and circumstances of our company 5 Because of this perceived assault from government companies have redoubled their political activities in recent decades Advocates of democracy have long feared that business has corrosive effects on the body politic Thomas Jefferson 17431826 was among the earliest in a long line of observers to worry about the imbalance of economic power and thus political power that stems from industrialization Jefferson was optimistic about the new United States but only because it was a farm society of small property owners Should wealth and economic might become concentrated as they did under the British factory system he worried that democracy would be put at risk6 efferson s agrarian society disappeared by the mid 1800s Business grew to vast size in America alarming large segments of the electorate in the process At the turn of the twentieth century populists and progressives mounted political challenges to the large corporations creat ing a raft of public policies intended to restrict their freedom of action Later in the New Deal and again during the 1960s and 19703 these challenges to corporations were renewed Repeat edly corporations have fought back and by the 19805 corporate political influence was on the upswing again GROUPBASED PoLrr1cs It is obvious that the United States today is not the type of democracy jefferson foresaw Political practices have followed a different track than the old town meeting and its direct citizen parti cipation in policy making As oseph Schumpeter points out modern democracies are no longer systems in which the public initiates policy and elects representatives to implement it8 Often the modern electorate is uninformed about issues and apathetic about getting involved in political action Few people even take the time to vote and many are alienated from politics9 This does not mean that public opinion has no effect On occasion an angered electorate does make its will felt especially if the press has taken up an issue In America throw the bums out 5 Don Clawson Alan Neustadtl and Denise Scott Money Talks Corporate PACS and Political In uence New York Basic Books 1992 p 25 6 Mark S Mizruchi The Structure of Corporate Political Action Cambridge Mass Harvard University Press 1992 p 14 7 Thomas Ferguson and Joel Rogers Right Turn The Decline of the Democrats and the Future of American Politics New York Hill and Wang 1986 8 Ioseph Schumpeter Capitalism Socialism and Democracy 3rd ed New York Harper and Row 1950 9 See William Greider Who Will Tell the People New York Simon and Schuster 1992 62 I always has a popular appeal even though Americans regularly do reelect incumbent officeholders Still popular involvement in public decisions is intermittent and often ineffective Who then if not the people runs the country The mainstream View is that the United States is today a group based democracy No one elite group from Wall Street financiers Big Business owners or East Coast intellectuals to name a few always holds sway rather there are many interest groups whose degree of influence varies according to the particular policy area involved Interest Group Competition Interest groups are formed to further the political and economic goals of the group s supporters which they do mainly by communicating with the authorities responsible for public policy The leaders of an interest group act as agents for the members and try to influence decision makers on the group s behalf Interest groups often vilified as special interests or pressure groups have a bad reputation Yet the right of the people peaceably to assemble to petition the Government for a redress of grievances as the First Amendment to the US Constitution quaintly de nes interest group activism is assured under American law The Founders felt it was essential for people to be free to organize and say what they want their government to do Thus interest group rivalry is at least as old as the American republic The first person to identify and discuss in detail the advantages of group representation as the basis for democracy was james Madison 1751 l836 According to Madison the Constitution should encourage many interest groups he called them factions so that no one group could oppress the others The idea was to promote competition among interest groups to produce a balance with all interests canceling each other Madison s argument is the political counterpart to Adam Smitlfs justification for unfettered markets Madison contended that group competition would create a similar Invisible Hand that would lead people unconsciously to seek the public good while pursuing their individual interests Following Madison group rivalry is often seen as the practical successor to efferson s agrarian democracy According to this line of reasoning in today s complex societies it is not possible and perhaps not even desirable given the level of expertise needed for citizens to take part continuously in governance Interest groups replace individual citizens in making public policy and democracy turns into the struggle among organized groups for favors from government As these groups bargain with each other winning on some issues and losing on others equilibrium is reached that approaches the public interest The results while not perfect are about as good as one can expect in a large industrial state Most political economists today do not make the same positive assessment of interest group activity that Madison did Instead they see conflict among interest groups threatening the ability of the state to respond to problems with policies that help society in general Nearly all interest groups are focused squarely on getting benefits for group members and they encourage government to take a narrow view of its job The result is muddled and deadlocked public policy which is not a desirable equilibrium 10 Steven Kelnian Making Public Policy New York Basic Books 1987 p 214 11 The classic critique of interest group democracy is Theodore Lowi s The End of Liberalism 2nd New York Norton 1979 recently voted the political science book with the most lasting influence in the past 20 years 63 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 123 Is Business on Top Critics of groupbased democracy also point out that the political contest is not fair The effective ness of interest groups is determined neither by the size of their memberships nor the merit of their goals Some interests are in George Orwell s phrase more equal than others with those who are well organized and business groups are among the best organized having disproportionate in uence A good example of a powerful set of business interests is the military industrial complex that President Dwight Eisenhower warned about in his farewell address Defense contractors he argued had twisted American public policy so that it favored the acquisition of more advanced weapons than were safe or necessary to protect the country Political economists suggest several reasons why companies often have the edge in a compet itive political system The obvious reason is that companies have money With deeper pockets than other groups they can sustain longterm political fights against competing groups who may not have as much money and who are less capable of mounting effective political campaigns Motivation may be as important as the amount of resources There are always fewer companies than there are potential adversaries such as consumers or workers There is a transaction cost to organizing large groups that gives companies the head start in getting together for political purposes A handful of producer organizations have a much easier time identifying common interests than do more numerous countervailing interests Also producers are apt to feel the greater impetus to get involved in interest group politics Consider the example of voluntary export restraints with the European Community now the European Union EU japan South Korea and other countries on steel Started in 1982 the restraints were intended to protect the US steel industry until it could compete internationally By the mid 1980s these were costing the consumer 7 billion a year or roughly 37500 for each person engaged in the industry Steel owners and workers had a strong motivation to get and keep these measures The same public policy was irrelevant to the average person 7 billion divided by the US national population is only 30 per head Similarly policies to raise milk prices or put passive restraints in automobiles mean much more to dairy farmers and carmakers than to milk drinkers and drivers In each case an obscure from the average person s point of view change of public policy can wreak major changes on the industry in question The group with the more concentrated interest usually the producer has more incentive to join the political fray The outcome is not a balance of all society s special interests but a systematic bias toward business A more extreme view is that big companies hold hegemony over the US political process Hegemony refers to a cultural worldview and set of institutions that structure how people think and coerces a particular way of life In capitalist societies business allegedly is different from other interest groups because of its pervasive in uence on society The business point of view is accepted without question on fundamental matters which few think to challenge This last characterization can be misleading if taken absolutely To the extent that it exists business hegemony is far from absolute Industrial interests are not all powerful winning on every issue The expiration of steel export restraints in 1992 refutes that unsophisticated argument As in 14 19 This point was first made by the late Mancur Olson r in his classic The Logic of Collective Action Cambridge Mass Harvard University Press 1965 13 Protections Stepchild Economist May 16 1992 p 98 14 Clawson et al Money Talks p 23 64 124 CHAPTER 7 most things sensible claims are not matters of one or the other but of more or less Firms are apt to have a disproportionate in uence on policy making although they can lose on specific issues One reason that firms do lose political battles is that the interests of the private sector are not uniform Depending on the position of various companies and industries an issue may be con flictual unifying or particularistic and of little concern to other firms15 The result is that industries and companies can take opposite stands on policies Consider the struggles in the United States over RampD tax credits Major companies prefer the tax credits but higl1 tech startups do not like them because new companies usually have no taxable profits They prefer a capital gains tax cut to make it easier to raise funds The two sides have ended up foiling each other on this important business issue16 As a rule companies are most likely to get their way on narrow questions that attract little public attention and do not affect other companies such as a tax expenditure that helps a particular industry They also are likely to prevail on broad policy issues affecting the entire economic system such as a change in income tax rates where they can enlist widespread support for their stand That leaves a broad range of contested issues In this middle ground where many safety and environ mental regulations lie nonbusiness interest groups can carry the day While American business power is not absolute it is stronger than in many other countries Business here has an unusual degree of influence on politics probably because Big Business predates the rise of Big Government Europe and apan had powerful states before modern capitalism emerged These states remain somewhat less open to interest group pressure and somewhat more capable of making independent decisions18 17 Corporatist Alternatives Interest groups are found in every society A feature that sets off American interest groups is their independence and self reliance Although Washiiigton and the state capitals are often forced to heed interest groups government neither sponsors these bodies nor officially recognizes them American interest groups do get indirect support through tax expenditures and legal recognition but they are still mainly private organizations One consequence is a cacophony of voices trying to be heard in the legislatures and executive offices So called corporatist states are less neutral about organized interests As we alluded to in Chapter 6 those societies include interests groups such as business and labor in the decision making process through formal arrangements for consultation and negotiation This setup which has medieval origins is sometimes called functional representation It is based on the idea that the community is divided into various strata with each stratum performing a unique function and that these strata should be represented in the polity Some evidence suggests that corporatist modes of representing interests are more efficient and fair Corporatist arrangements are alleged to help governments adjust to changes in the world economy and they offer the possibility of making 15 Mark A Smith American Business and Political Power Chicago University of Chicago Press 2000 p 15 15 jeffrey H Birnbaum The Lobbyists How In uence Peddlers Get Their Way in Washington New York Times Books 1992 17 Sanford M jacoby Masters to Managers Historical and Comparative Perspectives on American Employers New York Columbia University Press 1991 18 Thomas K McCraw Business and Government The Origins of the Adversary Relationship California Management Review vol 26 no 2 1984 3352 65 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 125 Countries generally considered to be corporatist include Germany Sweden Norway Austria Holland and Denmark All of these countries use a system of representation in which mono polistic organizations express the major interests of society in particular business and labor These monopolistic organuzations which are recognized and encouraged by the state get to bargain over public policy The idea is to generate consensus so that the government does not take steps that are unacceptable to these important interests For their part the interest groups accept responsibil ity to help the government carry out its policies Compared with interest group activity in the pluralist United States the relationship with gov ernment is more formal and structured and is carried out through well established institutions In Germany for example meetings between government and the social partners were held from the 19603 to the 1980s to achieve agreements on economic policy Before any federal ministry submits a bill for consideration it must by law consult with the chambers or interest group peak associations Thus interest group pressure is funneled through an institutionalized process of consultation Arguably this process helped Ger many cope with the oil shocks of the period better than a country such as the United States that lacks consultative procedures Corporatist countries have done well in other respects main taining very high standards of living Germany however has been stepping away from the cor poratist model and corporatism is being chal lenged in other countries as well Why the dissatisfaction with functional representation and consensual bargaining One problem is doubt about the fiscal viability of corporatism as it often fuels the growth of an abundant welfare state to buy o the workers Also there is a breakdown in the consensus in these societies a fragmentation of interests such as in the United States Finally international competi tion makes it more di icult for interests to reach a compromise on tough issues Some companies have done well in recent years while others have done poorly and one policy no longer suits all economic policy making a nonzero sum game so that everyone is better off Lately though the model seems to be losing its relevance see Box 71 The United States experimented with corporatism and functional representation in the 19303 but their constitutionality was challenged and the proceedings were dropped Britain also tried to involve labor and capital in formal decision making until the Thatcher government stopped the practice in 1979 TYPES OF INTEREST GROUPS Interest groups can form around any issuefrom abortion to euthanasia from peace to war but the interest groups that occupy us in this book are the ones devoted mainly to economic matters There are three main clusters of economic interest groups those associated with business with labor and with the social or public interest All are pledged to make government take the right steps as they define them toward satisfying their members 19 Wyn Grant ed The Political Economy of Corporatism New York St Martin s 1985 p 25 66 126 CHAPTER 7 Some group activities are not always aimed at in uencing public policy They may perform tasks that members find uneconomical to do themselves such as providing research and educa tional services Yet lobbying is our principal concern in this chapter Let us look at the three clusters of interest groups one at a time Business Self Representation Today many companies see political activism as a major part of their strategy for dealing with their environment Large firms have the resources to represent themselves with lawmakers Citicorp for example which has the largest lobbying force in the banking industry employs eight registered lobbyists in its Washington office These lobbyists spend most of their time blocking and blunting policies that could hurt Citico1p s credit card and student loan businesses and other activities2 Citicorp is far from alone for hundreds of firms maintain offices in Washington with in house lobbyists Three quarters of large companies employ outside private lobbyists as well according to a Conference Board survey More than half of the 300 companies queried had increased their internal government relations staff or the use of outside lobbyists during the 1980321 Again Citicorp is typical In addition to representing itself Citicorp retains six law firms to represent its interests on Capitol Hill Similar trends are seen in Europe More than 250 companies have representative offices in Brussels to serve the EU There also has been an explosion in the number of EU wide pressure groups across all sectors particularly in those related to new technology22 Business Interest Groups Smaller companies may lack the resources to take part in politics by themselves They may choose instead to Work with alliances of similar companies to push their interests Large companies also see advantages in working with competitors toward whatever public policy goals they happen to share To fill this widespread need for common representation thousands of business groups have emerged in the United States Some are umbrella organizations known as general purpose business groups or peak associations that claim to speak for large categories of companies Others are trade associations that represent specific lines of trade Forty six different associations exist for the US iron and steel industry for example including associations of producers importers and users Table 71 shows the scale and growth of these groups In 1968 there were already some 2800 national trade business or commercial associations today that number has grown by more than 1000 additional organizations There has also been dramatic growth in other business and pro fessional groups particularly in the medical area Membership is voluntary but companies and individual professionals like to join to get services and in uence public policy The associations have multiplied largely in response to perceived challenges to trade and industry from other interest gI39O11PS 20 Kenneth H Bacon For Citicorp Wliicli Has Largest Lobbying Force in Banking industry Victories Are Won Quietly Wall Street journal December 14 1993 p A13 21 Seymour Lusterman Managing Federal Government Relations Wasliington DC Conference Board 1989 22 Alan Butt Philip and Oliver Gray Directory of Pressure Groups in the E U London Catermill 1996 67 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 127 BUSINESS AND PROFESSIONAL ASSOCIATION Gnown1 IN THE US Number of National NonProfit Associations 1968 1980 2004 Trade business commercial 2832 3118 3812 Agriculture environmental 508 677 1140 Scientific engineering technology 548 1039 1354 Health medical 791 1413 2921 Source Statistical Abstract of the United States various years Peak Associations Important peak business associations are listed in Table 72 The oldest is the National Association of Manufacturers NAM which was founded in 1895 largely to counter antibusiness policies being pushed by Progressive Era reformers Later the NAM became a platform for attacks on the New Deal and the labor movement It currently has a membership of 13600 companies who together account for about three fourths of the nation s manufacturing production and employment The NAM was a low key operation in the 1950s and 19605 when business interests were comparatively secure In 1974 it moved its headquarters to Washington DC to increase its political in uence One year later it registered with Congress as an organization whose main activity is lobbying23 Today the NAM maintains an active presence in the nation s capital with a staff of 180 and a budget of 14 million Also dating from the Progressive Era is the Chamber of Commerce established in 1912 It represents a federation of 2800 local and state chapters plus thousands of individual companies and industries and is now the largest business interest group in Washington Between 1974 and 1980 its membership more than doubled and it currently has 1100 staff members and a budget of 65 million Traditionally the Chamber of Commerce has stressed opposition to Big Government and the welfare state24 Started during the New Deal period is the Business Council Interestingly the Business Council was originally attached to the Department of Commerce as President Roosevelt dabbled with corporatism during the Great Depression The Business Council declared its independence in 1962 partly due to suspicion about its quasigovernmental status Membership is limited to 65 CEOS of the largest corporations who maintain liaison committees that connect with various government departments The newest peak association for employers is the Business Roundtable Established in 1972 following the most recent surge of regulatory activity the Business Roundtable is made up of the CE Os of 200 major corporations Membership is by invitation and the chief executives agree to join directly in the group s meetings Because it primarily represents Big Business the Business 23 Sar A Levitan and Martha R Cooper Business Lobbies Baltimore johns Hopkins University Press 1984 pp 1415 24 David Vogel Fluctuating Fortunes The Political Power of Business in America New York Basic Books 1989 68 128 CHAPTER 7 PEAK Assocumons THAT REPRESENT SEGMENTS or THE BUSINESS Secron Year founded Member firms Staff size Budget mill Business Roundtabie 1972 200 16 na Chamber of Commerce 1912 180000 200 65 National Association of Manufacturers 1885 12500 1100 14 Business Council 1933 276 3 na National Federation of independent Business 1943 560000 225 52 Source Encyclopedia of Associations 27th ed 1993 Roundtable sometimes had a less antagonistic view of labor unions and government regulation than either the NAM or the Chamber of Commerce Representing smaller businesses only is the National Federation of Independent Business NFIB established in 1943 It has nearly half a million members two thirds of whom employ fewer than ten people This organization mushroomed from 500 members in 1975 in reaction to their view that new regulation was causing them particular hardships According to Fortune magazines 2001 Power 25 list of Washington s most powerful interest groups the NFIB is the most in uential business association in the nation s capital It works with Congress the 50 state legislatures and administrative agencies to ensure that the needs of small employers are considered in new laws and regulations A rival voice for small business is the National Small Business Association founded in 1937 which claims 50000 member companies These peak associations have many resources to utilize to in uence government activity All are handicapped however by their assorted member ship When companies both big and small manufacturers and service providers importers and exporters get together they find it hard to agree on positions and present a united front For example small business members of the Chamber of Commerce revolted over the Washington headquarters temporary decision to support employer mandated health insurance premiums The group red its top lobbyist over the issue in 199425 Trade Associations Specialized trade associations which coalesce around the needs of specific groups of companies usually have more in uence than the more diffuse peak associations The number of industry specific groups in the United States is huge and growing A sample is shown in Table 73 Prominent groups such as the National Automobile Dealers Association or the American Bankers Association can have thousands of members Other industry groups such as the American Petroleum Institute the Iron and Steel Institute or the Motor Vehicle Manufacturers Association represent large sectors of the economy Their budgets and staffs may rival those of the general business groups Most trade associations however are small They represent specialized lines of work and have narrow range tl1e Peanut Butter Manufacturers Association the Frozen Onion Ring Packers Council and the Frozen Potato Products Institute There even is a trade association 25 jeanne Saddler and Rick Wartzman Chamber of Commerce is Boiled by a Revolt Within Rank and File VVall Street journal April 15 1994 p A1 69 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 129 SPECIALIZED US TRADE AND PROFESSIONAL ASSOCEATIONS Year founded Member firms Staff size Budget mill American Bankers Association 1875 10000 400 62 American League of Lobbyists 1979 na na na American Trucking Association 1933 4100 291 35 Air Transport Association of America 1936 22 125 8 Bow Tie Manufacturers Association na na na na Chemical Manufacturers Association 1872 185 246 36 Frozen Onion Ring Packers Council 1942 520 18 na Frozen Potato Products institute 1958 12 na na Motor Vehicie Manufacturers Association 1913 7 109 14 National Automobile Deaiers Association 1917 19600 405 10 National Association of Broadcasters 1922 7500 165 17 Peanut Butter Manufacturers Association 1969 180 3 na National Pretzel Bakers institutes Pharmaceutical Manufacturers Association 1958 93 90 10 Source Encyclopedia of Associations for people who work for trade associations the American Society of Association Executives Lobbyists may join the American League of Lobbyists Because of their focus trade associations may find it easier to define their members interest compared with the general purpose groups because they are less well known they also may avoid the pitfalls of excess publicity that larger umbrella groups can attract They are apt to be particularly forceful on the small issues that concern their members but that do not touch the wider public It is safe to say that no significant commercial interest goes unrepresented today Political economists see in these trends clear evidence of increased rent seeking by business As David Vogel of the Haas School of Business Berkeley points out corporations in effect now treat their Washington offices as another profit center He states Companies originally came to Washington in the early 19705 primarily to defend themselves But once having invested so much in learning how the political process works many decided to use their political skills to help them gain advantages over their competitors domestic as well as foreign As a result the political agenda became increasingly dominated by the requests of particular firms and industries for changes in public policies that would enhance their competitive positions26 With the expansion of state government businesses also have greatly increased their political activity at the state level The percentage of associations monitoring state issues grew from 35 percent to 70 percent from 1982 to 1987 There were 42000 registered lobbyists in state capitals in 199027 Whether corporations are heard and get results is another question that we will look at shortly 26 Vogel Fluctuating Fortunes p 287 27 Alan Rosenthal The Third House Lobbyists and Lobbying in the States Washington DC Congressional Quarterly Press 1993 pp 34 70 130 CHAPTER 7 Business Organizations Overseas Employers political associations are prevalent in other countries In Germany more than 70 percent of all but the smallest employers belong to trade associations which in turn are affiliated with the German Federation of Industry In France the Comit National du Patronat Francais is the umbrella organization for large employers Japan has the Keidanren the Federation of Eco nomic Organizations which groups together more than 1000 of apan s biggest companies As in the United States there is movement back and forth between these private organizations and the government what the japanese call amakurdi in which retired officials in the Ministry of Finance or the Ministry of International Trade and Industry take over top jobs in politics or business The major difference is that in democracies with corporatist overtones the relation between business political organizations and the state is usually more centralized and formal than in the United States In Germany one organization the National Association of German Employers handles labor negotiations The boundary between the public and private sectors is correspon dingly less clear in such countries28 Japan is the best example Iapanese peak associations are stronger than in the United States and some government assistance is provided in apan which is not true in the United States29 Companies in a particular sector must belong to the respective apanese trade association which is endowed with extralegal powers that curtail independent corporate decisions These groups are linked to the government bureaucracy and often act on the behalf of the government3O Thus apan s voluntary agreement not to sell as many cars as it can in the United States is carried out by the trade association representing Iapanese automakers see Chapter 17 The corporatist setup often is preferred by government as a matter of convenience It is an advantage to have a single body to consult for broad sectors of the economy Also public officials like differences of opinion within an industry to be worked out by a business association before a question is brought to their attention The resulting cooperation and coordination is thought by many to have played a key role in apan s and Germany s economic success since World War II Labor Unions Workers have long sought representation in public policy making usually as a counterbalance to business Their vehicle has been labor unions Unions join the political fray to get government to make business act more favorably toward employees In describing American democracy in the 19505 John Kenneth Galbraith called this mechanism the principle of countervailing power According to the analysis in his book American Capitalism business and workers tended to balance off of one another Labor union power in the United States probably was near its peak when Galbraith wrote American C apitalism Unions then claimed about onequarter of the work force compared with less than onesixth today Their shrinking ranks have reduced their influence as have their links to the Democrats who held the Presidency for only four years between 1969 and 1993 These and other 28 Graham K W son Business and Politics A Comparative Introduction 2nd ed Chatham N Chatham House 1990 29 Leonard H Lynn and Timothy McKeown Organiz39ng Business Trade Associations in America and japan Washington DC American Enterprise Institute 1988 p 4 30 Karel Von Wolferen The Enigma of japanese Power London MacMillan 1990 31 john Kenneth Galbraith American Capitalism The Concept of Countemailing Power rev ed Boston Houghton Miffiin I956 71 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 131 factors have weakened organized labor s ability to further its cause in recent tiines Symptomatic of organized labor s lack of clout was the passage of the North American Free Trade Agreement NAFTA in 1993 Despite an allout lobbying effort on the Democratic Congress and President the trade unions could not block NAFTA Still 235 unions remain in the United States today with more than 16 million members Important individual unions such as the Teamsters United Mine Worker39s and United Auto Workers stay active in American politics They work on issues directly relevant to their members and still affect public policy despite their dwindling numbers Many American unions belong to the AFL CID A peak association parallel to the general purpose business groups it was formed in 1955 from the merger of two competing labor bodies the American Federation of Labor and the Congress of Industrial Organizations Today the AFLCIO has more than 100 affiliated unions representing everyone from teachers and plumbers to garment workers and meat cutters The organization supports some 300 lobbyists who work for the member unions to influence national policy on matters such as social welfare job training minimum wages child labor and occupational safety Fortune ranks it the sixth most powerful interest group in America Public Interest Groups The rise of public interest groups is a significant event in recent US politics Public interest or citizens groups are organizations that seek public goods whose provision will purportedly help society as a whole They profess to act on behalf of people other than the group s members This trait sets public interest groups apart from special interests such as business or labor which admittedly speak for their members first and the public second Relying heavily on voluntary contributions of time and effort public interest groups push for government policies to provide such collective benefits as less in uence of money on elections safer products and workplaces and cleaner air and water Their stances often cause them to clash with business groups Support for public interest groups comes mainly from professionals and intellectuals with organizational skills and educational resources and they have had more impact than their modest finances would suggest Accounting for no more than 7 percent of all interest groups citizens groups appear to be overrepresented in press accounts and congressional testi mony on public policy issues Public interest groups claim to be motivated mainly by altruism not selfinterest The claim is partly true in the sense that members do not always have a direct material stake in the policies being pursued Yet political economists point out that there is usually an element of self interest even in such seemingly selfless pressure group activity Support for environmental groups for instance often comes from middle class people who use the outdoors for recreation or whose property values will be enhanced by slowed economic development The point here is not to denounce public interest groups but only to note that enlightened selfinterest and public spirited ness are not incompatible Common Cause is the most prominent generalpurpose public interest group Founded in 197 0 to make office seekers more honest and hold them more accountable for decisions Common Cause has focused on matters such as secure and accurate elections campaign financing lobbying disclosure laws and open hearings requirements in Congress It claims a membership of 300000 32 Jeffrey M Berry The New Liberalism The Rising Power of Citizen Groups Washington DC Brookings Institution 1999 72 132 CHAPTER 7 The best known consumer groups are those organized by Ralph Nader such as tl1e Center for the Study of Responsive Law the Auto Safety Center the Public Citizen s Health Research Group and the Public Interest Research Group As we will see in Chapter 13 Nader made a significant impact on policy particularly in the 1960s and early 1970s Although he is known mainly as a consumer activist Nader has lately pursued political office on a platform of checking what he sees as overweening Big Business power The environmental movement has spawned many public interest groups as well The Environ mental Defense Fund for instance urges concerned citizens to press for testing of local fish for dioxin levels and to act as watchdogs for proposed solidwaste incinerators The Sierra Club promotes citizen action to stop paper companies from clearcutting timber in old growth forests33 Member ship in environmental nongovernmental organizations NGOs has been rising with the election of pro business President Bush See Chapter 17 for more on the environmental movement The civil rights and women s movements have given rise to another class of publicly spirited interest group although because of their ties to identifiable categories of people they are often distinguished from the better government consumer and environmental organizations The impor tant point is that groups such as jesse ackson s Operation PUSH or the National Organization of Woinen have among their aims the objective of getting business to act more favorably toward their real or potential members who in total make up most of the population Jackson for example recently threatened a boycott against automaker Toyota accusing the company of using racist advertising while excluding blacks among its dealers board of directors and advertising teams Industry often sets up phony public interest groups as front organizations to combat true public interest groups Typically these industrybacked bodies take misleading names to create the impression of a grassroots movement The biggest spending lobby in Washington in 1986 for example was the Citizens for the Control of Acid Rain The citizens in question were organized by coal and electric utility companies fearful of stricter controls on polluting emissions Another example is the Coalition for Vehicle Choice founded by Ford General Motors in 1990 to fight proposals for higher fuel standards34 Groups that pretend to represent the public are not illegal No federal law requires any advertising or mail solicitations to identify their major sponsors These steal lobbying cam paigns are becoming more common The tobacco industry has launched one the largest stealth campaigns to date in favor of legislation that will give it special immunity from legal liability a lobbying campaign carried out under the cover of The Campaign for Tobacco Free Kids35 ALTRUISM AND PUBLIC POLICY It is cynical and inaccurate to see egotism behind everything done by public interest groups just as it is unduly distrustful to debunk every corporate profession of social responsibility Selfinterest narrowly understood is not the only motivator of human political and economic activity The model of rational choice employed in this book to account for most political behavior should not be 33 Murray Weidenbaum Business Government and the Public 4th ed Englewood Cliffs N PrenticeHall 1990 p 417 34 Public Interest Pretenders Consumer Reports May 1994 pp 31718 35 jill Abramson with Barry Meier Tobacco Braced For Costly Fight New York Times December 15 1997 Also see the Advocacy Institutes By Hook Or By Crook A Guide to Stealth Lobbying Washington DC 1995 73 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 133 interpreted so narrowly as to deny the possibility of altruism or genuine regard for other people s wellbeing What motivates men and women to support public interest groups or to look beyond profits Partly it is to enhance personal power and income but supporters are obviously not involved in every group action for the greatest net benefit to themselves Human behavior is actuated by mixed motives People find satisfaction in social networks that generate solidarity and mutual responsi bility not just in individual aggrandizement They ful ll themselves through duty and obligation as well as through power and prestige Steven Kelinan of Harvard s Kennedy School of Government argues that there is in fact a high level of public spirit in much public policy making By public spiritedness he means that some participants in the policy proceSs interest groups politicians and bureaucrats do make good faith efforts to obtain good policies They do not simply pursue what is best for them Public spiritedness thus may temper the painful side effects of interest group compet139tion36 There are at least two themes that run through the public spirit37 One is the idea of trustee ship of separating business decisions from the personal realm Like all business functions govern ment relations are a public trust and should not be exploited for particular advantage A second theme is that of service to society Public policies should be shaped to respond to societal needs as fairly as possible Together these themes form a professional ethos that inoderatesmnot elirni nates the selfseeking of managers in all sectors TACTICS FOR BUSINESS AND OTHER INTEREST GROUPS As the previous discussion hints the distinction between public and special interest groups is partly in the eye of the beholder It has been Said that a Special interest group is one to which you don t belong and there is truth in the statement The reverse also can be true public and special interests overlap In capitalist societies representatives of business can make a strong claim that whatever helps business helps society by providing jobs tax revenue new products and so forth Few people disagreed with the famous statement made in 1953 by Charles Engine Charlie Wilson president of General Motors at his nomination hearings to become Secretary of Defense Asked about possible conflicts between the national interest and that of his company he replied that no such conflict was possible for years I thought what was good for our country was good for General Motors and vice versa 38 Unwise would be the spokesperson for business who did not link the fortunes of his or her company or industry with the public good Obvious self interest is not nearly as effective in attracting support Assertions about the public good serve to build political alliancestl1e wider their benefit the easier it is to sell public policy proposals to other groups whose agreement is needed to make the proposal law Many Americans in the 19605 and early 1970s became skeptical about arguments such Engine Charlie s but they are more trusting of such reasoning today One reason is that business interest groups have persuaded voters that the nation s long term economic health perhaps the most unifying public cause depends on giving companies a freer hand the 36 Kelman Making Public Policy 37 I borrow these themes from Milton Esman Management Dz39mensz390ns of Development VVest Hartford Conn Kumarian 1991 pp 15051 38 Cited in Robert B Reich The VVork of Nations New York Vintage 1992 p 48 74 134 CHAPTER 7 archetype of self serving interest39 Many managers are not being cynical about this they truly believe that business requirements are indistinguishable from the larger society s needs and there is some truth to this view Although the argument for probusiness policies seems self evident to most management stu dents probusiness policies do not simply happen by themselves they require a great deal of spadework by business interest groups An enormous investment of political resources must be made to get government to do what business wants In the next section we review specific tactics that companies use to promote their policy agendas and guard against damaging government decisions Public Issues Management As they began to come under siege in the 1960s many rms expanded and strengthened their public affairs departments An outgrowth of older public relations units these public affairs departments seek to create favorable public perceptions of the firm and promote its public policy goals The current National Directory of Corporate Affairs lists 1900 corporate offices that conduct public affairs activities40 Public affairs units have three main jobs 1 communication or efforts to articulate the company s interest to stakeholders both inside and outside 2 philanthropy or efforts to in uence the social cultural and economic conditions in company communities and 3 government relations or alerting the company to threatening political trends and devising ways to divert them Let us look at each of these jobs more carefully Communication Companies naturally want to put their best face forward and they are sure to announce good news about their activities to the media or try to put a spin on bad news Rather than rely solely on press releases and the like many companies engage in image advertising as a defense move The purpose is to create a positive impression by presenting their company as caring about the environ ment health and similar issues An illustration is British Petroleunfs recent ad campaign that uses the theme of Beyond Petroleum Ford bought nearly 40 percent of Time magazines special Earth Day 2000 edition This exclusive sponsorship of Times How to Save the Earth and the Heroes for the Planet Who Are Making It Happen looked suspiciously like company promotional material to some alert readers Companies also use video news releases VNRs These are pre produced news items supplied free to television stations by public relations firms that are subtly slanted to sell a client s products and ideas while appearing to be real TV news VN Rs are very widely broadcast and TV stations rarely disclose VNRS to viewers Increasingly companies are taking stands on broader public policy issues that concern shareholders managers and employees what is often called advocacy advertising By the early 1980s corporations were reported to be spending one third of their tax deductible 39 See as examples Ferguson and Rogers Right Turn pp 8994 and Vogel Fluctuating Fortunes pp 228432 40 Valerie Steele and others National Directory of Corporate A airs 16th ed Washington DC Columbia Books 1998 41 Diane Farsetta and Daniel Price Fake TV News Widespread and Undisclosed Center for Media and Democracy April 6 2006 75 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 135 advertising budgets to in uence people as citizens not as customers42 According to the Annen berg Center at the University of Pennsylvania during the 2000 election cycle more than 70 groups ran television spots on public policy issues Spending on issue advertising was dominated by a small number of groups including the Business Roundtable the US Chamber of Com merce and Citizens for Better Medicare Despite its name this last group is not a community organization but an arm of the Pharmaceutical Research and Manufacturers Association Because issue ads are not federally regulated sponsors are subject to no disclosure requirements and may purposefully be vague about their names see the discussion of independent expendi tures and soft money below The impact of issue or advocacy ads is diluted however by the extent to which it is perceived as self serving propaganda A more subtle way that companies defend their interests is to commission research with predetermined outcomes to defend their interests The results are then released without mention of who funded the study A good example was Procter and Gamble s subsidization of a 1990 study of disposable diapers by Arthur D Little the consulting firm The Arthur D Little study proved that disposables an important Procter and Gamble product were no worse for the physical environment than cloth diapers This finding effectively ended the environmentalist campaign against disposable diapers43 Similarly industryfunded skeptics have sown confusion among the public about the scientific basis of climate change studies Another way that companies in uence public opinion is through educational programs often targeted at public schools More than half the Fortune 500 firms provide readings videos speakers and other teaching materials to classrooms around the country A less obvious but maybe more potent in uence is through the acquisition of equity positions in the media such as General Electric s purchase of NBC Corporate ownership likely has a dampening effect on critical news stories about the parent company The same can be said of corporate sponsorship of news programs which may de ect some reports Fox News owned by prominent conservative tycoon Rupert Murdoch is frequently accused of selective reporting with a prowbusiness slant Public Policy Research Institutions A notable indirect way that US business sways public opinion and government action is by underwriting think tanks or public policy research institutions Think tanks are a twentieth century phenomenon Endowed with private funds they began to appear in the United States around 1900 to bring science and reason to government Their scope is diverse but many think tanks specialize in policies meaningful to business and industry Today public policy research institutions number over 100 not including those sponsored by universities or attached to govern ment Most are headquartered in Washington DC where they have access to national policy makers and news outlets Corporations have discovered that funding of research publications media campaigns and other forms of advocacy on policy issues can serve as an adjunct to traditional corporate lobbying and political contributions according to Iames Allen Smith author of The Idea Brokers a book about think tanks 44 Paralleling the growth of corporate interest groups nearly half the US think 42 Frances Fox Piven and Richard Cloward The New Class VVar rev ed New York Pantheon 1985 p 9 43 Cynthia Crossen Tainted Truth New York Simon and Schuster 1994 44 Quoted in Dan Morgan Think Tanks Corporations Quiet Weapon W391shz39ngton Post January 29 2000 76 136 CHAPTER 7 tanks were founded in the period 1976 9O45 According to Congressional Quarterly among nation ally focused institutions begun since 197 6 twice as many are conservative than liberal in ideology among state and regional think tanks nearly three times as many of those emerging during this period have a conservative ideology Prominent institutions with a conservative or libertarian economic focus are the American Enterprise Institute 1943 the Heritage Foundation 1974 the Cato Institute 1977 and the Reason Foundation 1978 Much of their research is of a high order The quality of think tank scholarship helps make them credible with policy makers and the general voting population The explosion of public policy research institutions has been paid for largely by corporations and wealthy investors The Coors brewing family is a major benefactor of the Heritage Foundation The Cato Institute lists such donors as Coca Cola Citibank Shell Oil Philip Morris and Toyota4 6 One of the biggest benefactors of policy research is the tobacco industry although they deny any causeeffect link between charitable giving and think tank advocacy As explained in Chapter 6 US business was shaken by many public policies in the 19605 and 19703 From the business vantage point too much red tape and too many taxes were being imposed on them without sufficient regard for the consequences justification for these bad policies came from government agencies and universities which were believed to be unsympa thetic to business needs At the time the corporate community lacked the intellectual artillery to fight back with reasoned objections and ideas for good policies that would cut their cost of doing business The think tanks gave business a seemingly unbiased means to sponsor applied research into its political agenda The groups provide analyses TV interviews polling and academic studies that add an air of authority to corporate 3I g11IT16I1tSOft Bil while maintaining the corporate donors anonymity For example the largest supporter of Cato s study of Social Security privati zation is the US insurance company AIG which manages privatized retirement systems abroad and stands to benefit if as Cato is recominendingmsuch an option is put in place in the United States48 Rightwing think tanks supply disproportionate numbers of commentators for tele vision usually presented as objective experts not spokespersons for a particular set of inter estsflg The civil society group Think Tank Monitor reports that the centrist Brookings Institution is the most widely cited think tank Three right wing institutionsmthe Heritage Foundation American Enterprise Institute and Cato Institutemare the second third and fourth most cited institutions The business conimunity s project to change the grounds for debate over business and public policy in the United States has been highly successful The liberalsocial democrat paradigm of activist government dominant in the 19603 was largely replaced by a laissezfaire paradigm in the 19803 The center of gravity in American politics has continued moving sharply to the right in the 21 century toward the direction that most business people favored 45 jarnes G McGann Academics to Ideologues A Brief History of the Public Policy Research Industry PS vol 25 no 4 December 1992 73340 46 john Fialka Cato Institute s In uence Grows in Washington As RepublicanDominated Congress Sets Up Shop Wall Street joumal December 14 1994 p A16 47 Timothy Noah and Laurie McGinley Tobacco Industry s Figures on Political Spending Don t Reflect Gifts to Think Tanks Other Groups Wall Street journal March 25 1996 48 Morgan Think Tanks Corporations Quiet Weapon 49 Paul Steidlmeier Institutional Approaches in Strategic Management journal of Economic Issues vol 27 no 1 1993 201 77 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE I37 Philanthropy Charitable donations are another important means that corporations use to try to make a favorable impression on key stakeholders These donations are aimed primarily at the local community in which plants and offices are located Promoting themselves as good citizens companies give away significant amounts to worthy causes paying for scholarships underwriting plays and concerts beautifying parks and the like Donations to the arts may have a disproportionate effect on the perceptions of elite policymakers and thus be a particularly important part of a larger political strategy Some corporate philanthropy also goes to support operations of the nonprofit think tanks discussed in the previous section Skeptics call these practices mere symbolism encouraged by public policy that allows a tax writeoff for charitable donations We saw in Chapter 4 however that corporate giving can reduce opposition to a co1npany s actions and win the support of concerned investors and consumers although the direct economic payoff may be intangible Interestingly companies often work for this goal by supporting NCOS and other stakeholder groups that frequently oppose corporate activities5O This may represent a business strategy of trying to co opt its public policy critics About 40 percent of large firms give to charity51 Corporate foundations gave away 35 billion in 2003 according to the Foundation Center That tiny fraction of profits earns considerable good will with corporate constituencies Whether considered tokenisrn or not corporate philanthropy can be helpful for society and does put a good face on a company s other activities Yet the amounts are small relative to the size of the corporations involved as Table 74 suggests u p S THE TEN LARGEST CORPORATE GRANTMAKERS 2004 Annual giving million WaliVlart Foundation 120 Aventis Pharmaceuticals Health Care Foundation 115 Ford Motor Company Fund 77 The Bank of America Charitable Foundation Inc 77 Verizon Foundation 58 Citigroup Foundation 58 The JPMorgan Chase Foundation 55 GE Foundation 51 Exxonlvlobil Foundation 50 The Wells Fargo Foundation 46 Source The Foundation Center 50 Christopher Yablonslci Patterns of Corporate Philanthropy The Advocacy Masquerade Washington DC Capital Research Center 1999 51 Wendy L Hansen and Neil Mitchell Disaggregating and Explaining Corporate Political Activity American Political Science Review 94 2000 p 895 78 138 CHAPTER 7 GOVERNMENT RELATIONS The most important facet of corporate public affairs is government relations This activity includes keeping abreast of policy changes One of the growth areas of corporate public affairs departments is regulatory work according to a 1992 survey5 Government relations also covers attempts to convince decision makers to support policies that a company wants an activity known more prosaically as lobbying Companies may lobby at one remove through their trade associations or more straightforwardly through law consulting and public relations firms that they hire to act as intermediaries In Washington federal legislation has required since 1946 that professional lobbyists register with Congress The 1995 Lobbying Disclosure Act mandates organizations that hire lobbyists to disclose what issues they are seeking to in uence and how much they are spending to in uence federal executive and legislative officials The law covers lobbying on legislation and executive branch enforcement and regulatory decisions as well as contract awards Almost 35000 people are registered as lobbyists in the nation s capital more than double the number five years ago Overall expenditures on federal lobbying were 21 billion in 2005 up 30 percent since 200053 Business accounts for nearly 90 percent of the total These sums are an understatement of the effort that goes into influencing public policy since they probably do not include much indirect or grass roots lobbying see below Special provisions cover lobbyists working for foreign governments and international corpora tions who are required to register as foreign agents with the Justice Department japanese organizations reportedly employed 140 US lobbying and public relations firms in 1990 at a price of 100 million to influence Washington policy making54 The government of Mexico spent nearly 30 million over three years to push for NAFTA according to the Center for Public Integrity Naturally there is controversy over the danger that such foreign lobbying may represent to US national interests Lobbyists do not try to affect all policies but specialize in those that they or their clients consider most important Most lobbying effort is spent on defensive activities such as tracking and blocking what are seen as undesirable proposals The US way of making public policy is deliber ative with many checks and balances so preventing action is generally easier than making some thing happen Lobbyists work the points in the system where policies that are bad for their clients can be stalled altered or defeated Types of Lobbying At its most elemental level lobbying is about the transfer of information Interest groups often have exclusive information that elected officials and their staff may want or need to make policy decisions In fact officials seek out lobbyists for briefings on issues and help in drafting rules Why Because they want to know what harmful impact new policies may have on constituents before making up their minds Lobbyists can also be of great assistance by helping legislators and 52 National Directory of Corporate Public A fairs p 6 53 Ieffrey H Birnbaum The Road to Riches Is Called K Street VVashz39ngt0n Post June 22 2005 p 7 54 Pat Choate Agents of Influence New York Knopf 1990 79 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 139 staffers to draft bills However lobbyists have no power or in uence until a public servant gives it to them55 Most lobbying traditionally takes place out of the public eye at closeddoor meetings in the halls of Congress or at scantily attended public hearings This is sometimes known as the insider game of lobbying and in uence peddling Sometimes lobbyists offer legislators or staffers lunches trips or other favors as a way to plead their case regarding a particular piece of legislation We will look at the mechanics of traditional insider lobbying more closely in Chapter 9 In recent years however lobbyists have also been relying more heavily on an outsider game to press their cases with legislators The outsider game involves arousing voters to support a special interest position These are called grass roots campaigns They encourage influential constituents to bring pressure to bear on decision makers or organize e mail or telephone cam paigns Companies can pitch in by asking their employees to write their representatives These orchestrated efforts can lead to a barrage of mail and phone calls that force legislators to change their minds on issues that matter to the interest in question An early example of grass roots lobbying is the US banking industry s 1983 campaign to overturn an amendment to the tax code The amendment would have required them to withhold taxes from customers interest and dividends While the average citizen did not like withholding it was not a salient issue for most people To jolt the public s apathy the American Banking Association produced 15000 repeal kits for member banks complete with drafts of letters to congressmen and prepackaged op ed articles to be submitted to local newspapers The banks were instructed to give customers preprinted preaddressed postcard protests with their monthly statements which caused an avalanche of protest mail on Congress The effort to get the public to take industry s side worked and support for the withholding amendment withered Two weeks before the law was to take effect the Senate reversed itself and voted 864 against tax with holding Similar events occur at the state level In Massachusetts the tobacco industry formed the Fair Tax Coalition to fight an initiative petition to hike the cigarette excise in 1992 The Philip Morris Company the Smokeless Tobacco Council and other organizations spent 675000 to lobby state lawmakers and administration officials They also ran a 7 1 million media campaign outspending an antismoking coalition led by the American Cancer Society by more than ten to one57 In this case lobbying did not work and the cigarette excise passed easily Lobbying in Other Political Systems Business lobbyists in other nations usually avoid the kinds of public campaigns that are becoming prevalent in the United States preferring a more confidential approach Coalition building often occurs through industry associations and peak organizations such as apan s Keidanren As noted in Chapter 6 consultation and bargaining are apt to be more formal and systematic in other countries than in the freewheeling United States Still we should not exaggerate the differences Even in corporatist states there is an informal side to lobbying that is not unlike American lobbying In Japan for example firms use their 55 A good guidebook to the practical details of lobbying is Bruce C Wolpe Lobbying Congress How the System IVorks Washington DC Congressional Quarterly 1990 56 Hedrick Smith The Power Game New York Random House 1988 pp 243 45 57 Frank Phillips Over 800000 Spent in 92 on Hill by Tobacco Gambling Interests Boston Globe January 20 1993 p 21 and Factions Spent 16 million on 92 Ballot Initiatives Boston Globe January 26 1993 p 14 80 140 CHAPTER 7 personal contacts to keep abreast of developments and express their policy preferences to the bureaucracy the dominant political party and the Diet legislature The connections are often based on school ties since many top executives and bureaucrats attended the same prestigious universities To maintain access to politicians companies make regular campaign contributions legal and tax deductible under japanese law58 Also similar to the United States lobbyists in japan tiy to diversify their relationships and points of access japanese firms focus on those legislative committees and bureaucratic agencies that are most important to their concerns The Legal Status of Lobbying The US policymaking system works reasonably well for single companies and industries Given the system s fragmented structure and the opportunities for endless dickering individual companies can often neutralize unwanted policies especially narrowly drawn regulatory policies Professor Theodore Lowi of Cornell University once called the result governing by universalized ticket fiXing 59 The standard remedy is to bring lobbyists into the open by compelling them to register Massachusetts passed America s first lobbying disclosure law in 1890 Federal bills to control lobbying were introduced starting in 1907 Foreign agents were made to register in 1938 The first far reaching federal law had to wait until the end of the Second World War with the passage of the Regulation of Lobbying Act of 1946 which required the listing of all individuals and agents seeking to in uence legislation However the law had many loopholes The scandal here is not that the rules were broken the scandal is the rules themselves says Representative Martin T Meehan Democrat of Massachusetts He has introduced legislation that would require lobbyists to file quarterly instead of semiannual financial disclosures and to disclose which people in the government they lobbied Former members of Congress would also not be able to lobby their colleagues for two years as opposed to the current one year limitation Current members of Congress would be obliged to submit detailed itineraries and descriptions of expenses for privately sponsored travel60 Whatever laws are put in place companies and their lobbyists can usually find ways around them The possibility of selective lawbreaking raises the deeper moral issue of how far companies and their lobbyists should push to block changes in the law wchanges that might hurt the company but help some of its stakeholders in society The tobacco companies for instance have fought hard against all legislation aimed at them in the United States such as proposals to raise cigarette taxes to punitive levels High taxes would discourage smoking especially among nonsmokers and contribute to the population s health Yet the taxes also would mean less cigarette consumption lower profits and ultimately harm for its owner and worker stakeholders Is it legitimate for the tobacco industry to use its vast resources to promote policies that hurt consumers but help its bottom line In fact cigarette companies have never admitted that science has proven a link between smoking and health out of fear that such an admission would open them to product liability suits 58 David P Baron Business and Its Einviromnent Englewood Cliffs N Prentice Hall 1993 pp 39596 59 Quoted in VVilliam Creider W720 VV239lI Tell the People New York Simon and Schuster 1992 p 198 60 Todd S Purdom Go Ahead Try to Stop K Street New York Times january 8 2006 81 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 141 CAMPAIGN DONATIONS Promoting a company s message via lobbying requires a foothold in the centers of power The best way to gain admission is by helping friendly legislators get elected and hostile ones get defeated Since elections run on money campaign donations play a critical role in creating the conditions for effective policy advocacy The money does not usually buy a candidate s vote with a direct quid pro quo There are exceptions of course Politicians are periodically caught taking bribes in exchange for a vote What campaign donations usually succeed in buying however is access Everyone has the right to petition their legislators but prominent donors get to the head of the line where they stand a greater chance of being heard than the average person Candidates need money to run elections Their need for money creates a symbiotic relationship with campaign donors who want to supply funds to gain a right of entry with the politician In 2000 an estimated 39 billion was spent on elections in the United States This is in addition to and should not be confused with the millions spent on lobbying Many of these funds come from the business community The amounts sound substantial but they are actually minute compared with the possible value of favorable public policy decisions62 Because US campaign finance law bans corporate political contributions funds must be channeled through indirect streams Some firms worry about the potential damage to a company s image and reputation Rather than risk alienating customers and shareholders they have political contribution policies that affirm nonpartisanship For instance the Campbell Soup Co rejects all political solicitations because it does not want to associate its products with a particular party or candidateIBM has a similar policy63 For companies that choose to get involved one way to make donations is through a political action committee PAC PACs are voluntary groups of individuals organized to support political candidates There are 6500 federally registered PACs in the United States and corporations directly sponsor the majority Over half the Fortune 500 companies have PACs64 Wal Mart is currently the largest corporate political contributor through its PAC65 The Federal Election Campaign Act of 1971 legitimized the practice of using PACs Before that time corporations had funneled campaign contributions through executives individual gifts which were unlimited and unregulated Direct corporate contributions to federal campaigns had been illegal since 1907 but companies got around this rule by paying bonuses to managers that were subsequently redirected to candidates The campaign reform act put a ceiling of 25000 on individual campaign contributions thus ending the era of the large political donor The Federal Election Commission FEC is the government agency charged with regulating these practices Under the 1971 act as amended in 1974 and 1976 companies may collect unforced donations from employees shareholders or their families and distribute them through a PAC to candidates for political office Easing the task of maintaining a corporate PAC employee contributions can be made through a payroll deduction plan and company funds can be used to organize and pay 61 Joseph E Cantor Campaign Fz39nancz39ng Congressional Research Service Issue Brief for Congress August 3 2004 52 Business for Social Responsibility Issue Brief Political Contributions CC 20012006 63 Stephen Ansolabehere Iohn M de Figueiredo and ames M Snyder r Wl1y is There So Little Money in US Politics journal of Ec0n0m239c Perspectives Winter 2003 pp I0530 54 Hansen and Mitchell Disaggregating and Explaining Corporate Political Activity 65 Edward Alden and Neil Buckley WalMart Becomes Largest Corporate Political Investor The Financial Times February 24 2004 82 142 CHAPTER 7 120 100 E 9 E W 80 8 0 Corporate 9 g 69 w Trade Membership gm Health 40 lte Labor U E gtlt Unconnected 20 is Y gltr39 X 0 I I I I I 1 E I I I 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 86 88 90 92 94 96 98 2000 02 04 FIGURE 71 Growth of corporate and business association PAC contributions Source Federal Election Commission administrative costs The corporation for example is permitted to pay for printing and mailing PAC solicitations salaries of PAC employees rent and other expenses of maintaining PAC offices and attorneys accountants and other professional advisors to the PAC Corporate PACS donated nearly 116 million in hard money to federal candidates in 2003 04 over twice as much as in the mid 1980s see Figure 71 Hard money refers to funds that are tracked and limited by the FEC There are also some 900 national PACS sponsored by commercial or professional membership associations such as realtors doctors or trial lawyers and they gave away 83 million to federal candidates in 200304 Other PACS focus on state or local issues In Massachusetts for example 26 new state PACS organized in 199293 Included were such obscure or specialized groups as the Professional Tow Operators of Massachusetts PAC the Political Committee for Responsible Massachusetts Growth representing commercial developers and the FBMAPAC associated with Fleet Bank the state s largest66 These organizations gave thousands of dollars to state politicians or worked to support or defeat ballot questions I Not all PACs are connected to business Labor unions for example have also established PACs Citizen groups such as the American Association of Retired Persons and special interest organ izations such as the National Ri e Association also form these organizations to support friendly political candidates The amounts given are much less than those given by business PACS to national campaigns see Figure 71 55 Craig Sandler The Price of Power The Brookline TAB October 12 1993 83 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 143 The amounts solicited and donated by PACS are not large in isolation No one may contribute more than 5000 to a particular PAC in one year and the PAC cannot give more than 10000 in a twoyear election cycle to a candidate or over 20000 to a national party committee in a calendar year There are many ways for companies to make bigger gifts however One approach is to contribute to a 527 Group so named after a section of the tax code These non profits may raise unlimited soft money which they use for voter mobilization and certain types of issue advocacy but not for efforts that expressly advocate the election or defeat of a federal candidate Donations are unlimited although they must be disclosed to the Internal Revenue Service but usually not to the FEC Soft money makes a mockery of US campaign finance laws It indirectly influences federal elections but is raised and spent outside the purview of federal laws and would be illegal if spent directly on a federal election Millions of dollars in corporate funds used to be given to national political parties each year With great fanfare the Bipartisan Campaign Reform Act also known as McCainFeingold for the two lead senators who sponsored the law in 2002 closed this particular loophole However corporations simply shifted much of their soft money donations to the state level which are not covered by the federal legislation Also none of the provisions apply to fundraising for presidential inauguration ceremonies Companies and their executives picked up almost the entire tab for President George W Bush s second inaugural in 200567 Another soft money loophole in the law allows businesses to engage in so called independent expenditures These are campaign activities to support or defeat clearly defined national candi dates The expenditures are independent in the sense that they are not run through a candidate s campaign As long as the activities are not coordinated with the person seeking office no legal limits apply to what PACS can spend on independent efforts to defeat their opponents Companies can also support issue advertising campaigns as discussed earlier which may have the effect of obliquely in uencing political contests The McCainFeingold law now restricts these types of political expenditures shortly before national Election Day Another technique used by companies to dodge the spirit of campaign finance rules is bun dling Bundling is when an individual appeals for contributions to a congressman senator or other candidate The bundler acts as the collection point for these hard money donations which do not count against the personal 2000 limit He or she collects the checks and delivers them to the politician reaping the political credit for raising the money In the 2004 primary campaign Bush raised at least 765 million of his primary campaign budget from 548 bundlers His opponent John Kerry used the same approach less successfully raising about half as much money from a similar number of bundlers58 The vast majority of bundlers are corporate executives They are recruited because of their contacts with other executives in the company and industry as well as with customers and suppliers69 For example the disgraced exCEO of Enron Ken Lay bundled over 100000 in individual contribu tions for candidate Bush in the 2000 election far exceeding what the company PAC could give by itself There also is family bundling Carl Lindner Chiquita Brands and his wife supplied 786000 in contributions for the 2000 election with two thirds given to Republicans Other family members donated tens of thousands more 57 Public Citizen The Importance of Bundlers to the Bush and Kerry Campaigns PostElection Summary of Findings 2004 58 Public Citizen Busl1 s 2005 Inauguration Celebration Brought to You by Corporate America Update II Ianuary 18 2005 59 Tim Reason Office Politics Banned from Making Political Donations Companies Harvest Them from Employees Instead CFO Magazine July 1 2004 84 144 CHAPTER 7 One last tactic that some politicians use to get around campaign finance limitations is by establishing a non profit foundation to which contributors can make unlimited donations These foundations are technically nonpartisan charities but they sometimes engage in political activities A recent controversial example is former House Majority Leader Tom DeLay s Celebrations for Children Inc VVhile net proceeds purportedly go to children s chariues Delay s foundation also paid for dinners a golf tournament a rock concert Broadway tickets and the other fundraising events at the 2004 Republican national convention giving donors a new form of soft money contributions70 Criticism and Reform The main charges against current US campaign practices are two First the ood of money into politics helps push the cost of running for office to unacceptable levels Top spenders win most of the races The Center for Responsive Politics reports that in 2000 the price of admission to the House of Representatives was about 800000 for the Senate it was 74 million Democrat Jon Corzine of New jersey spent an estimated 60 million of his personal fortune to win election to the Senate establishing a new record for a Senate campaign Office seekers need spend far less in other countries Compare the US figures with the British general election in 2001 Campaign spending per party was legally capped at just 28 million That is about one tentl1 of the US total when prorated per eligible voter American politicians get caught on a treadmill of fundraising responsi bilities that leaves them too little time to focus on issues and leads them to take money wherever they can find it Second the diverse sources of campaign funds tear apart cohesive influences in US politics by pressing politicians to act parochially Fred Wertheiiner former president of Common Cause con tends that PAC money is like a laser beam It helps a particular interest group play out very powerful influences on the issue that it cares about while the general public is kind of diluted and left out of it What are the balance wheels The issue is one of weighing That whole balancing process is done by representatives If they are not free to balance then our system s not working 71 Numerous reforms have been adopted over the years to reduce money s debasing influence on American public policy and create a better balance between business and other interest groups The Pendleton Act was passed in 1883 to professionalize the federal bureaucracy by introducing an objective system of hiring and promotion It took decades to fully carry out the law s provisions despite continuous political pressure from civic organizations The Tillman Act of 1907 banned corporate campaign donations thus trying to stop industrial interests from exercising untoward influence on public policy The fact that we are still wrestling with these issues in the 21 century is testimony to their resilience Another idea is to put a ceiling on campaign spending To stop the escalating race for funds candidates would be barred from spending above a certain amount for election However the Supreme Court in 1976 declared it unconstitutional for the law to set any limit on candidates expenditures of their money and on overall spending in a campaign unless they voluntarily accepted public financing Public financing exists now for the Presidency Some reformers propose expanding this practice for House and Senate races as a Way to break the money cycle Similar methods have long been the 70 Nicholas Thompson Corporate Donors Intent Scrutinized Boston Globe june 12 2005 71 Quoted in Smith Power Game p 263 85 BUSINESS INTEREST GROUPS AND POLITICAL INFLUENCE 145 Germany was the first country to finance its parties starting in 1959 Political contributions from trade unions are illegal and the country s conservative parties also want to be less depend ent on donations from industry Currently the parties in the Bundestag get about 150 million per year The Scandinavian countries follow the German model Since the 1960s they pay subsidies to par ties based on their share of the vote Parties must publish information revealing their my39or donors In Italy state financing was introduced in 1974 but the practice did not stop electoral abuses Italians rejected state financing in a refer endum in 1993 Italian parties also are required to publish details of how they get money and the names of big contributors Great Britain is an exception with even less regulation than the United States It provides no money for parties election expenses It does not limit what they spend and does not have strict disclosure requirements practice in Europe with mixed results see Box 72 Being one of the two main parties Repub licans have resisted this suggestion charging that public financing does not level the playing field but blatantly favors incumbent office holders Because incumbents are better known they have campaign advantages in not having to spend as much as their challengers to have the same effect As a minority party with fewer incumbents in Congress Republicans would be further disabled by public financing Because of the difficulty in improving the campaign nance system several states have passed term limits for office holders to reach the same goal of cleaning up politics The idea of term limits is to force turnover among politicians and prevent them from becoming too cozy with interest groups and lobbyists It is the other major party the Democrats that is apt to be opposed to this reform ust as public financing might hurt Republicans because they have fewer incumbents term limits might hurt Democrats because they have the most members with long tenure in office Term limits could have the reverse effect however and increase the in uence of special interests Veteran politicians with knowledge and ex perience can be less dependent on lobbyists for information compared with rookie politicians In the 1993 budget debate for instance lobbyists specifically targeted freshmen in Congress on the assumption that they are the easiest to influ ence72 By lowering the experience level in Washington and the state capitals term limits would bare the government to more outside pressure than it is currently experiencing As more con servatives won elections in the 19903 however the gas went out of the term limit movement CONCLUSION This chapter has reviewed the role of interest groups in determining public policy We have seen that many groups vie in the political marketplace for in uence and that business interests are among the most active and effective The goal is to produce benefits for the rin such as a 72 oel Brinkley A Strategy on the Budget Round Up the Greenhorns New York Times fuly 23 1993 86 146 CHAPTER 7 friendlier regulatoiy environment lower taxes or additional government contracts We have looked at the weapons in the modern corporate political arsenal Business has devised strategies for using these weapons craftily and with stealth although the power of companies is neither constant nor monolithic For firms to get the policies they want they have made public affairs and especially government relations into critical areas of modern corporate strategy These activities have not been without cost to the larger society as they have tended to Balkanize decisions and stall change Some countries seem to have done better than the United States in focusing political energy and making hard choices in part because they have different political institutions and procedures These institutions and procedures are our main subject in the next two chapters 87 88 1 HYBRID ORGANIZATIONS growth or scale of impact particularly for placebased solutions hybrid organizations can indeed be more effective and enduring than traditional organizations in meeting humanity s common challenges FIGURE 1 Hybrid organization definition See also page 8 Hybrid organization A market oriented and commongood mission centered organization Hybrid organizations may exhibit the foilowing characteristics Non financial performance valuation Privately heid by connected individuai investors Sub market rates of return Aiternative capitalization This book presents the results of an 18month effort into researching companies that pursue the twopronged goal of environmental sustain ability and pro tability Such organizations are referred to here as hybrid organizations a marketoriented and commongood missioncentered organization see Fig 1 This book compiles the wisdom trends and lessons learned from the 47 hybrid organizations that provided valuable responses to survey questions about strategies nances organizational structure leadership processes and innovations Five of these compa nies allowed the research team to perform interviews with their organiza tions for the development of case studies 68 6 HYBRID ORGANIZATIONS The hypothesis for this research is that the inherent business model of hybrid organizations can contribute positively to environmental sus tainability outcomes The business model of this type of organization strives to have a positive impact on the environment not just to mini mize or reduce negative impact Hybrids are different from traditional forpro t and nonpro t organizations because their primary motivation is to use business and market forces as tools to solve the world s largest challenges This book highlights hybrid organizations that are effectively combining goals of nancial viability and environmental stewardship Since minimal research has been done on this combination the main aim of this book is to explore the trends solutions and lessons learned from hybrid organizations with speci c environmental missions Documenta tion and better understanding of these ndings may facilitate value cre ation for other practitioners in this sector as well as provoke discussion among researchers exploring highimpact organizations Furthermore understanding the struggles and successes of the hybrid organizations in this study will help future entrepreneurs combat environmental degrada tion in more effective ways Background hybrid organizations defined According the United Nations Millennium Development Goals poverty income and gender inequality disease and environmental degrada tion are among the most challenging problems facing the world today Sachs 2005 Numerous approaches to solving these problems have been attempted by local and national governments international organiza tions regionai nonpro t organizations and forpro t businesses seeking to adhere to corporate social responsibility CSR standards While no one company or organization is expected to solve the World s problems alone some nonpro t and formpro t organizations endeavor to be valu able and signi cant contributors to larger solutions However the cur rent approaches of both traditional nonpro ts and forpro ts have often proven ineffective in generating and continuing large scale change A growing understanding exists in the nonpro t world that traditional funding sources will no longer be adequate to address such problems and that organizations cannot rely upon a continuous supply of donor funding for their operations Alexander 2000 Draper 2005 The result 1 WHY HYBRID ORGANIZATIONS 7 is a need for a new emphasis on social enterprise models that provides some direction for solving this funding problem through earned income creation though work in this eld is in a nascent phase Various chal lenges remain to be solved in this new area for example the tax clas si cation of nonprofit social enterprises potential mission drift among nonpro ts undertaking earned income strategies and achieving consen sus regarding the appropriateness of nonpro t organizations in competi tive business ventures Billitteri 2007 Foster and Bradach 2005 Heritage and Orlebeke 2004 For all the important work being done by nonpro t organizations throughout the world such effort has yielded limited suc cess in achieving largescale solutions Traditional businesses have fared even worse due to their reluctance to address development goals primarily leaving social and environmen tal issues to government agencies and civil society Though some people argue that the majority of the problems facing the world are the result of market failures many businesses answer that it is not in their corporate mandate to attempt to address these problems This situation is slowly changing and many businesses now understand that it is in their best interest to deal with social and environmental issues Beheiry et al 2006 Hillman and Keim 2001 Swanson 1999 The growth of corporate philan thropy and sustainability departments within many large multinational corporations attests to this changing attitude among businesses How ever even with this new emphasis on social and environmental issues the traditional business model often fails to adequately address the criti cal problems facing the world today Some propose that the optimal approach combines the best of nonpro t organizations and forpro t businesses These hybrid models which are variously referred to as Fourth Sector Blended Value ForBene t or BCorporations may hold promise for addressing the most troublesome challenges facing both the developed and developing Worlds Billitteri 2007 Emerson and Bonini 2003 Strom 2007 While some research has been conducted on this type of organization few comprehensive stud ies have been completed and little has been done to understand com pany best practices in this eld Alter 2004 Haugh 2005 Smallbone et al 2001 Kim Alter Founder and Managing Director of Virtue Ventures has con ducted research on hybrid organizations Her hybrid spectrum repro 1 See also About B Corp wwwbcorporationnetabout accessed January 29 2009 06 8 HYBRID ORGANIZATIONS duced in Figure 2 categorizes hybrids along a continuum according to their relative position between the traditional nonpro t and forpro t spaces The Virtue Ventures website states All hybrid organizations generate both social and economic value and are organized by degree of activity as it relates to 1 motive 2 accountability and 3 use of income Alter s model presents a taxonomy of four types of hybrid organiza tions On the left side of the hybrid spectrum are those nonpro ts whose business activities generate pro ts to fund their social mission and report back to their stakeholders On the right side of the hybrid spectrum are forwpro t companies that create social value but are mainly driven by pro ts and are accountable to shareholders FEGURE 2 Ater s hybrid spectrum SourcewwwvirtueventurescomsetypologyindexphpidliYBRiDSPECTRUiI1amplmO Hybrid spectrum Traditional N lquot f39t Social I I v A Iquot 39I Pz z Traditional nonprofit Wm enterprise forprofit mcome generating activities Pro t mailting motive Shareholder accountability Profit redistributed to shareholders While Alter s model is useful in representing differences and trade offs among hybrid organizations we propose that the realm of hybrid organi zations cannot be categorized along the single dimension that her model employs rather pro t and mission motives are relatively independent organizational dimensions Indeed hybrid organizations exist that are highly driven by both pro t and mission and thus challenge the notion of trade ofis between mission and pro t motives We developed the illus tration in Figure 3 to represent the blurring of boundaries between tradi tional nonpro t and forpro t organizations 2 wwwvirtueventurescoInsetypologyindeXphpidHYBRlDSPECTRUlVlampimm0 accessed May 27 2009 I WHY HYBRID ORGANIZATIONS 9 FIGURE 3 Mission and profit dimensions of business models Tradigional nonpliofits Mission motivation i i K Profit motivation This book explores organizations motivated by both mission and pro t Such hybrid organizations not only blur the distinctions between the nonpro t and for pro t sectors but through their emphasis on envi ronmental social and nancial value creation they also provide another business model for addressing worldwide societal problems Forpro t hybrid organizations will not be held accountable solely to the legal duciary duty to their shareholders and can thus gain the exibility to be innovative in their approaches to these problems At the same time because these organizations depend on suf cient pro tability to main tain existence and serve their missions critics may contend that they are hampered by their dual motivations Scope A hybrid organization is de ned as a market oriented commongood mis sion centered organization which operates in the blurred space between traditional forpro t and nonpro t enterprises in reviewing industry and L6 10 HYBRID ORGANIZATIONS academic literature we identi ed a gap in research on hybrid organiza tions that are in particular forpro t and privately owned The goal of this book is to ll that gap with a speci c focus on companies with an environmental sustainability mission This book narrows criteria for environmental sustainability mission driven companies to encompass those where either the direct business activity products or services or the most signi cant inputs raw materi als or resources contribute to at least one of the following basic human needs 0 Clean air 0 Clean energy 0 Clean water Sustainable food or agricultural systems Sustainable housing While little has been written about for pro t hybrid organizations a larger body of literature exists on corporate social responsibility sustain able businesses and nonpro t social enterprises These elds provide the basis for hybrid organizations but the focus has often been narrow or concentrated on a single aspect of the eld Research into traditional businesses does not address organizations that go beyond corporate social responsibility While some authors have shown that it is in businesses best interest to deal with social and envi ronmental issues Beheiry et al 2006 Hillman and Keim 2001 Reed and WRI 2001 Swanson 1999 they do not address organizations that make these their primary mission Recently a good deal of literature has been written about social entre preneurship but a general focus on addressing social problems mostly ignores environmental issues A new emphasis on sustainable entrepre neurship the creation of businesses that have both social and environ mental goals has garnered much attention but literature on the subject also falls short of offering a comprehensive understanding of hybrid orga nizations Sustainable entrepreneurship research deals primarily with the formation of these enterprises and the motivations behind them in addition some recent research has focused on nonpro t and business co operation but these projects fail to address hybrid organizations which bridge the two types of organizational motives Overall the literature on hybrid organizations remains lacking with regard to research speci cally addressing hybrid organizations Z6 12 HYBRID ORGANIZATIONS Corporate social responsibility Corporate social responsibility is not a new concept but recently it has received much research interest Many writers have attempted to show that business is a force for change with regards to social and environ mental issues and can be a main driver to create a more just and sus tainable world Hart 2005 Prahalad 2005 Robinson 2004 SustainAbility I 2007 This research has been both theoretical and empirical with much focus on the effect of corporate social responsibility on the nancial per formance of an organization The empirical evidence is mixed with regard to the relationship between social focus and nancial success Some sug gest a tradeoff between the two Burke and Logsdon 1996 McGuire et al 1988 McWilliams and Siegel 2000 while others do not conceptualize the relationship in such a straightforward manner Empirical and theoretical research has explored corporate social responsibility for almost 50 years Early empirical researchers supported the idea that superior business practice equated to social responsibil ity Davis 1960 Whetten er al 2002 Wren 1979 More recently some researchers have concurred suggesting that businesses need to respond to social issues in order to be viable Engen 2005 Johnson 2000 while others have seen it as simply good business sense Dentchev 2004 Epstein and Roy 2003 During these same decades theoretical approaches have looked into more descriptive studies of corporate social responsibility Much has been written about the importance of the attitudinal motivations of manag ers toward corporate social responsibility trumping the nancial factors involved Bowman and Haire 1975 D nizD niz and Garcia Falc n 2002 Marz et al 2003 Quazi and O Brien 2000 Rojsek 2001 Others have relied on case studies to understand corporate social responsibility Weiser and Zadek 2000 Overall this research has simply set the stage for fur ther inquiry into the linkages between corporate social responsibility and nancial performance While theoretical research into corporate social responsibility has sug gested a positive relationship between businesses response to social issues and nancial performance Carroll 1999 Wood 1991 the empirical evidence is mixed Over the years many different studies have attempted to show that corporate social responsibility is good for business How ever no clear consensus on this linkage has emerged The results have run the gamut from a negative relationship between the two to a neutral 2 THE HYBRID LANDSCAPE 113 one and nally to a positive relationship Table 2 provides an overview of the ndings of this relationship TABLE 2 Research on linkages between social and financial performance For a more detaiied example see Salzmann et al 2005 Relationship Framework Authors Negative Tradenoff Friedman 1962 Vance 1975 Managerial opportunism Preston and O39Bannon 1997 Posner and Schmidt 1992 Alkhafaii 1989 Negative synergy Preston and O Bannon 1997 Neutral Supply and demand theory Mcwiliiams and Siege 2000 Anderson and Frankle 1980 Aupperle et al 1985 Freedman and Jaggi 1982 Positive Social impact Cornell and Shapiro 1987 Pava and Krausz 1996 Preston and O39Bannon 1997 Available fundsslack resources Waddock and Graves 1997 McGuire et al 1988 Kraft and Hage 1990 Positive synergy Waddock and Graves 1997 Stanwick and Stanwick 1998 Preston and O39Bannon 1997 Pava and Krausz 1996 Although no agreement exists concerning the relationship between cor porate social responsibility and nancial performance this research has been helpful in establishing a baseline understanding of hybrid organiza 96 11 HYBRID ORGANIZATIONS tions This concept of corporate social responsibility represents a pre cursor to hybrid organizational theory and understanding the parallels can illuminate the motivations and expectations of hybrid organization practitioners However the research falls short of clarifying what exactly a hybrid organization is and how it functions in the realm of business and nonpro t organizations Furthermore the research often leaves out any mention of environmental motivations and performance Sustainable entrepreneurship Another topic receiving considerable research over the past few years is sustainable entrepreneurship The focus of this research has been pri marily based on the entrepreneurial aspects of businesses and individu als and their use in improving environmental and social issues While this research is exceptionally valuable to the understanding of hybrid organizations and their creation once again the focus illuminates only a small part of what constitutes a hybrid Much of the research in this area starts with the traditional de nition of entrepreneurship as value creation through innovation Drucker 2006 Schumpeter 1989 Some simply View sustainable entrepreneurs as one category of entrepreneurs with little difference between them and tradi tional entrepreneurs Dees 1998a Others see valuesbased sustainable enterprises as a different breed requiring a unique perspective Brown and NetLibrary Inc 2005 Parrish 2005 A great deal of recent research has been undertaken in the eld of sus tainable entrepreneurship Abrahamsson 2007 Cohen and Winn 2005 Crals and Vereeck 2004 Keijzers 2002 and entrepreneurs in this eld have been called by many different names Emerson and Twersky 1996 The term ecopreneur dates back to the early 1990s Labels such as eco preneuring and ecopreneurship have shown up in the literature since this time Bennett 1991 Blue 1990 Dixon and Clifford 2007 Schaper 2002 2005 The term green entrepreneur has also been used to label practitio ners in this eld Berle 1991 Finally the label of sustainability entrepre neurship or sustainopreneurship has shown up in more recent research Abrahamsson 2007 Gerlach 2003ab Hockerts 2003 Schaltegger 2000 However regardless of the terminology the commonality among entre 2 THE HYBRlD LANDSCAPE 15 preneurs in this eld is their use of traditional business skills and knowl edge to accomplish social and environmental goals While the idea of sustainable entrepreneurship appears quite similar to hybrid organizations the research is limited The focus on sustain able entrepreneurship helps to understand the motivation of individual entrepreneurs and the formation of their companies However it does not assist in comprehending the ongoing operations of mature hybrids or their adaptation to changes as markets mature The use of different terms to discuss sustainable enterprises and their practitioners confuses the issue still further Additional research is needed in order to understand many of the issues facing hybrid organizations Although the research into sustainable entrepreneurship can help understand the formation and players behind hybrid organizations its focus is necessarily more narrow than the broader scope of hybrid organizations Social enterprise and business nonprofit alliances As noted above many writers see forpro t businesses and nonpro t organizations as existing on a continuum with pure businesses seeking only pro t maximization on one end of the spectrum and valuesbased organizations working solely for environmental or social issues on the other end of the spectrum Alter 2004 Conaty 2001 Peredo and McLean 2006 Social enterprises are often placed near the center of the spec trum and are almost exclusively looked upon as nonpro t ventures Alli ances between nonpro ts and businesses are simply viewed as linkages between two separate parts of the spectrum While the research into non pro t social enterprises is quite extensive little emphasis is placed on forpro t businesses with similar goals and aspirations Also although the alliance between nonpro ts and forpro ts is beginning to receive more attention almost no attention is given to organizations that fully encompass both ends of the spectrum in a single enterprise Much of the research into social enterprises focuses solely on non pro t organizations Dees 1998b Dees er al 2004 Emerson and Twersky 1996 Hall 2005 Some state that social enterprises can be formed only through nonpro t organizations Taylor et al 2000 or View social entre 176 16 HYBRID ORGANIZARONS preneurship simply as good business practice within nonpro ts Reis and Clohesy 2001 Others question whether social enterprises are good for nonpro t organizations or addressing social issues Casselrnan 2007 Foster and Bradach 2005 While the majority of the research on social 9 enterprise focuses solely on the nonpro t realm comprehension of this organizational form still proves advantageous in understanding for pro t hybrid models The research on social entrepreneurship and social enterprises is quite extensive Much has been written about a de nition of social entrepre neurs and social enterprises Boschee and McClurg 2003 Dees 1998b Case studies of social enterprises are beginning to become more preva lent Alvord et al 2004 Boschee 2001 Emerson and Twersky 1996 Mas sarsky and Beinhacker 2002 Shaw et al 2002 and many are available through websites on social entrepreneurs Taken as a whole the research on social enterprise and social entrepreneurs demonstrates the ability of nonpro ts to undertake commercial endeavors However little is writ ten about environmental organizations attempting similar practices The research does not address organizations and entrepreneurs undertak ing social and environmental value creation as traditional businesses or crossing de nitional boundaries Research into alliances between nonpro t organizations and busi nesses attempts to ll in the aforementioned void Some ailiances demon strate strong linkages between traditional businesses and environmental and social issues Most of the research however does not focus on the bene ts of such linkages Some attempt to show how business and non pro t alliances bene t environmental causes through green alliances Arts 2002 Austin 2000 Austin er al 2007 Dacin er al 2007 However the majority of the research reviews only cases of alliances forgoing any anal ysis of costs or bene ts Bendell 2000 Yates 2007 Overall the existing research into nonpro t and forpro t alliances appears to be bene cial in understanding only some of the aspects of hybrid organizations The case studies and de nitions of social entrepreneurship and social enterprises can be quite useful as a guide to understanding hybrids but the focus on nonpro ts limits the scope of the research As noted ear lier the majority of the research focuses on social issues for the most 1 See for example Ashoka wwwashokaorgfellows accessed May 7 2009 and Schwab Foundation for Social Entrepreneurship wwwschwabfound0rgsf SocialEntrepreneursindexhtm accessed May 7 2009 2 THE HYBRID LANDSCAPE 17 part ignoring environmental issues Hybrid organizations often encom pass both social and environmental concerns and the current research is minimal in this area Literature summary The research on hybrid organizations is relativeiy new The concept of organizations crossing the boundaries between forpro ts and nonpro ts has appeared in the literature only recently Some have posited that this requires a new legal de nition beyond the stringent nonpro tfor pro t delineations Billitteri 2007 Etchart and Davis 2003 Posner and Malani 2006 Others have expressed interest in creating a new business model to encompass this emerging eld Birkin et al 2007 2009 Engen 2005 A few case studies have been written about hybrid organizations empha sizing the viability of this new form but do not offer deep analysis of the organizations Cooney 2006 Hudnut et al 2006 A few authors have attempted to show the importance of organizations that bridge nonpro ts and forpro ts but they have not given a comprehensive picture of what constitutes a hybrid Brandsen er al 2005 Davis 1998 Hockerts 2003 Johnson 2000 Strom 2007 Overall new research is needed into hybrid organizations The follow ing analysis of practitioners and their activities in this eld will go a long way towards understanding the formation of hybrids their environmen tal practices and how they are adding value while attempting to solve some of the most pressing issues facing the world today 2 SeealsoCorporation2020 NewPrinciplesofCorporateDesign wwwcorporation2020 org accessed January 30 2009 96 D 3gt Ln rn gx U1 l D lt g g2 naiquotquotp 39 quot quot r w L quot n im 0w w w A quot We me gmvry M e as W a aw Wquotir v x l l gaze late at as S inf P L P L train nee trig Introduction As of 2008 Maggie s Organics headquartered in Ypsilanti MI was the oldest organic apparel company in the United States see Table 15 for an overview of the company Holding itself to the highest standards of social and environmental responsibility Maggie s Organics is dedicated to changing the Way business is done in the apparel industry The com pany was founded with the goal of saving land from the devastation of conventional cotton growing and as a rst mover it played an important role in the development of the US organic cotton apparel industry One of Maggie s core values is that there is no environmental sustain ability without social responsibility Thus all products are made by workers in the US and Latin America who have a safe working environ ment fair wages and an active voice in their future The most celebrated 1 wwwmaggiesorganicscomsociaiaspectsphp accessed May 28 2009 8 MAGGIL39s ORGANICS 107 TABLE 15 Maggie39s Organics overview Maggie s Organics in 2oo8 Yearfounded 1992 Annual revenue Not available No of employees 14 Headquarters Ypsilanti MI USA Environmental focus Sustainable agriculture Profitability level Consistently profitable since 2004 Mission To produce and provide comfortable durable affordabie and beautiful articles of apparei and accessories made from materials that restore sustain and enhance the resources including human from which they are made example of this commitment is the 100 workerowned cooperative in Nueva Vida Nicaragua with whom Maggie s has worked closely since 1999 Having worked for organic food companies for several decades before founding Maggie s in 1992 Bend Burda founder and President is a pio neer of the organics industry Her perspective on the mission driven val ues of her company she explains is unique I am not a fair trade person and I m not socially responsible This is simply the way we choose to do business and we wouldn t do it any other way 2 The passion and dedi cation that she infuses into her business has resulted in deep personal relationships with all the producers and many of Maggie s customers Bena and her team work hard to communicate the benefits of organic cotton to their producers and consumers alike She believes that this con nection to the company s mission contributes to the development of loyal and trusting relationships which are the cornerstone of Maggie s nan cial environmental and social successes 2 Personal communication with B Burda Ypsilanti Mi January 24 2008 96 108 HYBRlDORGANiZAT1ONS Overview and history Industry overview organic cotton apparel The organic cotton apparel industry began in the US in the early 1990s Fueled by the eco fashion trend of the early 1990s and demands from apparel companies such as Esprit and Levi s who both introduced eco clothing lines organic cotton farm acreage in the US grew from 100 acres in 1989 to 25000 acres in 1995 But there were a variety of problems associated with this production expansion First organic cotton items were more expensive and custom ers weren t willing to pay a premium for them Second companies had trouble telling the organic cotton story without discounting their con ventional cotton items In addition the supply of organic cotton was vola tile because the industry itself was so new Moreover the fashion industry went through a retro phase in the mid1990s which brought synthetics back into favor and caused the eco clothes trend to ounder For all these reasons the bottom fell out of the organic apparel market many companies went out of business or stopped offering organic cotton lines V and by 1996 US organic cotton farming had dropped to 10000 acres However 1996 also marked the year that Patagonia made the decl sion to use only 100 organic cotton in its cotton clothing This fueled FIGURE 27 Estimated global retail sales organic cotton products Source Organic Exchange 2006 3000 2500 A C 2000 A 1500 USD millions 500 W 0 0 1 I l 39 39 2001 2005 2006 2007 2003 2008 sales figure is projected 8 MAGGlE39S onomsucs 109 the renewed growth of the organic cotton apparel industry Within a few years Patagonia s efforts helped to signi cantly raise consumer aware ness about the environmental and social value of organic cotton in the US The industry saw tremendous growth from 2000 to 2008 in part due to longterm commitments by brands and retailers to use organic cotton and in part because of overall consumer lifestyle changes towards sustain ability As Figure 27 shows the estimated global retail sales of organic cot ton products increased from 245 million in 2001 to 583 million in 2005 re ecting an annual average growth rate of 35 By the end of 2008 sales were expected to reach close to 2 billion Organic Exchange 2006 Why choose organic cotton Conventionally grown cotton is one of most heavily sprayed eld crops in the world and conventional cotton growers typically use many of the most hazardous pesticides on the market These include aldicarb pho rate methamidophos and endosulfan Utilizing 2 of worldwide farm land conventional cotton farming consumes 10 of the world s pesticides and 25 of all insecticides Sprayed from the air these highly toxic pesticides often drift over farm houses roads water sources and workers contaminating water and soil and creating health dangers for wildlife and humans Because cotton is also a food crop namely through cottonseed oil used in snack foods and in rations for beef cattle pesticidelaced cotton that enters the food sup ply poses a global public health threat The threats of conventionally grown cotton are disproportionately distributed around the world because 99 of all cotton farmers live in developing countries the developing world bears the brunt of the envi ronmental and health problems caused by conventional cotton produc tion CEJF 2007 In contrast organically grown cotton prohibits the use of synthetic chemicals to control pests except in extreme cases Instead natural pred ators and intercropping are used to control pests and special machinery and re control handle weeds EJF 2007 A eld must be pesticide free for at least three years to be certi ed organic 3 Problems with Conventional Cotton Production PANNA Pesticide Action Net work North America wwwpannaorg iesconventionaiCottondvhtrnl accessed January 29 2008 A6 110 HYBRiD ORGANIZATIONS Recognized organic ber certifying organizations include Control Union World Group formerly SKAL OCIA International and NASAA All three organizations are accredited by the National Organic Program NOP of the US Department of Agriculture USDA and this accreditation allows products certi ed by these organizations to be sold in the US The NOP standards apply to organic agricultural production within the US as well as to organic products being imported into the US These standards require eld certi cation only meaning that only the organic certi cation of the raw commodity cotton or wool is recognized in the US and as of 2008 there were no organic processing standards Background information In 1992 Maggie s Organics was founded in Ann Arbor MI by Bena Burda and her former business partner Jennifer Mueller By then Bena had worked in the organic food industry for 14 years Maggie s was the second organic apparel company founded in the US and is the oldest organic apparel company remaining in the market as of 20085 It is one of the few companies in the apparel industry that sells 100 organic clothing The idea for Maggie s started with an organic tortilla chip In the early 1990s Bena was working for an organic food company that was sourcing blue corn from Texas farms to produce tortilla chips She noticed that some of the chips were faded in color and asked a farmer for recom mendations on how to improve the quality of the corn He recommended rotating in organic cotton crops on the land that the blue corn was being grown When his cotton produced a yield the farmer asked Bena to help him sell it Bena s business partner invested 500000 into the organic cotton berbefore the company even had its rst product The rst products socks produced by North Carolina knitters emerged soon thereafter 9 Bena considered the socks a good rst product because they were small and inexpensive impulse purchase items These socks became one of the rst nonfood products sold at the Natural Food Expo in Califor nia5 This event not only marked the beginning of the company s growth 1 National Organic Program US Department of Agriculture wwwamsusdagov nopindexiehtrn accessed January 29 2009 S A company called Eco Sport was the first seller of organic cotton apparel in the US but no longer exists 6 The Natural Food Expo is now called the Natural Products Expo 8 MAGGlE39S ORGANICS 111 it also the highlighted one of the company s primary competitive advan tages selling organic apparel products at retail stores and trade shows dedicated to food products As of 2008 Maggie s Organics carried over 350 stockkeeping units SKUs and sold its products in over 1500 stores across the United States7 Goals and objectives Maggie s Organics was founded with the intention of saving the planet s land from the devastation of conventional cotton growing Since 1992 Maggie s Organics has manufactured apparel and accessories made from certi ed organic bers certi ed by Control Union World Group OCIA International and NASAA while utilizing fair labor practices Maggie s mission is To produce and provide comfortable durable affordable and beautiful articles of apparel and accessories made from materi als that restore sustain and enhance the resources including human from which they are made3 Product information Maggie s produces organic clothing in four major categories 0 Apparel shirts and pants 0 Socks 0 Tights 0 Baby wear As of 2008 most of the apparel and baby wear was produced at 100 workerowned co operat1ves in Nicaragua and Costa Rica while the socks were produced by knitters in North Carolina and the tights were pro duced in Peru All Maggie s products are made from certi ed organic bers These are primarily cotton but several varieties of socks are made from organic 7 Approximately 7585 of these stores are conventional or natural food product stores 8 wwwmaggiesorganicscommaggiesstoryphp accessed May 28 2009 86 112 HYBRlD 0RGANlZATIONS wool Most of the products contain small percentages of other materialsd primarily nylon Lycra and rubber Doug Wilson Benas husb and an the Vice President of Sales describes Maggie s as a blue collar organic company meaning that while a small organic premium is included in the price they work hard to keep prices low and refuse to take advantage 0 the consumer quot10 Business strategy and model Strategy Maggie s competes in the US market for organic cotton apparel selling its products both to major chain stores and to smaller mom and pop retailers When it was founded in 1992 Maggie s was competing in a new market with new products see Fig 28 As the organic cotton apparel market matured and established itself Maggie s maintained its competi tive advantage by continuing to sell exclusively organic apparel products FiGURE 28 Maggie s Organics strategic positioning 1992 strategy WHERE THEY COMPETE zoos strategy Established market New market Same How game THEY compare A New game 9 Personal communication with D Wilson Ypsilanti MI January 24 2008 10 Organic cotton is more expensive to produce than regular cotton for two primary reasons 1 due to the crop rotation system one third of the cash prop is out of production every year 2 lack of synthetic fertilizers results in a 200 lower yield Ecomall 2008 8 MAGGlE39S ORGANICS 113 and distributing its products through the large US natural food distribu tors Bena s intention when starting Maggie s was to establish a new norm for the way a successful business could be operated within the apparel industry which she accomplished by creating a business that respected the environment and the lives of the people making the products Sourcing In the beginning the company sourced cotton primarily from US farmers Supply was readily available and this strategy aligned with the company s mission to purchase ber from the closest possible source thereby reduc ing the energy required to transport it to Maggie s production facilities But as the industry evolved and as demand for organic cotton increased it became more difficult for Maggie s to source only within the US As of 2008 Maggie s organic cotton is purchased from a number of dif ferent countries worldwide though as of 2008 its supplies came primarily from Turkey and were subsequently shipped to the production facilities in the US Nicaragua Costa Rica and Peru The company chooses not to source cotton from China or India due to the comparatively high energy costs required to transport the cotton to Maggie s production facilities as well as the questionable labor practices sanctioned by the governments of these countries The company is dedi cated to being a leader in a sustainable and responsible industry and the management team believes it is important to source from the most cred ible suppliers possible In addition to making sure that all of the cotton used for production is certi ed organic Maggie s abides by the Organic Trade Association OTA s American Organic Standards for Fiber Processing Production In the 1990s Maggie s production facilities were also exciusively US based including contractors in Alabama Tennessee North Carolina and California Between 1999 and 2000 Maggie s lost ve cutandsew house 11 Turkey produced the most organic cotton globally in the 20062007 growing season Frequently Asked Questions Organic Exchange wwworganicexchangeorgfaq2 php accessed January 29 2009 12 wwwmaggiesorganicscomstanciardsphp accessed May 28 2009 66 114 HYBRID ORGANIZATIONS contracts to bankruptcy and Bena became increasingly frustrated Wlth quality control problems and the inability of the remaining contractors to meet deadlines When she visited these facilities she discovered that the women producers were literally indentured servants Most she observed were undereducated single parents who had absolutely no incentive to produce highquality goods Bena s dissatisfaction with the production options in the US and the fact that many producers started to go out of business led her to con sider offshore options but she would only go ahead with this plan if she could be completely sure that Maggie s clothing was not produced under unethical sweatshop conditions in 1999 Peter Murray Maggie s Production Manager met Michael Wood ard the Director of the Center for Development of Central America a non pro t organization located in Managua Nicaragua at an organic meeting in the US Michael was trying to help Nicaraguan C0mIIll1I1iti 5 1 eC0Ve139 from the devastation caused by Hurricane Mitch in October 1998 which destroyed their homes and left many individuals living in refugee camps Unemployment was one of the biggest problems Michael saw so he and his team decided to explore models of workerowned co operat1V S The Production Manager asked Michael if any of these P901319 knew how to sew and Michael said that with 40000 people working in sweatshops in Nicaragua some of the people in the refugee camps would surely know how to sew Bena believed this was the answer to Maggie s production dilemma and told Michael if you can build this we will come She prom ised that if Michael could get the cooperative off the ground Maggie 3 would give it as many apparel sewing contracts as they had left in the US This was the genesis of a 100 workerowned sewing cooperative In the refugee community of Nueva Vida Nicaragua which today is known as The Fair Trade Zone FT Z Sewing Co operative This co operative is the world s rst 100 workerowned free trade zone a geographical area where some normal trade barriers such as tariffs and quotas are eliminated in hopes of attracting new business Historically multinational companies have used these zones to set up production factories in devel oping countries The Fair Trade Zone cooperatives status as a free trade zone contributes to the coop s economic success 13 Ants That Move Mountains Maggie s Organics Vid 0 2008 WquotquotWmaggiesorgamca commediaantswmv accessed January 29 2009 8 MAGGlE39S ORGANICS 115 Phish Food for thought Bena describes a major turning point in the history and strategic direction of Maggie s the ahaquot moment when she realized that it would be much easier to create high quality products when the producer herself has a vested interest in the enterprises success in 1997 Ben amp Jerry39s had just launched a new flavor of ice cream Phish Food in a joint venture with the eponymous band Ben amp Jerry39s and Phish organized a benefit concert to mark the launch of the new ice cream flavor and to raise awareness about the increasing pollution of Lake Champlain All the proceeds from the concert were designated to contribute to the restoration of Lake Champlain Ben amp Jerry39s was Maggie s biggest customer at the time account ing for approximately 4o of Maggie s sales revenues and an average of 1ooooo Tshirts per year The ice cream company placed an order with Maggie s for 14000 Tshirts which had been designed espe cially for the benefit concert Days before the concert the production facility owner called Bena and told her there was no way he could have the concert Tshirts ready on time Bena realizing that the future of her company was potentially at risk drove her van from Michigan to the facility in Ala bama She joined the production assembly line and when the owner told her to leave she responded by telling him that she was not leav ing until she got her Tshirts At first the women in the production facility looked at her like she was crazy and did not speak to her but Ben began to talk to them about the importance ofboth the organic cotton that they were sewing as well as the benefit concert for which the T shirts were being made For the first time the women had a connection to both the material they were sewing and the end customer and cause Many of them called home and told their families they were going to be getting home late from work that day and the rest of that week because they had a lake to save Bena personally delivered all 14000 Twshlrts to Burlington VT in time for the benefit concert and came away from the experi ence realizing that in order to maintain the consistent hlgh quallty production required to ensure the future success of Maggie s she needed to find an operation in which the producers had skin in the game through ownership and profitsharing OOL 116 HYBRID ORGANIZATIONS FIGURE 29 Bena Burda and Michael Woodard review a new product sewn by members of the FTZ Sewing Co operative The co operative building was constructed by the women themselves and as of 2008 the cooperative was owned and operated by 65 women who earned over 70 more than the average annual per capita income in Nicaragua They work a regular Nicaraguan work week of 47 hours Over time is paid double and is completely voluntary No workers are under the age of 18 Being a cooperative the members decide collectively how they will be paid hourly or by the piece for example what holidays to take etc By contracting the sewing of its garments to the cooperative Maggie s has made it possible for the women to create community sustainability in a highly impoverished area of Nicaragua This partnership allows the women to take control of their own lives set up a trust fund to support the development of other businesses in their community and provide stable livable income for their families At the beginning of this partnership there were growing pains as the women learned to sew to the speci cations of Maggie s products But they got up to speed quickly and were soon producing highquality goods for 11 Clothes for a Change Leaders of the Apparel industry OCA Organic Consum ers Association wwworganicconsumersorgclothesleaderscfm accessed Janu ary 29 2009 8 MAGGiE39S ORGANICS 117 FiGURE 30 Six of the original members of the FTZ Sewing Co operative after sewing their first batch of organic cotton camisoles sale in the US market Beginning in 2007 some quality problems started to reemerge and Bena believes these are a result of the women becoming more independent and less willing to listen to feedback from the Maggie s team Bena acknowledges that the partnership with the cooperative has in some ways sti ed the growth of the company From the beginning Bena made a strong commitment to stick with them and she refuses to pull out even if goods are not delivered by deadline or quality is not up to par Maggie s relationship with the FTZ co operative is completely differ ent than that which it had with its US sewing contractors With the US contractors the relationship was only with the management and Mag gie s was simply one of several clients to them In contrast the company s contract and commitments to FTZ put the cooperative in business and for a long while kept the co operative in business In addition because the producers are the owners the relationship with Maggie39s extends to every member of the cooperative The result is that lVIaggie s is more than just a client to FTZ Michael Woodard who still plays an integral role in the operations of the co operative has said The happiest and saddest day of my life will be when they tell me to go away we don t need you anymore I hope one day LOL 118 HYBRID 0RGANiZATiONS they can internalize what they can verbalize so well that they own the cooperative run it and bene t from its success For Bena there is a tension between wanting the women to reach their full potential in terms of independence and self suf ciency and needing them to receive and integrate constructive feedback from the Maggie s production team to ensure highquality products There is a quality con trol process and if product standards are not met the products are either shipped back or deducted from the supplier s credit The management team believes it is important to treat the cooperative like any other supplier and not cut them any slack in terms of quality Maggie s is dealing with the recent quality issues in the same way that it has always approached its partners with respect transparency and communication and as the company s track record has shown these tactics generally lead to successful outcomes Distribution Maggie s sells its products exclusively in the US via wholesale retail and directto consumer channels Wholesale channel A large part of the Maggie s success story is based on the fact that it is the only company selling certi ed organic cotton apparel through some of the largest food distributors in the US These distributors generate a signi cant amount of revenue for Maggie s Doug Wilson is very proud of this achievement and hopes that the company is able to maintain its position as the sole organic apparel company in this channel In addition to these large food distributors Maggie s works with smaller distributors and a brokerage rms which act as sales representatives for its products and other companies products in the natural products industry Retail channel Maggie s sells products directly to many independent natural food retail ers Doug takes pride in the solid relationships it has formed with these mom and pop natural food stores across the US and Canada 15 Ants That Move Mountains Maggie s Organics Video 2008 wwwmaggiesorganics commediaantswmV accessed January 29 2009 Z P 8 MAGGl 39S ORGANICS 119 Direct to consumer channel As of 2008 8 of total sales revenues were generated from orders placed by consumers on the Maggie s website These orders are ful lled and shipped from the Maggie s headquarters in Ypsilanti MI Competition The organic apparel industry has evolved into a fairly broad sector with numerous companies making products with at least some amount of cer ti ed organic bers The industry includes retailer giants such as Nike the largest Tshirt manufacturer in the US American Apparel and Edun Bono s lead singer of the rock band U2 socially conscious apparel company Organic clothing makes up only a portion of the apparel sales for each of these companies and more importantly these companies do not compete in the same market as Maggie s Because of the unique positioning that Maggie s has as an apparel company in the natural food market the competition is relatively small particularly in the smaller stores The company faces its greatest compe tition in the national retail chains that sell a large collection of both natu ral foods and organic apparel one competitor in this category is Whole Foods But in many smaller retail stores that sell Maggie s products no other organic apparel is sold Finance Maggie s Organics was initially nanced by Bena and her business part ner Jennifer Mueller In 1997 Bena bought out the company from Jennifer by creating a parent company called Clean Clothes Inc As of 2008 the company was majorityowned by Bena with two of her friends holding partial ownership The company has been consistently pro table since 2004 Over the years Bena has utilized a very conservative scal approach and has been able to grow the company without taking in outside capital since a friend gave the initial 10000 investment in 1997 to help start Clean Clothes Inc 16 wwwmaggiesorganicscom ZOL 120 HYBRID ORGAMZATIONS The majority of the capital required to start Clean Clothes Inc as well as the capital required to buy out Jennifer s shares of Maggie s was made available to Bena through a credit line she opened in 1997 using her own personal guarantee and resources as collateral She periodically taps into that credit line but has not needed to nd outside resources to fund the company s growth As a privately held company Maggie s has a policy of not sharing addi tional nancial information with the public Organization Leader driven mission Bena Burda s career in the organics industry began in 1978 when she dropped out of the University of Michigan to start working with Eden Foods After ten years at Eden Foods she took a position as a sales man ager for Bearito s Brand Organic Tortilla Chips and as described earlier the idea for the Maggie s business arose while seeking a natural solution for the problem of the fading color of the company s blue corn tortilla chips Without any knowledge of the apparel industry Bena took on the challenge of putting the inedible cotton crop to good use and Maggie s was born When Maggie s was founded in 1992 there were no governmental stan dards for organic clothing and as of 2008 these standards still did not exist But Bena used her leadership position on the Organic Trade Associ ation s Fiber Council to formulate the American Organic Fiber Processing Standards which are industryled and apply to the US and Canada OTA s organic ber processing standards approved in January 2004 address all stages of textile processing including postharvest handling wet process ing including bleaching dyeing printing fabrication product assembly storage and transportation pest management and labeling nished prod ucts They also include an extensive list of materials permitted for or prohibited from use in organic ber processing under the standards 17 Four industry leaders will be honored at All Things Organic OTA Organic Trade Association press release Aprii 30 2002 wwwotacomnewspress29html accessed January 29 2009 8 MAGGlE39S ORGANICS 121 The OTA standards have been incorporated into the Global Organic Textile Standard an international nongovernmental collaboration that allows for a single organic textile certi cation mark accepted in markets worldwide Sandra Marquardt who coordinated OTA s Fiber Council steering committee stated Without Ben fs drive I doubt the organic ber process ing standards would have become part of the OTA American Organic Standards or the new Global Organic Textile Standards Oliver 2007 When the US cutandsew production industry began to collapse in the late 1990s Bena found an alternative to the sweatshops used to produce much of the conventional textiles sold in the United States Bena s passionate leadership has driven Maggie s to become a role model for the apparel industry in terms of commitment to socially and environmentally responsible sourcing and production practices The Organic Trade Association recognized Bena s leadership role in the organ ics industry by choosing her to receive the 2002 Organic Leadership Spe cial Pioneer Award 18 Organizational structure and culture Legal structure Maggie s Organics is a brand of the parent company Clean Clothes Inc and is a registered C Corporation where Bena is the primary shareholder Clean Clothes Inc is 90 owned by Bena and 10 owned by a friend who invested some of the startup capital The company has a board of direc tors though it is rarely involved in the decisionmaking of the company While the company has very close relationships with several coopera tives in Central America these organizations are wholly workerowned and independent of Maggie s Organizational structure and culture Maggie s is a very small company with 14 employees Working in its sole administrative of ce in Ypsilanti MI There is a warehouse in the Ypsi lanti of ce and another in North Carolina This small size is re ected in 18 Ibid SOL 122 HYBRID ORGANIZATIONS the close knit culture of the organization as well as the strong relation ships that the company has with all of its suppliers Bena commented that developing relationships with people who work in the mills and sew our garments is one of the unique things about Maggie s 19 While Maggie s operates within de ned functional areas in practice it is a nota bly at structure with a family atmosphere that extends beyond Bena and Doug s wife husband management team The Maggie s of ce culture is built on a foundation of respect which Bena and Doug strongly believe contributes to the company s success The company pays competitive wages and there is a relatively small dif ference between the salaries of the lowest and highest paid employees including Bena and Doug The lowestpaid employee earns slightly more than 50 of the salary of the highestpaid employee All employees receive full health insurance bene ts plus an additional 1000 annual heath and wellness bene t to cover the cost of alternative medical treatments not covered by the traditional plan Perhaps the most unique feature of the Maggie s bene ts package is the free monthly massage available to each employee We hope that our employees feel good about working at Maggie s and therefore can be a part of the company s campaign says Doug Processes and metrics Environmental processes and metrics While Maggie s does not yet formally track its environmental sustainabil ity performance this is an important goal for Bena and Doug and they plan to begin tracking when they can justify spending the resources Despite the lack of formal tracking processes environmental sustain ability is an integral part of the everyday decisions and strategies of the company The company mission includes 1 Raising awareness about the harmful impacts of conventionai cotton 19 Personal communication with B Burda Ypsilanti MI January 24 2008 20 Personal communication with D Wilson Ypsilanti Mi January 24 2008 3 MAGGE39S ORGANICS 123 2 Leading the way to a more sustainable and responsible industry and product All the cotton and wool sourced for Maggie s products is 100 certi ed organic For the post harvest production process Maggie s abides by the OTA s American Organic Standards for Fiber Processing a set of Stan dards that Bena played a major role in creating The OTA standards are voluntary and there is no of cial certi cation for companies that abide by them In addition to ensuring the environmental sustainability of the organic bers from harvest to production Maggie s also works with its printing and packaging partners to implement more sustainable procedures into their company operations One success story on this front is VGKids a screen printing company in Ypsilanti MI By working together Maggie s has become the preferred organic cotton Tshirt supplier for all VGKids customers In addition Maggie s was able to work directly with James Marks owner of VGKids to explore phthalatefree inks and other alterna tives to conventional printing These inks are now part of VGKids stan dard procedures for all printing options Social process and metrics Again Maggie s does not formally track its social impact performance but the labor standards used by the company are based on those of the internationally recognized grassroots antisweatshop organization The Clean Clothes Campaignquot1 Maggie s requires full disclosure of working conditions and production standards for each of its producer partners A questionnaire for all suppli ers developed to ask speci c questions about average salary bene ts healthcare etc is reviewed before production begins as well as on an annual basis In most cases a Maggie s employee visits the facilities and interviews workers as well as management to ensure that workers rights and needs are respected As of 2008 there were no thirdparty audits of the production facility working conditions Maggie s is working with the Fair Labeling Organiza tion to develop thirdparty standards for auditing all stages of produc tion but this will take time to implement 21 For more information see wwwc1eanclothesorg The Clean Clothes Campaign is not related to Maggie s Organics parent company Clean Ciothes inc VOL 124 HYBRID ORGANIZATIONS Innovation Pioneer of organic apparel industry Maggie s is the oldest surviving organic apparel company in the US It is one of the few companies in the apparel industry that offers clothing made with 100 certi ed organic cotton and maintains direct relation ships with its rnanufacturersquot Guided by Bena s passionate leadership Maggie s played a critical role in the development of the US organic apparel industry and has remained a model for social and environmental stewardship within the industry According to Doug one of the key fac tors in Maggie s success is the growing numbers of consumers with a conscience Without them Doug says Maggie s would be nowhere 23 Workerownedproduction model Since 1999 Maggie s has been absolutely committed topartnering with workerowned cooperatives As noted earlier Maggie s first coop part ner The Fair Trade Zone cooperative in Nueva Vida Nicaragua is the world s rst and only 100 workerowned free trade zone Building on the success of its partnership with the FTZ cooperative Maggie s has part nered with or supported the development of additional cooperatives in Nicaragua Costa Rica and North Carolina 0 In Nicaragua Maggie s is supporting the development of a spin ning cooperative next door to FTZ which will spin all of the cot ton yarn for its sister cooperative 0 In Costa Rica Maggie s has partnered with a 100 worker owned cooperative 0 In rural North Carolina Maggie s is developing another 100 workerowned cooperative Bena believes there is a great opportunity for expanding the worker owned cooperative model in the US as a way to create empowering economic opportunities for lowincome communities 22 Clothes for a Change Leaders of the Apparei Industry OCA Organic Consum ers Association wwworganicconsumersorgclothesleaderscfm accessed Janu ary 29 2009 23 Personal communication with D Wilson Ypsilanti MI February 20 2008 h C o 8 MAGGlE395 ORGANICS 125 Natural food distribution channel Doug says that selling Maggie s apparel products through food distribu tors is like having an oil product in a water distributor 2 This is because Maggie s ghts tooth and nail to stay in these channels On one hand with no other organic apparel companies selling products in these stores Maggie s has an incredible advantage However when distributors and retailers balk at selling Maggie s products through traditional food chan nels the sales team must work hard to sell them on their products advantages ie no shelf life price competitiveness quality and most importantly consumer demand Challenges for the future Market risks Increasing competition As the oldest organic apparel company in the US Maggie s had rst mover advantage in the industry It has maintained its competitive advan tage in part through its position as the sole organic apparel company working with the country s three largest natural food distributors But in recent years increasing consumer demand for organic products has opened the oodgates for a slew of new companies many of whom enter the eld armed with dynamic founders and exciting stories Increasing competition on the organic apparel shelves of Whole Foods is a sign of the times and the challenge for Maggie s will be to keep its brand topofmind with the retailers The long standing relationships that Maggie s has fostered with its retailers will help the company to some degree but the introduction of fresh new products and marketing materi als will be important elements as well Future of the economy The signi cant growth of the organics industry since 2000 is owed at least in part to consumers willingness to pay a premium price for the certified organic label Doug comments that this may be why Wal Mart 21 Personal communication with D Wilson Ypsilanti MI February 20 2008 90L 126 HYBRID ORGANIZATIONS does not tout its own category of organic products which it introduced a couple of years ago WalMart built its brand on low cost and the Wal Mart consumer does not appear to be willing to pay a premium for any product The future growth of Maggie s and the US organic products industry as a whole is dependent on the economic health of the country In a period of economic recession the size of the population with disposable income will shrink and the willingness to pay a premium for organic products may follow suit Organizational risks Maintaining commitment to fair trade Increasing costs eg rising fuel costs wages in developing countries etc and increasing competition from goods made in countries such as China from which Maggie s refuses to source or produce its materials will continue to pressure its margins These factors combined with a potential economic recession will make it increasingly dif cult for Mag gie s to maintain its pro tability and its commitment to fair prices to pro ducers Quality control Doug says that We deal with quality issues every day quot6 The issue of quality control becomes more complex as Maggie s adds new production partners and as existing production partners become more indepen dent As the company continues to grow it needs to nd ways to mitigate the risks associated with poor quality while maintaining its commitment to supporting and developing the cooperative model of production Useful methods for doing this include 1 Maintaining open lines of communication with the production facilities 2 Keeping producers accountable for their quality mistakes through nancial penalties 25 Personal communication with D Wilson Ypsilanti MI February 20 2008 26 Personal communication with D Wilson Ypsilanti MI January 24 2008 8 MAGGlE39S ORGANICS 127 If expectations and consequences are clearly understood this will pro vide a foundation for handling issues as they arise Copycat competitors Maggie s spends signi cant resources working with partners to develop new methods of production and new types of packaging For example Maggie s spent three months working with a manufacturer to develop a postconsumer recycled hanger adapted to both baby apparel and accessories As a result this manufacturer is becoming the source for eco apparel packaging and several competitors are scheduled to debut products using adaptations of this postconsumer hanger So competi tors bene t greatly from the time and resources Maggie s spent in devel oping this innovative new packaging This pattern will continue in the future and while it is not a problem that is unique to Maggie s it is a risk associated with being an innovator in the industry Richard lvey School of Business a PQ I E The University of Western Ontario 9B11 M033 PEPSCO S TURNING POINT ESTABLISHING A ROLE IN A SUSTAINABLE SOCIETY1 Professor Mike Vaente wrote this case solely to provide material for class discussion The author does not intend to illustrate either effective or ineffective handling of a managerial situation The author may have disguised certain names and other identifying information to protect con dentiality Richard lvey School of Business Foundation prohibits any form of reproduction storage or transmission without its written permission Reproduction of this material is not covered under authorization by any reproduction rights organization To order copies or request permission to reproduce materials contact lvey Publishing Richard lvey School of Business Foundation The University of Western Ontario London Ontario Canada N6A 3K7 phone 519 6613208 fax 519 6613882 email casesiveyuwoca Copyright 2011 Richard lvey School of Business Foundation Version 20111208 Growing criticism has begun to haunt major players in the food and beverage industry as an increasing number of newspaper articles academic studies and blog postings warn of the close connection between the Western diet and trends in obesity diabetes heart disease cancer and ecological devastation Although some of the many claims put forward by activists may be exaggerated it is common knowledge that products of the large food and beverage corporations do not in the very best case represent an antidote to remedy these issues Indra Nooyi CEO of PepsiCo one of the largest food and beverage companies in the world has recognized that society people and lifestyles have changed and that PepsiCo has no choice but to move in healthier directions Indeed PepsiCo has made some impressive moves in reducing the negative health and ecological impacts of some of its products but these steps have been arguably piecemeal up until now largely a reaction to shifts in market demand rather than any genuinely systematic attempt to play a role in curbing these trends There is no denying that PepsiCo CocaCola Nestle and other food and beverage companies have shaped consumer tastes and behaviours over the last few decades One has to wonder whether it would be in PepsiCo s best interests to use this same power to shift some consumer tastes to a healthier set of options that ultimately catered to society s interests PEPSICO Headquartered in Purchase New York PepsiCo is a world leader in convenient snacks foods and beverages with more than 285000 employees across ve major billiondollar brands PepsiCola Frito Lay Tropicana Quaker and Gatorade found in nearly 200 countries around the globe3 In 2009 1 This case has been written on the basis of published sources only Consequently the interpretation and perspectives presented in this case are not necessarily those of PepsiCo or any of its employees Nanette Byrnes Pepsi Brings in the Health Police Bloomberg Businessweek January 14 2010 httpwwwbusinessweek commagazinecontent1004b41 6405051 1214htm chan innovationbrandingbrandpro Ies accessed September 10 2010 1 3 Products under each of these brand umbrellas can be found at wwwpepsicocomBrands This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 106 Page 2 9B11M033 PepsiCo s estimated worldwide retail sales amounted to US108 billion US432 billion of which represented total net revenue of PepsiCo Inc and its subsidiaries5 6 Indra Nooyi has been the chief executive officer of PepsiCo since 2006 PepsiCo s success is clearly the result of the company having built its empire on the manufacture and distribution of instantly recognizable products According to one observer PepsiCo could get a bag of Lay s or a can of Mountain Dew to customers practically anywhere in the world 7 The company s ability to market the product also represents a core competence while product development is emerging as a new source of competitive advantage THE FOOD AND BEVERAGE INDUSTRY The food and beverage industry is best characterized as the industry that specializes in the conceptualization the making of and delivery of foods 8 In the past halfcentury the industry has blossomed from a collection of momandpop operations to a trillion dollar powerhouse led by huge international corporationsg Familiar names such as Coca Cola Starbucks and McDonald s dominate the industry and could be found in all corners of the globe The upstream end of the industry is dominated by agribusiness where companies are involved in the production of livestock and raw agricultural commodities such as corn wheat soybeans and rice Monsanto DuPont Tyson Smith eld and Archer DanielMidland ADM represent some of the major players in this space The next major step in the chain is the processing of food where companies such as Kraft Foods General Mills CocaCola Hershey Foods and Kellogg process raw material foods into forms that could be more easily distributed and sold to consumers Processed food comes in a variety of forms but could be divided into food beverages and confectionary To process food crops such as corn undergo intensive processes such as wet milling whereby corn starch is broken down into the seed kernel s component parts1O Food companies can remove those nutrients and vitamins that attract bacteria and fortify food with less attractive ingredients that allow companies to expand their market reach beyond their localized environment increasing revenue exponentially Processed food also allows companies to manipulate the ingredients of its products to take advantage of both the pricing variability of raw materials and the latest nutritional trends According to estimates approximately half of all the food that US and Canadian citizens eat is processed These processed foods include breakfast cereals breads our tofu cheese chicken pot pies Lean Cuisine prepared meals and thousands of other products The nal segment of the industry is distribution where companies such as Safeway McDonald s and Starbucks are involved in placing finished or nearfinished food products into the hands of consumers This segment is divided into grocers quick service restaurants and casual and upscale restaurants 4 All funds in U S dollars unless specified otherwise 5 Worldwide retail sales include all PepsiCo products including those sold by their partners and franchised bottlers 5 Financial highlights can be found at httpwwwpepsicocomannua09 nancialHighhighlightshtm Nanette Byrnes quotPepsi Brings in the Health Police Bloomberg Businessweek January 14 2010 httpwwwbusinessweekcommagazinecontent1004b41 6405051 1214htm chaninnovationbrandingbrandpro les accessed September 10 2010 8 httpwwwfoodesbeverageblogspotcom accessed April 7th 2011 httpenwikipediaorgwikiFoodandBeverage accessed September 10 2010 9 lbid 10 Michael Pollan Omnivore s Dilemma Penguin Group New York 2006 1 Michael Pollan In Defense of Food Penguin Group New York 2008 12 Will Allen quotThe Real Cost of Cheap Food AIterNet June 6 2008 httpwwwalternetorgenvironment86986A accessed September 20 2008 3 lbid 74 lbid This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 107 Page 3 9B11 M033 Industry Growth Constraints Unlike other industries the food and beverage industry faces a rather unique constraint food consumption is ultimately tapped Whereas the consumer electronics industry could sell multiple variations of its products to the same consumer individuals could consume only so much food In effect taking into consideration population levels the food industry should in theory follow a l per cent growth rate per year In other words caloric consumption is not highly elastic to income levels Regardless of a person s income consuming a steady rate of approximately 18002000 calories per day is in the best health interests of women as is consuming 24002550 calories per day for men16 Food and beverage companies are therefore left with two options convince consumers to eat more or increase pro t margins by adding value to existing foods so that consumers want to pay more The food industry currently produces 3900 calories per capita each day roughly twice the energy needs of the Western population Where is this food going At least four reasons explain why consumers have grown to eat more First the demand and supply has increased for supersized portions and bulk packaging of processed foods Second because mammals are particularly attracted to food rich in salt sugar and saturated fats the increased prevalence of these ingredients in food has led to an increase in consumption Third nutrient density has decreased over time both as a result of soil biodiversity loss and the removal of nutrients and minerals in processed food This loss of nutrients forces consumers to consume higher amounts of calories to make up for the shortfall Finally companies add value to their products through food forti cation by adding ber omega3 fatty acids and other nutrients to commodity products as a means of differentiating the product in the minds of consumers thus resulting in higher price points Paraphrasing a General Mills vice president Michael Pollan said Selling unprocessed or minimally processed whole foods will always be a fool s game since the price of agricultural commodities tends to fall over time whether they re organic or not It will always be hard to distinguish one company s corn or chickens or apples from any other company s It makes much more sense to turn the corn into a brand name cereal the chicken into a TV dinner and the apples into a component in a low moisture naturally sweetened apple piece infused with a redwine extract Companies therefore earn more profits by processing and adding value to fruits and vegetables such as PepsiCo s Tropolis a smooth blend of real squeezable fruit packed with nutrition 19 available in plastic containers that allow for long shelf lives and convenient consumption Onslaught of Criticism The industry is facing an increasing number of criticisms by many consumers non goVernmental organizations activists environmentalists nutritionists and human rights groups who claim that the 15 Wikipedia World Population httpenwikipediaorgwikiWordpopuation accessed March 3 2011 16 Ready2Beat Suggested Calorie Intake per Day httpready2beatcomtechnologyhealthsuggestedcaIorie intakeday accessed March 3 2011 17 Michael Pollan In Defense of Food Penguin Group New York 2008 78 Michael Pollan Omnivore s Dilemma A Natural History of Four Meals Gail Cengage Learning Large Print Press New York 2006 p 161 Pepsico Tropicana Introduces Tropicana Tropolis TM to Squeeze More Fruit into Kids Daily Diets httpwwwpepsico comPressReIeaseTropicanaIntroducesTropicana Tropolis TMtoSqueeze More Fruitinto KidsDaiy 12162010htmI accessed April 10 2011 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 108 Page 4 9B11 M033 industry s practices are partly responsible for some of the more fundamental social and ecological issues evident in society today A large part of this criticism originates from the fact that many of the social and ecological negative externalities are not incorporated into the actual cost of bringing the food to the consumer20 These unaccountedfor costs could be summarized into ecological effects and social and health effects Ecological Costs In the l950s the first load of ammonium nitrate fertilizer was used on a farm catalyzing a quiet revolution because it meant that humanity could draw on a seemingly endless supply of fossil fuels to make nitrogen rather than rely on energy from the sun21 The in ux of nitrogen into the food system has resulted in dramatic ecological effects including reduced drinking water increased greenhouse gas emissions from soil changes in plant composition polluted water tables river contamination and oceanic dead zones22 Food and beverage companies are both mass users of nitrogenrich fertilizers and mass purchasers of nitrogenrich ingredients and products thereby implicating them as contributors to some of the major ecological effects we re seeing today in society Social and Health Costs With the help of government subsidies and the concentration of major agriculture companies such as Monsanto Tyson Foods and ArcherDanielMidland food and beverage companies have been able to substantially reduce the costs of processed foods by limiting the ingredients to two primary crops corn and soy By using the derivatives of corn and soy food scientists could avoid the limitations of perishable food and make their own version of butter margarine fruit juice fruit drink and whipped cream Cool Whip A search through the processed food aisles of grocery stores will likely reveal products that have corn and soy derivatives including among others highfructose corn syrup citric and lactic acid glucose fructose maltodextrin ethanol sorbitol Xanthan gum sucrose and ethyl acetate Some estimate that close to 90 per cent of products in the grocery store contain either a corn or a soy derivative or both For example the following commonly consumed products contain corn or soy or both ketchup batteries Twinkies peanut butter salad dressing Motrin painkiller soft drinks burgers and Aunt Jemima syrup24 One might argue that the inclusion of corn and soy derivatives is merely the natural evolution of food production Others however argue that important social costs are associated with shifting away from real food to a system of manufactured food made from low cost poornutrient ingredients that lead to consumers consuming more of the same food to ingest the required nutrients 2 Will Allen The Real Cost of Cheap Food AlterNet June 6 2008 httpwwwalternetorgenvironment869864 accessed September 20 2008 2 What had been a local sun driven cycle of fertility in which the legumes fed the corn which fed the livestock which in turn through manure fed the corn was now broken Now the farmer could plant corn every year and on as much of his acreage as he chose since he had no need for the legumes or the animal manure He could buy fertility in a bag fertility that had originally been produced billions of years ago halfway around the world Michael Pollan Omnivore s Dilemma A Natural History of Four Meals Gail Cengage Learning Large Print Press New York 2006 p 7778 22 Mark E Fenn et al Ecological Effects of Nitrogen Deposition in the Western United States Hiohbeam Business httpb usiness highbeam com41 1908artice 1G 11 0060521 0ecologicaleffectsnitrogen depositionwesternunited gccessed March 3 2011 24 Robert Kenner director Food Inc documentary film Magnolia Pictures New York 2008 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 109 Page 5 9B11 M033 Although the wet milling process has afforded food companies with enormous exibility when designing food a growing number of corresponding health concerns have emerged because processed food requires systemic chemicals hormones antibiotics pesticides toxins and additives 5 The Environmental Protection Agency warned of highly toxic dioxins in food and con rmed that these dioxins cause cancer and other negative health effects even at extremely low levels of exposure while stating that most Americans are being exposed to unsafe levels of chemicals through foods that they eat 26 To save on costs milk companies in China watered down milk that would be used in milk chocolate for Cadbury Because the diluted milk resulted in protein levels that were below regulatory standards companies forti ed the milk with melamine unaware or ignorant of the potential health consequences In 2008 50000 Chinese babies fell ill and four were killed by milk tainted with the industrial chemical Currently more than 1 billion adults are overweight and at least 300 million of them are clinically obese An estimated 22 million children under ve years of age are estimated to be overweight worldwide Since 1980 the number of overweight children in the United States has doubled while the prevalence of obese children aged 6 to 11 years has more than doubled since the 19605 This trend extends to US teenagers whose obesity prevalence has increased from 5 per cent of boys aged 12 to 17 in 1970 to 13 per cent in 1988 and from 5 per cent of girls aged 12 to 17 in 1970 to 9 per cent in198828 This problem is not isolated to the West obesity rates are 20 per cent in some Chinese cities and up to 75 per cent in urban Samoa29 Many have estimated that because of their Western diet children of today s society will have a shorter lifespan by 10 years compared with their parents30 Although of cial estimates of the cost of obesity add up to 2 to 7 per cent of total health costs true costs are undoubtedly much greater as not all obesityerelated conditions are included in the calculations Worldrenowned chef Jamie Oliver estimates that obesity costs Americans 10 per cent of their health care bill or 150 billion a year set to increase to 300 billion in 10 years Nonfatal but debilitating health problems include respiratory dif culties chronic musculoskeletal problems skin problems and infertility whereas more lifethreatening problems include cardiovascular disease type 2 diabetes gallbladder disease and certain types of cancers especially the hormonally related and largebowel cancers33 Approximately 85 per cent of diabetic people have type 2 diabetes of which 90 per cent are obese or overweight Of the developing countries India and the Middle East are expected to take over as the largest populations with type 2 diabetes by 2025 Large increases are also expected by 2025 in Latin America and the Caribbean China and the rest of Asia In the analyses carried out for World Health Report 2002 approximately 58 per cent of patients with diabetes and 21 per cent of patients with ischemic heart disease and 8 to 42 per cent of certain cancers globally were attributable to a BMI body mass index above 21 kgm2 34 25 Will Allen quotThe Real Cost of Cheap Food 1terNet June 6 2008 httpwwwalternetorgenvironment869864 accessed September 20 2008 26 Eartha Jane Melzer EPA Warns of Dioxin in Food Michigan Messenger June 4 2010 httpmichiganmessengercom38492epawarnsofdioxininfood accessed September 29 2010 27 BBC News Melamine Found in Cadbury Goods September 29 2008 httpnewsbbc co uk2hi764 131 7stm accessed September 5 2010 28 World Health Organization March 2011 quotObesity and Overweight httpwww whointmediacentrefactsheetsfs31 1en accessed April 4 201 1 29 bid 3 Jamie Oliver Jamie Oliver s TED Prize Wish Teach Every Child about Food February 2010 httpwwwtedcomtalks4amieoliverhtml accessed September 10 2010 3 World Health Organization Obesity and Overweight httpwwwwhointmediacentrefactsheetsfs311en accessed A ril 2011 32p Jamie Oliver Jamie Oliver s TED Prize Wish Teach Every Child about Food February 2010 laiattpwww ted comtalksjamieoliverhtml accessed September 10 2010 3421S This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 110 Page 6 S 9B11M033 SOME CAUSES OF NEGATIVE EXTERNALITIES FROM FOOD The key causes of obesity and its associated diseases are increased consumption of energy dense nutrient poor calorierich foods with high levels of sugar and saturated fats combined with reduced physical activity Unhealthy food is de ned as products high in sugar salt andor fat and generally nutrientpoor and include confectionary chocolate sugary cereals sugary soft drinks ice cream fast food hamburgers French fries pizza fried chicken processed meat and meat products such as hot dogs and sausages sauces ketchup mayonnaise dips and dressings and ready prepared meals35 Despite eating people remain hungry because unhealthy food does not possess the adequate amounts of amino acids essential fatty acids and antioxidants In effect consumers need to consume three slices of bread today to gain the same nutrients that one slice of bread provided in the 1950536 The same effect occurs as a result of simpli ed soil levels caused by an overuse of chemical fertilizers and pesticides one now needs to eat three apples to obtain the same amount of complex nutrients one apple provided in the 1950337 Many would argue that the prevalence of saturated fats and salty and sugary foods in our diet is no coincidence Because mammals have a natural vulnerability to fat sugar and salt the more they eat of them the more they want Some of the leading addiction researchers believe highly processed modernday foods interact with the brain in ways similar to drugs of abuse38 Dr David Kessler author of The End of Overeating and former US Food and Drug Administration commissioner explained that the three points of the compass fat sugar and salt are directly connected to the emotional core of our brains and that companies are interested in nding ways to exploit this vulnerability by nding bliss points to maximize consumer pleasure Dr Mark Gold distinguished professor and chair of psychiatry at University of Florida College of Medicine pioneered the hypothesis of pathological attachment which refers to our propensity to become addicted to hedonically appealing food Studies involving sugar chocolate and other foods suggest that like drugs continued consumption causes changes in the frontal part of the brain that governs insight and impulse control The moment consumers put a chocolateglazed doughnut or other highsugar highfat food in their mouths the brain releases opioids which give food its pleasure and make us want to keep eating The brain also releases dopamine the chemical associated with feelings of reward The more stimulating the food Kessler says the more vigorously we pursue it 4O Jamie Oliver applied this idea to a seemingly untouchable product milk To increase sales of milk in schools it is in the best interest of food producers to inject avourings colourings and sugar so that more children will want to drink it As he put it We know our food system is killing the planet killing us with heart disease diabetes and cancer and threatens to incubate a deadly global pandemic but how can we resist when it tastes oh so good 41 In effect because the wet milling process affords food and beverage companies the power to manipulate the ingredients in food these companies have the power to inject foods with those ingredients that psychologists claim can make consumers addicted Critics also claim that the food and beverage industry has reduced the diversity of the foods that our farmers grow which arguably causes negative health effects 35 Ethical Investment Research Services EIRIS Obesity Concerns in the Food and Beverage Industry February 2006 36 Michael Pollan In Defense of Food Penguin Group New York 2008 Michael Pollan The Omnivore s Dilemma Penguin Group New York 2006 3 lbid 3quot Sharon Kirkey quotMany of Us Are Wired in the Brain to Eat Edmonton Journal March 7 2010 p 81 39 Arun Gupta Gonzo Gastronomy How the Food Industry Has Made Bacon a Weapon of Mass Destruction AIterNet f uly 23 2009 httpwwwalternetorgstoy1414984 accessed October 23 2009 lbid 4 Jamie Oliver Jamie Oliver s TED Prize Wish Teach Every Child about Food February 2010 httpwww ted comtalksjamieoliver html accessed September 10 2010 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 1 1 1 Page 7 4 9B1 1 M033 As small and mid size farms got swallowed up by the massive monoculture operations we now call conventional the Varieties of fruits and Vegetables grown on those farms got whittled down to just those few that shipped the best and had the longest shelf life42 Eating a more Varied diet is associated with a higher intake of macro and micro nutrients as well as higher nutritional adequacy and diet quality 43 In effect dietary diversity scores appear to have an inverse relationship with obesity suggesting that greater diversity in an individual s diet can reduce the likelihood of obesity and diabetes4 Food and beverage industry advocates argue that the power to improve the food available in the marketplace is in the hands of consumers However many studies have shown that low income consumers or consumers more severely hit by the recent nancial crisis are particularly susceptible to relying on less healthy food45 For instance following the economic downturn strong sales were recorded by such products as Kraft Foods macaroni and cheese Delissio Pizza processed cheese product Velveeta and nostalgic favorites such as JellO and KoolAid Kraft s net revenues increased by 194 per cent between July and late September of 2009 Kraft s Lynne Galia said We feel that in this challenging environment we re well positioned to win 46 Cara Miller a mother of four commented A lot of my friends and other Canadian parents that I converse with on a daily basis they re feeling that crunch The prices keep going up I can go to the grocery store and if I buy four liters of milk it s costing me almost 7 but if I go buy twoliter bottles of Coca Cola it s going to cost me two and change That s a problem that I have and I think it s a problem for society in general TRENDS IN CONSUMER BEHAVIOUR Approximately half of all the food that US citizens eat is processed Bill Pecoriello CEO of Consumer Edge Research an independent stock research firm in Stamford Connecticut explained that The consumer can move to baked chips or pretzels or Sun Chips but they re not yet giving up their chips for an apple or carrot stick 49 42 Kerry Trueman Welcome to the Food Revolution AlterNet August 25 2008 httpwwwalternetorgenvironment96072welcometothefoodrevolutionA accessed December 3 2010 43 L Azadbakht et al Variety Scores of Food Groups Contribute to the Specific Nutrient Adequacy in Tehranian Men European Journal of Clinical Nutrition issue 59 2005 pp 12331240 P Mirmiran et al Dietary Diversity Score in Adolescents A Good Indicator of the Nutritional Adequacy of Diets Tehran Lipid and Glucose Study Asia Pacific Journal of Clinical Nutrition issue 13 2004 pp 5660 P Mirmiran et al quotDietary Diversity Score in Adolescents A Good Indicator of the Nutritional Adequacy of Diets Tehran Lipid and Glucose Study Journal of the American College of Nutrition issue 25 2006 pp 354361 N Steyn et al quotFood Variety and Dietary Diversity Scores Are They Good Indicators of Dietary Adequacy Public Health Nutrition issue 9 2006 pp 644650 44 L Azadbakht and A Esmailzadeh quotDietary Diversity Score is Related to Obesity and Abdominal Adiposity among Iranian Female Youth Public Health Nutrition vol 14 issue 1 2010 pp 6269 45 ZosiaBieIski Really Cheap Eats How Low Will We Go Globe and Mail January 12 2009 t isttpwwwtheglobeandmailcomlifereally cheapeatshowlow wiIlwegoarticle9653954 accessed April 6 2010 lbid 47 lbid 48 Will Allen quotThe Real Cost of Cheap Food AlterNet June 6 2008 httpwwwalternetorgenvironmenV86986A accessed September 20 2008 49 Nanette Byrnes Pepsi Brings in the Health Police Bloomberq Businessweek January 14 2010 httpwwwbusinessweek commagazinecontent1 004b41 6405051 1214htm chan innovationbrandingbrandpro les accessed September 10 2010 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 112 Page 8 9B11M033 Yet there is no question that consumers and the general public are beginning to catch on to the negative effects of the food and beverage industry Despite hard economic times US sales of organic products both food and non food reached 246 billion by the end of 2008 representing a 171 per cent increase from 200750 The Organic Trade Association Executive Director Christine Bushway said that organic products represent value to consumers who have shown continued resilience in seeking out these products 51 Organic food sales are anticipated to increase an average of 18 per cent each year The sales of larger grocery natural food stores combined with smaller independent natural food stores and chains account for 44 per cent of organic food and beverage sales52 But organic food and beverages represents only 37 per cent of the total food and beverage industry meaning that 98 to 99 per cent of sales are for less healthy products53 And it s important to keep in mind that because organic and natural food tend to be more expensive 1 per cent of unhealthy food has many more calories than 1 per cent of healthier food meaning that 1 to 2 per cent is likely an exaggerated amount when we consider the amount of food consumed as opposed to sales While governments and corporations respond to rates of obesity by pushing for increased physical activity a growing body of research shows that the amount of energy burned through exercise is far less important than the number of calories consumed54 People get fat because they eat more than people who are lean 55 Consider the fact that the average female is advised to consume approximately 1800 2000 calories per day yet the average person consumes between 2800 and 3200 calories per day56 Walking for 60 minutes at a very brisk pace would expend approximately 280 calories meaning that the consumer would remain 920 calories above the recommended intake This example is not to suggest that physical activity is irrelevant but the onus falls more on calorie intake than on physical exercise Put another way one cannot combat poor eating habits with physical exercise CORPORATE SOCIAL lRRESPONSBLTY IN THE FOOD amp BEVERAGE INDUSTRY Amid growing criticism toward the food and beverage industry food companies responded with a seemingly endless set of claims that they are socially responsible We empower individuals to make informed choices about how to maintain the essential balance between energy intake calories consumed as food and energy expenditure calories burned in physical activity McDonald s Corporation55 We have launched new broadbased physical and nutrition education programs that reach even the least athletic students CocaCola Corporation 3 Dan Shapley Organic Products Market Grows to 24 6 Billion GlobeNet May 8 2009 bid 52 bid 55 Organic Trade Association Industry Statistics and Projected Growth httpwwwotacomorganicmtbusinesshtml accessed April 6 2011 54 Sharon Kirkey Many of Us Are Wired in the Brain to Eat Edmonton Journal March 7 2010 p 81 55 David Kessler The End of Overeatino Taking Control of the Insatiable American Appetite Rodae Books New York 2009 55 U S Department of Agriculture Profiling Food Consumption in America httpwwwusdagovwpsportalusdausdahome accessed March 3 2011 57 Calorie Calculator httpexerciseaboutcomcs tnesstoolsblcalorieburnhtm accessed March 3 2011 55 Quoted in Ludwig and Nestle Can the Food Industry Play a Constructive Role in the Obesity Epidemic Journal of the gmerican MedicaAssociation 2008 300 15 pp 18081910 Ibid This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 1 13 Page 9 9B11M033 We can play an important role in helping kids lead healthier lives by offering healthy product choices in schools by developing healthy products that appeal to kids and by promoting programs that encourage kids to lead active lives PepsiCo6 Helping children and their families make healthy food choices while encouraging physical activity has become part of how Kraft gives back to communities Kraft Foods The food and beverage industry has spent millions of dollars on various charities such as McDonald s children s charities and Kraft s Make a Delicious Difference Week 62 Other food and beverage companies have sponsored major events meant to promote physical activity in children as a means to reduce obesity For example PepsiCo donated 116 million over ve years to the YMCA to support among other events an annual community day to celebrate healthy living encourage kids and families to get excited about physical fun and activity engage kids in play to be healthy63 CocaCola has launched more than 150 physical activity programs in more than 100 countries to reduce inactivity and help increase physical activity around the world 64 But to many skeptics these philanthropic gestures appear hollow when put into perspective of the amount of calories consumed in a soft drink In effect a child can easily consume more calories from a soft drink than would be expended at a sports event sponsored by a beverage company65 In a report to its investors Ethical Investment Research Services EIRIS compared a number of food and beverage companies on their response to the obesity epidemic Exhibit 1 provides the levels of risk determined by EIRIS and the performance of a selected number of food and beverage companies according to these levels Consumers have undoubtedly a wider selection of healthier products than they did in the past Claims of reductions in salt sugar and saturated fat and increases in ber omega3 fatty acids and Whole grains are plastered all over food and beverage products Yet many interpret these claims to be greenwashing66 A study requested by the World Health Organization found that despite McDonald s claims to being more socially responsible and to have discontinued the use of trans fats the fastfood giant continued to use trans fats in its cooking oil67 Both McDonald s and Kraft remained heavily engaged in marketing unhealthy products to children despite promises to ght childhood obesity68 McDonald s used toys games movie tieins and trips to Disney World to promote supersized versions of Happy Meals 9 6 lbid 5 lbi 62 Kraft Foods More Than 100 Kraft Foods Volunteers Team Up with Local Charities to Make a Delicious Difference in Bentonville and Rogersquot press release October 6 2009 httpwwwkraftfoodscompanycommediacentercountiypress releasesus2009uspr10062009aspx accessed September 30 2010 53 PepsiCo PepsiCo Joins with America s YMCAS to Help Americans Live Healthier Lives press release March 8 2006 httpphxcorporateirnetphoenixzhtmlc78265amppironewsArticleampD828887amphighight accessed September 26 2010 54 Coca Cola Company quotActive Healthy Living Suppon Active Healthy Lives Through Product Variety Nutrition Education and Physical Activity Programs httpwwwthecocacolacompanycomcitizenship tnessactivemlifestyleshtml accessed September 28 2010 65 David Ludwig and Marion Nestle Can the Food Industry Play a Constructive Role in the Obesity Epidemic Journal of me American MedicalAssociation October 15 2008 vol 300 no 15 pp 18081810 56 Greenwashing is defined as the act of misleading consumers regarding the environmental practices of a company or the environmental benefits of a product or service www sinsofgreenwashing org 57 A Lewln et al Food Industry Promises to Address Childhood Obesity Preliminary Evaluation Journal of Public Health Policy 2006 vol 27 no 4 pp 327348 58 lbid 69 bid This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 1 14 Page 10 9B11M033 The integrity of the industry s corporate social responsibility CSR initiatives is weakened when considering that it spent 568 million in political lobbying in 2009 A good chunk of these efforts have gone to oppose health groups that wanted to restrict vending machines in schools and the use of trans fats in restaurants and food and beverage products70 Ironically although companies in the industry have put forth impressive statements regarding their commitment toward reducing the negative effects of their products they lobby vociferously against policies to improve children s health make misleading statements and misrepresent their policies at government meetings and other public venues and make public promises of corporate responsibility that sound good but in reality amount to no more than public relations PepsiCo s lobbying expenses rose 300 per cent to 42 million in 2009 from 117 million in 2008 Much of the increased lobbying expenses were due to the industry s ght against increased taxes on soft drinks72 According to the Center for Media and Democracy several food and beverage companies such as Coca Cola Cargill and Wendy s have contributed undisclosed donations to the Center for Consumer Freedom CCF an organization that lobbies aggressively against obesity related public health campaigns scientists who advocate for healthier diets and legislation to regulate marketing of junk food to children The food and beverage industry has also been criticized for funding studies that result in conclusions that favour companies Thelikelihood of a conclusion favouring industry was four fold to eightfold higher if the study received full rather than no industry funding74 Food journalist Michael Pollan argued that companies are interested in funding studies that uncover the latest nutritional fad eg omega 3 fatty acids ber so that they can fortify their existing products with this ingredient and ride the media s coverage of these findings Companies such as PepsiCo Kellogg and General Mills were recently criticized for instituting a very lax and misleading certi cation program called Smart Choices that was meant to help consumers nd healthier food options Organizations including the Food and Drug Administration criticized the fact that unhealthy foods such as F root Loops Fudgesicle bars and Frosted Flakes were branded with the Smart Choices logo despite their lack of nutritional content Froot Loops for example is 41 per cent sugar Although the program was meant to be independent in its certi cation decisions critics were particularly skeptical because the program was funded by the makers of these sugary products Each company would pay fees of up to 100000 a year to be able to use the Smart Choices label and the fees were based on the total sales of products that bore the label As one critic put it This means that the more food items certi ed by the Smart Choices program the more money it collects which gives it an incentive to apply the label 70 Op en Secrets Food and Beverage Background httpwwwopenseoretsorglobbybackgroundphp InameN01ampyear2009 accessed September 15 2010 71 Michele Simon quotCan Food Companies Be Trusted to SelfRegulate An Analysis of Corporate Lobbying and Deception to Undermine Children s Health Loyola Los Anueles Law Review 2006 no 39 pp 169236 72 Open Secrets Pepsi Co In c htlpwwwopensecretsorg obbyclientsumphpyear2009amplnamePepsiColncampidCenter for Responsive Politics November 20 2009 accessed September 15 2010 73 David Ludwig and Marion Nestle Can the Food Industry Play a Constructive Role in the Obesity Epidemic Journal of the American MedicalAssociation October 15 2008 vol 300 no 15 pp 18081810 74 Michael Pollan In Defense of Food Penguin Group New York 2008 Michael Pollan The Omnivore s Dilemma Penguin Group New Yorlt2006 75 Mike Smith Froot Loops Are a Bowl of Sugar Not a Smart Choice Changeorg September 7 2009 httpfoodchangeorgbiogviewfroozoopsareabowLoisugarnoLasmartchoice accessed September 12 2009 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 1 15 Page 11 9B11M033 1iberally 76 In response companies stated that some processed foods deserve the check mark because they are forti ed with vitamins and minerals But as pointed out by Dr Michael Jacobson of the Center for Science in the Public Interest You could start out with some sawdust add calcium or vitamin A and meet the Smart Choices criteria 77 Under pressure from state and federal authorities who feared consumers would be misled the food companies backed away from the labeling program PepsiCo said that it was cutting its ties with the program while Kellogg said that it would begin phasing out packaging bearing the program logo as its inventories ran out William Neuman from the New York Times stated that the regulators actions were a remarkable turnaround for an initiative that was developed by many of the country s largest food manufacturers that had taken at least two years to develop7 CORPORATE SOCIAL RESPONSIBILITY AT PEPSICO When Indra Nooyi started her job as CEO of PepsiCo in 2006 PepsiCo changed its fun for you slogan to better for you and good for you backed up by a diversification of products including fruit juices nuts and oatmeal Nooyi didn t see this approach as a tradeoff for profits and insisted that both were possible as re ected in her motto performance with purpose 79 which referred to delivering sustainable growth by investing in a healthier future for people and the planet The PepsiCo website claims As an industry leader we have a responsibility to help develop solutions to key global challenges such as obesity 8 As part of its commitment to delivering sustainable growth PepsiCo established more than a dozen policies that addressed corporate governance human sustainability environmental sustainability and talent sustainability On September 9 PepsiCo announced its inclusion in the 2010 Dow Jones Sustainability World Index and the Dow Jones Sustainability North America Index signifying its position as a sustainability leader in the beverage sector Human Sustainability In 2009 PepsiCo announced ll ambitious goals and commitments that spoke to the sustainability of people in both developed and developing countries see Exhibit 2 Four of these goals and commitments spoke directly to PepsiCo s products four were related to the marketplace and the remaining three related to the surrounding community Many would argue that a vast majority of PepsiCo s products contained ingredients that were detrimental to human health According to The Economist virtually all of Pepsi s products are bad for you or fun for you as the firm likes to put it 81 To remedy this perception PepsiCo acquired Quaker Oats and other wholesome brands such as TrueNorth nut snacks and SoBe Lifewater In 2006 PepsiCo paid 13 billion to purchase Naked Juice a maker of soy drinks and organic drinks that were advertised as having been made with high concentrations of antioxidants and without any added sugars or preservatives82 75 Jim Hightower quotFood Industry is Now Calling Junk Food Healthy Why Could That Be AlterNet September 17 2009 httpwwwalternetorgstory142668foodindustryisnowcallingunkfood27heathy27 whycouldthaLbeA accessed October 1 2009 77 lbid 78 William Neuman Food Label Program to Suspend Operations The New York Times October 23 2009 httpwwwnytimescom20091024business24foodhtml accessed October 25 2009 79 Economist Taking the Challenge May 25 2010 httpwwweconomistcomnode15772138 accessed May 31 2010 80 PepsiCo quotHuman Sustainability httpwvvwpepsicocomPurposeHumanSustainabilityhtml accessed September 13 2010 8 Economist Taking the Challenge May 25 2010 httpwww economist comnode15772138 accessed May 31 2010 82 PR Newswire PepsiCo agrees to acquire Naked Juice Company httpvvwwprnewswirecomnewsreleasespepsico agreesto acquirenakedjuice company 56477082htm accessed April 6 2011 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 116 Page 12 9B11MO33 Because a majority of PepsiCo s products were processed food scientists could fortify the food by removing and inserting minerals vitamins whole grains ber omega 3 fatty acids and vitamin C Yet critics were quick to point out that these initiatives merely represented marketing opportunities to distract consumers from the underlying negative health impacts of the product itself or the remaining ingredients that were not advertised For instance although PepsiCo s Quaker Dark Chocolate Chunk granola bar was advertised on the package to have Fiber amp Omega3 the granola bar was full of unhealthy ingredients such as white and brown sugar corn syrup evaporated cane juice hydrogenated soybean and cottonseed oils caramel colour and sorbitan rnonostereate That being said the Quaker brand was many argued PepsiCo s leading health brand In terms of the marketplace PepsiCo committed to responsible marketing including joining a leading group of food and beverage companies to change what younger children are seeing advertised on TV and in other media 84 PepsiCo thus only allowed certain products to be targeted to children that met speci c nutritional criteria In schools PepsiCo was committed to offering a portfolio of lowcalorie and nutritious beverage choices including bottled water juices sports drinks juice avored drinks iced teas and no or low calo8r5ie soft drinks They also removed all high sugar drinks from schools to which they sold directly Until recently PepsiCo hadn t emphasized research on healthy or unhealthy food Since taking over in 2006 Nooyi had increased the research and development RampD budget 38 per cent over three years to 388 million in 2008 Society people and lifestyles have changed Nooyi said86 The RampD needs for this new world are also different Her goal of expanding sales of healthy products to 30 billion per year in 10 years from 10 billion today nearly a fth of projected worldwide retail would require annual growth of more than 10 per cent twice the company s overall historical average growth87 Investors were skeptical that this sales increase could be achieved PepsiCo had hired an army of experts on health to work in its research and development business to give credibility to the nn s claim that it was applying science to creating healthier products for its customers Mahmood Khan a Britishborn doctor recruited to run Pepsi s RampD at the start of 2008 said he was pleasantly surprised by how rapidly this new health agenda has been embraced 88 Environmental Sustainability In 2009 PepsiCo announced 15 global goals and commitments related to environmental sustainability which were divided into water land and packaging climate change and community see Exhibit 3 One commitment included the reduction of packaging weight by 350 million pounds which would avoid the creation of 1 billion pounds of land ll waste by 2012 Other commitments were related to reducing greenhouse gas emissions and improving electricity use ef ciency and fuel use ef ciency PepsiCo also engaged in a numerous philanthropic activities such as committing to provide safe drinking water to 3 million people in developing countries by the end of 2015 83 Economist Taking the Challenge May 25 2010 http39wwweconomistcomnode15772138 accessed May 31 2010 PepsiCo Performance with Purpose httpwwwpepsicocomPurposePerformance with PurposePolicieshtml accessed September 13 2010 85 PepsiCo products sold by independent third parties eg through vending machine remained available in schools 86 Nanette Byrnes Pepsi Brings in the Health Police Bloomberq Businessweek January 14 2010 httpwwwbusinessweek commagazinecontent1 004b41 6405051 1214htm chan innovationbrandingbrandpro les accessed September 10 2010 37 lbid 88 Economist 2010 Taking the challenge May 25 2010 httpwwweconomistcomnode15772138 accessed May 31 2010 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 1 17 Page 13 9B11M033 PEPSCO S FUTURE There is no doubt that the food and beverage sector PepsiCo included has sustained much criticism for its contribution to obesity disease and ecological devastation But at the same time PepsiCo put forth a number of ambitious policies along with innovative changes to their products and operations But were these policies and changes enough to position PepsiCo as part of the solution not the cause of one of the biggest publichealth challenges a challenge fundamentally linked to their industry obesity 89 According to Nooyi responding to this issue was necessary to avoid food companies from going the way of tobacco rms which are perennially held responsible by governments for the health problems associated with their products and penalized accordingly 90 Governments appear to be playing a similarly active role in the food and beverage industry Some jurisdictions have banned trans fats which are a very common ingredient in much junk food salt has been banned in restaurants in New York as a result of a bill introduced in early 201091 by the state assembly and Michelle Obama has launched a campaign against obesity in children Critics claim that although PepsiCo has some innovative ideas to address its social and ecological footprint these ideas are isolated in nature and represent incremental improvements rather than the courageous radical changes to their operations required by Nooyi s goal of being part of the solution for obesity Put another way the core of PepsiCo s business remained the products that had been and continued to be responsible for these negative effects As was explained in the Economist article politicians and publichealth campaigners may not regard selling more healthy products while continuing to pro t handsomely from unhealthy ones as the best way to tackle obesity 92 There is a growing belief that it is PepsiCo s inherent nature to cause social and ecological issues and that any attempt by PepsiCo to act as a force for change would be at odds with the company s fundamental purpose of pro t creation93 For instance why would PepsiCo want to shift to using ingredients that on the one hand represented higher costs e g organic or natural ingredients and on the other hand would not want to leverage the consumers vulnerability to consuming saturated fat salt and sugar Was it even possible to combine the rm s strategic efforts with being a force for change in an increasingly obese world where diet was inextricably linked to disease overeating heart disease and even ecological devastation PepsiCo s strategic shift might make sense if PepsiCo were merely responding to the mainstream market s shift away from unhealthy products But PepsiCo wanted to play a much more proactive role of shifting the market to healthier products Was there a strategic advantage for PepsiCo With the possibility of a strategic advantage in mind some fundamental questions began to emerge for PepsiCo Should PepsiCo completely disassociate itself from unhealthy ingredients and products Should the company leave the competitive likes of CocaCola and Nestle completely If so When Should PepsiCo disassociate itself right away or over time How long of a time Or should the company straddle the market by being in both the unhealthy product mix and the healthy product mix by keeping true to higher margin unhealthy products while introducing new healthier products It s ok to have a slice of 9 David Weiner Salt Ban for Restaurants Lawmaker Introduces Bill to Kill Salt http39WWWhuf ngtonpostcom20100310saltbanforrestaurantsn493455html accessed March 3 2011 92 Economist 2010 Taking the Challenge May 25 2010 httpwwweconomistcomnode15772138 accessed May 31 2010 93 Quoted in Ludwig and Nestle Can the food industry play a constructive role in the obesity epidemic Journal of the American MedicaIAssociation 300 15 2008 p 1809 9 PepsiCo Human Sustainability httpwwwpepsicocomPurposeHumanSustainabilityhtml accessed September 13 2010 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 1 18 Page 14 9B11M033 birthday cake on your birthday said Mehmook Kahn Pepsi s first ever chief scienti c officer and former practicing physician specializing in nutrition He said Would you eat it every day of the week That s a different question we can actually make an impact on what is available for consumers 95 Another option for PepsiCo would be to create healthy options while making the bad stuff less bad Rather than change the entire product line perhaps it would be feasible to make PepsiCo s existing products as healthy as possible recognizing that a potato chip for example could never be as healthy as a plain cooked potato But how healthy should the company go Clearly what is considered healthy has varying interpretations Are potato chips healthy Is PepsiCola healthy Another option was to use PepsiCo s marketing and public relations team to exaggerate their efforts despite remaining true to their core products This strategy would involve marketing the small number of PepsiCo s healthier products and the incremental environmental improvements the company was making but remaining true to the f1rm s core business This approach would afford the company constant returns while creating the image that it was changing Many senior executives preferred this idea and many companies had been very successful in marketing change while avoiding any sacri ce that such a change would require operationally To this point perhaps PepsiCo s marketing team should Work to point the finger of blame away from how many calories people consumed to how few calories they burned As one executive 9s6aid Why aren t we going after computer and cableTV companies for creating a sedentary lifestyle Was it possible to use PepsiCo s expertise in product design packaging manufacture and distribution to make these new healthier products more enticing PepsiCo had built its empire on the manufacturing and distribution of instantly recognizable products Was continuing this trend important in deciding on a future strategy Should PepsiCo build some new competencies to act as a mechanism to differentiate PepsiCo from its competitors If so what should these new competencies be And how should the firm be positioned in the marketplace Should PepsiCo shift completely from the likes of CocaCola and Nestle to healthy product competitors In an economic recession PepsiCo sales should have increased rather than plateaued as they did in 200809 She was convinced that the world was beginning to change and didn t want PepsiCo to be left behind In a call to companies like PepsiCo worldrenowned chef and food activist Jamie Oliver said They need to help us shop They need to show us how to cook quick tasty seasonal meals for people that are busy This is not expensive it needs to be done across the board in America soon and quick The big brands you know the food brands need to put food education at the heart of their businesses I know easier said than done It s the future It s the only way98 95 Nanette Byrnes Pepsi Brings in the Health Police Bloomberci Businessweek January 14 2010 httpwwwbusinessweek commagazinecontent1 004b41 6405051 1214htm chaninnovationbrandingbrandpro les accessed September 10 2010 95 Economist 2010 Taking the Challenge May 25 2010 httpwwweconomistcomnode15772138 accessed May 31 2010 97 Nanette Byrnes Pepsi Brings in the Health Police Bloomberg Businassweek January 14 2010 httpwwvvbusinessweekcommagazinecontent1004b416405051 1214htm chaninnovationbrandingbrandpro les accessed September 10 2010 Jamie Oliver Jamie OIiver s TED Prize Wish Teach Every Child about Food February 2010 httpwwwtedcomtalks4amieoliverhtml accessed September 10 2010 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 1 19 Page 15 9B11M033 Exhibit 1A EXPOSURE TO RISKS OF OBESITY Exposure Category Thresholds High I 39 39 gt33 turnover related to unhealthy foods OR GBP 2 39 39 39 39 39 39 39 39 billion turnover from unhealthy foods Medium 15 to33 turnover related to unhealthy foods OR GBP 1 billion turnover from unhealthy foods Lowquot I i 39 Between 5 and 15 turnover related to unhealthy 39 quot 39 39 39 foods OR GBP 05 billion turnover from unhealthy foods 39 39 39 No lt5 tumover related to unhealthy foods AND GBP 05 billion turnover from unhealthy foods One Great Britain pound US0 61 Source Ethical Investment Research Services ERS Obesity Concerns in the Food and Beverage Industry February 2006 Exhibit 1B PERFORMANCE OF FampB COMPANIES ON HEALTHY PRODUCTS Company Total Turnover Turnover from Percentage GBP bn unhealthy products GBP bn Unilever 286 1 114 399 Kraft Foods 167 109 653 PepsiCo 152 122 801 Cadbury 67 60 896 CocaCola Company 114 103 904 McDonald s 110 105 955 One Great Britain pound US0 61 Source Ethical Investment Research Services EIRIS Obesity Concerns in the Food and Beverage Industry February 2006 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 120 Page 16 9B11MO33 Exhibit 2 PEPSICO HUMAN SUSTAINABILITY GOALS AND COMMITMENTS Products e Increase the amount of whole grains fruits vegetables nuts seeds and lowfat dairy in our global product portfolio 0 Reduce the average amount of sodium per serving in key global food brands in key countries by 25 percent by 2015 with a 2006 baseline 0 Reduce the average amount of saturated fat per serving in key global food brands in key countries by 15 percent by 2020 with a 2006 baseline 0 Reduce the average amount of added sugar per serving in key global beverage brands in key countries by 25 percent by 2020 with a 2006 baseline Marketplace 0 Display calorie count and key nutrients on our food and beverage packaging by 2012 0 Advertise to children under 12 only products that meet our global sciencebased nutrition standards 0 Eliminate the direct sale of fullsugar soft drinks to primary and secondary schools around the globe by 2012 0 Increase the range of foods and beverages that offer solutions for managing calories like portion sizes Community 0 Invest in our business and research and development to expand our offerings of more affordable nutritionally relevant products for underserved and lowerincome communities 0 Expand PepsiCo Foundation and PepsiCo Contributions initiatives to promote healthier communities including enhancing diet and physical activity programs 0 Integrate our policies and actions on human health agriculture and the environment to ensure they support each other Source PepsiCo quotPerformance with Purpose httpwwwpepsieocomPurposePerformancewithPurposePoieieshtml accessed September 13 2010 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 121 Page 17 9B11M033 Exhibit 3 ENVIRONMENTAL SUSTAINABILITY GOALS AND COMMITMENTS Water 0 Improve our water use efficiency by 20 percent per unit of production by 2015 o Strive for positive water balance in our operations in water distressed areas 0 Provide access to safe water to 3 million people in developing countries by the end of 2015 Land and Packaging 0 Continue to lead the industry by incorporating at least 10 percent recycled polyethylene terephthalate rPET in our primary soft drink containers in the US and broadly expand the use of rPET across key international markets 0 Create partnerships that promote the increase of US beverage container recycling rates to 50 percent by 2018 o Reduce packaging weight by 350 million pounds avoiding the creation of 1 billion pounds of landfill waste by 2012 Work to eliminate all solid waste to landfills from our production facilities Climate Change 0 Improve our electricity use efficiency by 20 percent per unit of production by 2015 Reduce our fuel use intensity by 25 percent per unit of production by 2015 Commit to a goal of reducing greenhouse gas GHG intensity for US operations by 25 percent through our partnership with the US Environmental Protection Agency Climate Leaders program Commit to an absolute reduction in GHG emissions across global operations Community Apply proven sustainable agricultural practices on our farmed land Provide funding technical support and training to local farmers Promote environmental education and best practices among our associates and business partners Integrate our policies and actions on human health agriculture and the environment to make sure they support each other Source Pepsico quotEnvironmental Sustainability httpwwwpepsicocomPurposeEnvironmentaSustainabilityhtml accessed September 13 2010 This document is authorized for use by Patrick Kennedy from 882013 to 482014 Use outside these parameters is a copyright violation 122 Richard lvey School of Business A P I E The University of Western Ontario 9B1 OM1 03 NESTLE A SOCIAL MEDIA NIGHTMARE A1 Benjamin Bigio wrote this case under the supenision of Professor Jana Seijts solely to provide material for class discussion The authors do not intend to illustrate either effective or ineffective handling of a managerial situation The authors may have disguised certain names and other identifying infonnation to protect confidentiality Richard lvey School of Business Foundation prohibits any fonn of reproduction storage or transmission without its written permission Reproduction of this material is not covered under authorization by any reproduction rights organization To order copies or request permission to reproduce materials contact lvey Publishing Richard lvey School of Business Foundation The University of Western Ontario London Ontario Canada N6A 3K7 phone 519 6613208 fax 519 6613882 email casesiveyuwoca Copyright 2010 Richard Ive y School of Business Foundation Version 20110822 INTRODUCTION Chairman of the board of directors of Nestle SA N estl Peter Brabeck Letmathe was drinking coffee in his of ce when the phone rang He was expecting news about a new product Nestle would be introducing in Europe Before he could even answer the phone Rudolf Ramsauer Nestle s corporate communications officer stormed into BrabeckLetmathe s office Ramsauer was furious about a video Greenpeace had posted to YouTube He was agitated with his staff and was frantically wondering what to do Brabeck Letmathe subtly looked at his watch It was 200 pm on Wednesday March 17 2010 He had no idea that he would soon be dealing with a calculated potentially catastrophic assault against Nestl s image The chairman smiled at Ramsauer and said So much for my long weekend His words would be a major understatement for the pending attack NESTLE SA Founded in 1866 by Henri Nestl and the Page brothers Nestle had quickly become the largest nutrition and foods company in the world2 Since its operations began in Switzerland the company had grown to an empire that operated in 86 countries and employed over 278000 people worldwide Despite lower pro ts during World War I and World War II Nestl had shown aggressive growth over the years by acquiring many companies Nestle had also diversi ed its strategy by acquiring companies outside the traditional food industry such as Alcon Laboratories Inc and a division of Novaitis Pharmaceuticals In 2009 worldwide sales were CHF1076 billion and net pro t was CHFl043 billion see Exhibits 1 and 23 Approximately 27 per cent of sales were from drinks 26 per cent from dairy and food products and 18 per cent from readyprepared dishes and ready cooked dishes4 Only 12 per cent of sales came from 7 This case has been written on the basis of published sources only Consequently the interpretation and perspectives presented in this case are not necessarily those of Nestl S A or any of its employees Nestle SA Corporate Communications 2006 The World of Nestle httpAvwwnestlefamilycomour companyenglishassetsdownloadsTheWorldofNestlepdli accessed February 22 2011 3 CHF1 Cdn0982 yearending rate or Cdn 1015 weighted average annual rate 4 Nestle Annual Report 2009 httpwwwnestlecomCommonNestleDocumentsDocumentsLibralyDocumentsAnnuaL 123 Page 2 9B10M103 chocolates Although most sales had traditionally originated in Europe 32 per cent in 2009 the North American market now represented 31 per cent of worldwide sales6 Despite recent nancial trouble Nestl s cash position in 2009 was stable at CHF 583 billion see Exhibit 3 9 GREENPEACE Stemming from the peace movement and anti nuclear protests Greenpeace was a nongovernmental environmental organization founded in 1971 by a small team of activists in Vancouver British Columbia Canada Greenpeace had evolved into a worldwide directaction lobbying and research organization that aimed to ensure the ability of the Earth to nurture life in all its diversity 7 With headquarters in Amsterdam Netherlands its 28 regional offices operated in 41 countries with zero mding from governments corporations and political parties As such it relied on its supporter base of more than 28 million people worldwide8 Since 2000 Greenpeace had paid particular attention to global warming animal rights and nuclear power issues However its directaction methods primarily protests had been the source of controversy in recent years9 Some protests had even resulted in violent actions and arrests although Greenpeace s core values see Exhibit 4 emphasized nonviolent confrontation DEMAND FOR PALM OIL Palm oil is a natural plant oil used primarily for processed food products Nestle was currently using palm oil in several chocolate barsKit Kat Rolo Butter nger and Coffee Crisp From 2007 to 2010 Nestl s use of palm oil had nearly doubled New research suggested that palm oil could also be mixed with diesel to create a palmoil biodiesel fuel mix Palm oil was inexpensive in comparison with other vegetable oils and was becoming a valuable export around the world Demand for palm oil had increased by approximately 67 per cent per year from 1990 to 200013 From 2000 to 2009 Indonesian exports of palm oil had increased by nearly 11 million tons or approximately 27 per cent per year Global demand for palm oil was more than 40 million tons per year making it central Reports2009 AnnualReportENpdl accessed February 22 2011 httpwwwNestl comResourceaxdId93839A79943E494281B386461COF2AAB accessed April 28 2010 Ibid 7 Greenpeace International Questions about Greenpeace in General Greenpeace International website January 8 2009 httpwwwgreenpeace orginternationalaboutfaqquestionsaboutgreenpeacein accessed April 28 2010 8 Greenpeace International The History of Greenpeace Greenpeace International website September 14 2009 httpwww greenpeaceorg nternationalabouthistory accessed April 28 2010 9 Anny Shaw Greenpeace Activists Arrested for Gatecrashing Royal Gala Dinner in Copenhagen Released from Jail Daily Ma January 7 2010 httpwww dailymail co uknewsarticle1241244Greenpeaceactivists arrestedgatecrashingroyal galadinnerCopenhagen releasedjailhtml accessed April 28 2010 Simon Houpt Kit Kat spat goes viral despite NestIequots efforts Globe and Mail March 17 I 2010 httplicenseicopyrightnetuserviewFreeUseactfuidNzU2NTY2OQ3D3D accessed February 22 2011 1 Greenpeace International Nestle doesn t deserve a break Greenpeace International website March 23 2010 httpwwwgreenpeaceorg nternationalennewsfeaturesNestleneedstogiverainfores accessed February 22 2011 Ben Block Global Palm Oil Demand Fueling Deforestation Eye on Earth April 10 2009 httpwwwworldwatchorgnode6059 accessed February 22 2011 13 Yusof Basiron Palm Oil and Its Global Supply and Demand Prospects Oil Palm Industry Economic Journal vol 2 no 1 2002 httpwwwchgscommydownloadOil20PaIm20lndustry20Economic20JournalvoI220no1Palm 200il20and20lts20GIobaI20Supply20and20Demand20Prospectspdf accessed April 18 2010 Ben Block Global Palm Oil Demand Fueling Deforestation Eye on Earth April 10 2009 httpwwwworldwatchorgnode6059 accessed April 18 2010 124 Page 3 9B10M103 to the economies of Malaysia and Indonesia where 90 per cent of the world s palm oil was sourced In 2010 Indonesian and Malaysian exports of palm oil were expected to expand between 7 to 10 per cent making palm oil a leading export for both countries GREENPEACE S ALLEGATIONS Freya Putt Greenpeace Forest Campaigner explained what Nestle was doing wrong Nestle is using palm oil and making chocolate bars out of palm oil and is pushing orangutans which are already endangered to the brink of extinction Other companies have acted and Nestle is responding to PR with a lot of talk and no action to change things According to Greenpeace s report Caught Red Handed several Indonesian companies were leveling rainforests in Indonesia to make way for palm oil plantations see Exhibit 5 For example Greenpeace claimed that the Sinar Mas Group s land bank was in heavily forested areas and its expansion would involve deforestation on protected carbon rich peatlands and in critical animal habitats The Group claimed to have the largest land bank in the world with 13 million hectares of land available for eXpansion 2 Areas surrounding Indonesia s Bukit Tigapuluh National Park were home to 100 of the last 400 critically endangered Sumatran tigers and 40 to 60 of the last endangered Sumatran elephants The Sinar Mas Group confirmed its intentions to clear this forested area Such deforestation had also pushed orangutans to the brink of extinction According to the Centre for Orangutan Protection at least 1500 orangutans died in 2006 because of loss of habitat and deliberate attacks by plantation workers expanding the palm oil plantations Greenpeace s investigation team also found evidence that the Sinar Mas Group was burning forests to clear land for oil palm plantations which was illegal under Indonesian law Greenpeace suggested that deforestation was responsible for 20 per cent of the world s total carbon emissions24 Furthermore by 2012 Indonesia was expected to become the third largest carbon emitter after the United States and China Because forests played a crucial role in absorbing carbon dioxide and regulating climate deforestation was a major contributing factor to global warming 4 15 John Platt Indonesia s Palm Oil Economy Drives Human Foitunes And Orangutan Misfortunes Scienti c American December 7 2009 httpwwwscienti camericancomblogpostcfm idindonesias paImoileconomydrives20091207 accessed April 18 2010 75 Yoga Rusmana and Claire Leow Palm Oil Exports from Indonesia to Climb Group Says Update 3 Bloomberg httpwwwbloomberg comappsnewspId20601 080ampsidaXFFClb QHbLA accessed April 1 8 2010 17 Personal communication with Freya Putt Greenpeace Forest Campaigner April 29 2010 18 Greenpeace International Caught Red Handed How NestI s Use of Palm Oil is Having a Devastating Impact on Rainforest the Climate and Orangutans Greenpeace International Amsterdam 2010 http39wwwgreenpeaceorgrawcontent nternationalpressreportscaughtredhandedhowNestI pdt accessed April 18 2010 9 Ibid 2 lbid pg 2 2 Ibid 22 Center for Orangutan Protection Speaks Out on Plantation Worker Cruelty Manila Times July 26 2007 www orangutanorg au3 79htmI accessed April 18 2010 23 Government Regulation No 42001 about Control of Damage and or Environment Pollution related to Forest and Land fire article 11 24 Greenpeace International Nestle doesn t deserve a break Greenpeace International website March 23 2010 75ttpwwwgreenpeaceorg nternationalennewsteaturesNestleneedstogiverainfores accessed February 22 2011 Ibid 125 Page 4 9B10M103 Greenpeace urged Nestle to follow suit with Unilever Kraft and Shell by ending its contract with the Sinar Mas Group26 Greenpeace also accused Nestle of turning a blind eye to its sourcing of palm oil which directly contravened Nestl s goal of Creating Shared Value see Exhibit 6 VIDEO GOES ONLINE Greenpeace decided it needed to launch a video on the Internet to draw attention to Nestl s harmful practices Greenpeace Forest Campaigner Freya Putt explained why Greenpeace decided to use video marketing Greenpeace has been speaking with Nestl for a considerable length of time The company hasn t been taking any serious steps unlike other companies It s a very serious problem both on biodiversity endangerment of orangutans and on the climate change front We had to do something video is a powerful tool to highlight issues to the public The campaign goal was to persuade Nestle to stop buying palm oil and to actively start a moratorium We wanted to raise awareness of rainforest destruction and palm oil and to engage people in the discussion The video was paired with a request for action for Greenpeace supporters and the general public to email Nestle to start a moratorium Greenpeace initially posted a parody video on YouTube the morning of March 17 2010 see Exhibit 7 The provocative video featured an of ce worker opening a Kit Kat bar containing orangutan ngers instead of chocolate He heedlessly bites the orangutan fingers which spurts out blood The worker continues to enjoy his Kit Kat bar and casually wipes the blood off his face Within a few hours the video quickly went viral and received more than 10000 views from a variety of websites mainly YouTube Virneo and Greenpeace s corporate website Within ve hours it had made the front page of YouTube CRISIS MANAGEMENT BrabeckLetmathe slowly sipped his coffee while Ramsauer stood in his office The chairman of the board of directors wondered what to do He needed to work on product development in Europe but he knew that Ramsauer needed his advice BrabeckLetmathe wondered whether the situation would resolve itself He took one last sip of his coffee and inhaled a deep breath What should BrabeckLetmathe tell Ramsauer Did he have a crisis on his hands Only time would tell 26 Hans David Tampubolon Unacceptable Practices See Unilever End Sinar Mas Deal The Jakarta Post December 12 2009 httpwww thejakartapost comnews20091212unacceptablepractices039seeunileverendsinarmasdeal html accessed April 18 2010 27 Nestle Creating Shared Value Nestle corporate website April 18 2010 httpwwwnestlecomCSVPagesCSVaspx accessed February 22 2011 A 28 Personal communication with Freya Putt Greenpeace Forest Campaigner April 29 2010 29 Bloody Chocolate Bars Greenpeace vs Nestle in KitKat Campaign video httpwwwtrendhuntercomtrendsgreenpeacevsnestle accessed April 18 2010 Greenpeace UK Have a Break video httpvimeocom10236827 accessed April 18 2010 126 Page 5 9B10M103 Exhibit 1 NESTLE SA CONSOLIDATED INCOME STATEMENT for the year ended December 31 2009 In millions of CHF Notes 3 3 ii 8 3 E 2 E E E 39 E E S 39 S 8 E E 8 E O O D O O C Sales 3 1oo 579 7 0391 103 086 6 322 Cost of goods sold 43 467 1 7413 45 756 Distribution expenses 8 237 183 8 895 Marketing and administration expenses 34 296 1 974 33 836 Research and development costs 1 357 664 1 359 EBIT Earnings Before Interest Taxes restructuring and impairments 3 13 222 2 4773 13 240 2 43 Other income 4 466 13 240 2 43 Other expenses 4 1 196 42 2 042 82 Profit before interest and taxes 1 12 492 2 478 11 383 11 595 Financial income 5 123 43 Financial expense 5 777 1 088 159 Profit before taxes and associates 11 838 10 338 11 4953 Taxes 7 3 087 275 3 687 100 Shares of results of associates 8 800 1 005 Profit for the year 9 551 2 242 7 656 11 395 of which attributable to noncontrolling interests 291 1 074 245 767 of which attributable to shareholders of the parent Net pro t 9 260 1 168 7 411 10 6283 As percentages of sales EBIT Earnings Before Interest Taxes restructuring and impairments 131 352 128 357 Pro t for the year attributable to shareholders of the parent Net pro t Earnings per share in CHF Basic earnings per share 9 259 033 200 287 Fully diluted earnings per share 9 258 033 199 285 Source Consolidated Financial Statements of Nestl Group 2009 httpwwwnestlecomCommonNestIeDocumentsDocumentsLibraryDocumentsFinanciaLStatements2009 Financial Statements ENpdf accessed February 22 2011 127 Page 6 9B10M103 Exhibit 2 NESTLE SA CONSOLIDATED BALANCE SHEET as of December 31 2009 In millions of CHF Notes 2009 2008 Assets Current assets Cash and cash equivalents 19 2 734 5 835 Short term investments 19 2 585 1 296 Inventories 12 7 734 9 342 Trade and other receivables 1019 12 309 13 442 Prepayments and accrued income 589 627 Derivative assets 1119 1 671 1 609 Current income tax assets 19 1 045 889 Assets held for sale 25 11 203 8 Total current assets 39 870 33 048 Noncurrent assets Property plant and equipment 13 21 599 21 097 Goodwill 14 27 502 30 637 Intangible assets 15 6 685 6 867 Investments in associates 8 8 693 7 796 Financial assets 19 4 162 3 868 Employee bene ts assets 16 230 60 Deferred tax assets 7 2 202 2 842 Total noncurrent assets 71 046 73 167 Total assets 110 916 106 215 128 Page 7 9B1OM103 Exhibit 2 continued Liabilities and equity Current liabilities Financial liabilities 19 14 438 15 383 Trade and other payables 19 13 033 12 608 Accruals and deferred income 2 779 2 931 Provisions 18 643 417 Derivative liabilities 1119 1 127 1 477 Current income tax liabilities 19 1 173 824 Liabilities directly associated with assets held for sale 25 2 890 Total current liabilities 36 083 33 640 Noncurrent liabilities Financial liabilities 19 8 966 6 344 Employee bene ts liabilities 16 6 249 5 464 Provisions 6 18 3 222 3 246 Deferred tax liabilities 7 1 404 1 341 Other payables 1 361 1 264 Total noncurrent liabilities 21 202 17 659 Total liabilities 57 285 51 299 Equity 21 Share capital 365 383 Treasury shares 8 011 9 652 Translation reserve 11 175 11 103 Retained earnings and other reserves 67 736 71 146 Total equity attributable to shareholders of the parent 48 915 50 774 Noncontrolling interests 4 716 4 142 Total equity 53 631 54 916 Total liabilities and equity 110 916 106 215 Source Consolidated Financial Statements of Nestl Group 2009 httpwwwnestIecomCommonNestleDocumentsDocumentsLibraryDocumentsFinanciaLStatements2009Financial StatementsENpdf accessed February 22 2011 129 Page 8 Exhibit 3 NESTLE SA CONSOLIDATED CASH FLOW STATEMENT for the year ended December 31 2009 9B10M103 In millions of CHF Notes 2009 2008 Operating activities Pro t for the year 11 793 19 051 Non cash items of income and expense 22 3 478 6 157 Decreaseincrease in working capital 22 2 442 1 787 Variation of other operating assets and liabilities 22 221 344 Operating cash flow 17 934 10 753 Investing activities Capital expenditure 13 4 641 4 869 Expenditure on intangible assets 15 400 585 Sale of property plant and equipment 111 122 Acquisition of businesses 23 796 937 Disposal of businesses 24 242 10 999 Cash flow with associates 195 266 Other investing cash flows 110 297 Cash flow from investing activities 5 399 4 599 Financing activities Dividend paid to shareholders of the parent 21 5 047 4 573 Purchase of treasury shares 22 7 013 8 696 Sale of treasury shares and options exercised 292 639 Cash flows with noncontrolling interests 720 367 Bonds issued 19 3 957 2 803 Bonds repaid 19 1 744 2 244 In ows from other noncurrent nancial liabilities 294 374 Outflows from other noncurrent financial liabilities 175 168 In owsout ows from current financial liabilities 446 6 100 In owsout ows from shortterm investments 1 759 1 448 Cash flow from financing activities 12 361 16 884 Currency retranslations 184 663 lncreaseIdecrease in cash and cash equivalents 10 759 Cash and cash equivalents at beginning of year 5 835 6 594 Cash and cash equivalents at end of year 22 5 825 5 835 Source Consolidated Statements Group 2009 httpwwwnestecomCommonNestleDocumentsDocumentsLibraryDocumentsFinanciaLStatements2009Financial StatementsENpdf accessed February 22 2011 130 Page 9 9B10M103 Exhibit 4 GREENPEACE S CORE VALUES Greenpeace s cornerstone principles and core values are reflected in all our environmental campaign work worldwide These are We bear witness to environmental destruction in a peaceful nonviolent manner We use non vioent confrontation to raise the level and quality of public debate In exposing threats to the environment and nding solutions we have no permanent allies or adversaries We ensure our financial independence from political or commercial interests We seek solutions for and promote open informed debate about society s environmental choices In developing our campaign strategies and policies we take great care to reflect our fundamental respect for democratic principles and to seek solutions that will promote global social equity Source Greenpeace International Our Core Values Greenpeace International website September 29 2006 httpwwwgreenpeaceorg nternationalaboutour corevaues accessed April 28 2010 131 Page 10 9B1OM103 Exhibit 5 GREENPEACE CAMPAIGN Source Greenpeace International Ask Nestle to give rainforests a break Greenpeace corporate website httpwwwgreenpeaceorg nternationalcampaignsclimatechangekitkat accessed February 22 2011 Source Greenpeace International Nestle Orangutan action in the UK Greenpeace corporate website httpwww greenpeace org nternationalenm ultimediavideosGreenpeaceNestleorangutanaction UK accessed February 22 201 1 132 Page 11 9B1OM103 Exhibit 5 continued Source International Cauqht Red Handed How NestI s Use of PaIm Oil is Havinq a Devastatina Impact on Rainforest the lLmate and Oranqutans Greenpeace International Amsterdam 2010 httpwwwgreenpeaceorgrawcontent nternationalpressreportscaughtredhandedhowNest pd accessed April 18 2010 133 Page 12 9B10M103 Exhibit 6 NESTLE S CREATING SHARED VALUE INITIATIVE f HM zcww j Y5535 r W PfZ U W 393 539 quot8v jquot 3 s 39 2 5quot gzz u 0 h lt gt39 v 39 if I quot is393 zv39Vgtlt2ltiltQvZ2v393 vlt ggtw Eev xrlt 7 5IV z u 4u39v s39 w 4 w V 39f 322 Z wm I K Q 39 gt t W Q 3 I 39rC4quotL s lt K n v 4 A 3if quot amsbm 4 39 tsrx gt a A 5 12 amp t s Pt xx 45 tyA gt3gt fl 5x3 5 int my M 39fr av E2 7 3 a 39fi 533 M FA N I quot 39 154 lt2 quotquot J 39quot V G Eh V rS39i3 quot5 gtlt lt2 G SB 3 w w 39 39 3quot 39 av 2 V 39 gt3 1 0 gt v 5 P Sf is kame fa gt 3 quot V34 271 a uw 2 w zs A393 2 I g6 2 quot ltlt P W A x 39 z39 3 va397 g r Va rv 2 3quot F 399 Cy 5 a x 3539 xRS2 39539 39r wlt gt pf6 ud quotquot lt lt wt W quot 39quot lt 3 quot ox W Ax A 39r Kg 395 t c f 3ltv gt3 T c I39 39 39 3z i fcL39i3 PX 3939 Wx 4451 23939 Zquotv s Eam q xxx 39339mlt Aw x 2m quot v P O AJC l x 3 A 4 Exhibit 7 GREENPEACE VIDEO SNAPSHOT g2v gt z V 0 0 Kn 11 5 sr t 32 A 1 gt 5 z Ar4 25 zZ Q quot quot Y quot J2 3 0 P vv E P I lt39 39 39 gt 9 xi 39 05 39 5 quot 39 I 39 39 v 7 39 H 4 m 5gquot m quot P 39 5 39 quot3 A 4 W 39 G WW t h x w 3 P lta lt X6 gt quot v Qt 5quot quot i 5 a w m 9 nG lt2 v ym ARV r wz 4 quot39 quot 539Z gt i z g l m j v 4rv vM gt al 39 FZ 39 39 39 Sc I vgtw39 39 4 MW lt M 0j7 w 39ra y 39 9 p 4 an a quotawva an Era quotI1 F W 39ulttChquotI E4 quot Ia 39quotr 39 quot X Pu 39 gt3 2 Source Office worker eating Orangutan nger httpadweekblogscomla6a00d8341c51C053ef0120a9482b56970b450wi accessed April 18 2010 134 Richard Ivey School of Business o I E The University of Western Ontario 9B1 OM1 O4 NESTLE A SOCIAL MEDIA NIGHTMARE 31 Benjamin Bigio wrote this case under the supervision of Professor Jana Ser39jts solely to provide material for class discussion The authors do not intend to illustrate either effective or ineffective handling of a managerial situation The authors may have disguised certain names and other identifying information to protect con dentiality Richard lvey School of Business Foundation prohibits any form of reproduction storage or transmission without its written permission Reproduction of this material is not covered under authorization by any reproduction rights organization To order copies or request permission to reproduce materials contact Ive y Publishing Richard lvey School of Business Foundation The University of Westem Ontario London Ontario Canada N6A 3K7 phone 519 6613208 fax 519 6613882 email casesiveyuwoca Copyright 2010 Richard Ivey School of Business Foundation Version 20110328 NESTLE ACTS FAST Nestl s legal department had quickly noti ed YouTube of the video s copyright infringement of the Kit Kat brand2 Fewer than 1000 viewers had seen the YouTube video before it was pulled from the site3 Nestl s corporate communications of cer Rudolf Ramsauer breathed a little easier knowing the video had been removed and was out of the public eye The chairman of the board of directors Peter Brabeck Letmathe could now return to product development in Europe without fear of Nestl s image being tainted Things could have been a lot worse if the video had remained on YouTube BrabeckLetmathe could not help but wonder whether having the video removed was the right decision He would nd out soon enough CRISIS AND PANIC Greenpeace Forest Campaigner Freya Putt stated We Greenpeace didn t expect Nestle to get the video removed So we quickly posted it to other websites By pulling the video from YouTube it inspired many people to want to watch the video It created much more of a buzz People were inspired to take action Activists soon launched worldwide campaigns on Nestl s corporate F acebook page Fueled by the momentum of the Greenpeace video Nestl s Facebook page soon became inundated with Nestle Killer Kit Kat bar logos 1 This case has been written on the basis of published sources only Consequently the interpretation and perspectives presented in this case are not necessarily those of Nestle S A or any of its employees 2 Paul Armstrong Greenpeace Nestl in battle over Kit Kat viral CNN March 19 2010 httparticlescnncom201003 19wordindonesia rainforests orangutan nestle 1sustainablepalm oilgreenpeacevideosharingweb site sPM39WORLD html accessed February 22 2011 3 Simon Houpt Kit Kat spat goes viral despite Nestl s efforts Globe and Mail March 17 2010 httplicenseicopyrightnetuserviewFreeUseactfuidNzU2NTY2OQ3D3D accessed February 22 2011 4 Personal communication with Freya Putt Greenpeace Forest Campaigner April 29 2010 135 Page 2 9B10M104 Putt stated that Greenpeace hadn t asked people to go to Nestl s Facebook page Supporters did it themselves It was not part of Greenpeace s campaign plan Nestle countered with a mild threat on its corporate Facebook fan page as shown in Exhibit 1 To repeat we welcome your comments but please don t post using an altered version of any of our logos as your pro le pic they will be deleted6 This comment triggered a further discussion between Facebook user Paul Grif n PG and the Nestl administrator unedited7 P G Hmm this comment is a bit Big Brotherish isn t it I ll have whatever I want as my logo pic thanks And if it s altered it s no longer your logo is it Nestle That s a new understanding of intellectual property rights We ll muse on that You can have what youlike as your pro le picture But if it s an altered version of any of our logos we ll remove it from this page P G Not sure you re going to win friends in the social media space with this sort of dogmatic approach Social Media is about embracing your market engaging and having a conversation rather than preaching Nestle Thanks for the lesson in manners Consider yourself embraced But it s our page we set the rules it was ever thus The public became irther antagonized by Nestl s sarcastic remarks Oh please it s not like we re censoring everything to allow only positive comments8 Nestl s sarcastic banter continued with Facebook users So let s see we have to be wellmannered all the time but it s perfectly acceptable to refer to us as everything from idiots right the way down to sons of satan with a few obscenities and strange sexual practices thrown in9 Reactions on the page from Visitors varied On March 17 2010 one Facebook user asked It s not OK for people to use altered versions of your logos but it s OK for you to alter the face of Indonesian rainforests1O 5 lbd 6 Caroline McCarthy Nestle Mess Shows Sticky Side of Facebook Pages CNET News March 19 2001 httpnews cnetcom83011357732000080536html accessed April 18 2010 7 htz pwwwswitchedcom20100322Nestl spalmoilprcrisispervades facebookA accessed April 18 2010 8 bid 9 David Griner Nestle Gets Feisty on Facebook over Palm Oil AdFreak com March 19 2010 httpadweekblogscomadfreak201003Nestlegets feistyonfacebook overpamoilhtml accessed April 18 2010 136 Page 3 9B10M104 By March 18 2010 the viral video had appeared on numerous video sharing websites Users also reposted the video to YouTube and other websites The video gained further public attention on major news channels across the world Nestle could not stop the spread of the video The Video had received more than 300000 views see Exhibit 2 The damage had been done One Facebook fan wrote Hey PR moron Thanks you are doing a far better job than we could ever achieve in destroying your brand12 RECOVERING FROM DISASTER On March 19 2010 a Nestle representative issued an apology This deleting logos was one in a series of mistakes for which I would like to apologise And for being rude We ve stopped deleting posts and I have stopped being rude 3 At this point the video had already been ranked number one on YouTube and had appeared on the front page of CNN s website By March 22 2010 Nestl s Facebook page had grown from 93000 fans to more than 200000 fans Nestl s stock price had also dropped by more than 100 per share see Exhibit 3 LOOKING BACK After a month of total chaos the chairman of the board of directors Peter Brabeck Letmathe stood in his of ce which he commonly referred to as the war room His desk was covered with papers reports and various hate mail from Greenpeace supporters He had many voicemails and many unread emails in his inbox He slowly eased into his chair and thought about the actions over the past month Given the quick pace of change in the social media world the chairman of the board of directors could not help but wonder whether this entire crisis could have been averted with a social media strategy at Nestl 10 Caroline McCan hy Nestl Mess Shows Sticky Side of Facebook Pages CNET News March 19 2001 httpnewscnetcom83011357732000080536htm accessed April 18 2010 7 Paul Armstrong Greenpeace Nestle in battle over Kit Kat viral CNN March 19 2010 httparticlescnncom201003 19world ndonesia rainforests orangutan nestle 1sustainablepalm oilgreenpeacevideosharingweb sitesPMWORLD html accessed February 22 2011 12 Caroline McCan hy Nestle Mess Shows Sticky Side of Facebook Pages CNE T News March 19 2001 httpnewscnetcom8301135773 2000080536htmI accessed April 18 2010 73 Patrick Stafford Nestl s Facebook Bungle an Example for SMEs Smartcompanv com March 23 2010 httpwwwsman companycomau nternet20100323Nestl sfacebookbungleanexamplefor smeshtml accessed April 18 2010 14 Addy Dugdale Nestle Learns an important Lesson in Social Media Management FastComganycom March 22 2010 http39wwwfastcompanycom1592926Nestl facebooksocial media accessed April 18 2010 137 Page 4 Exhibit 1 NESTLE S FACEBOOK PAGE 3E ae i a quotR3 t39 peat 22 we 40me 331arA lttrs1r1 nt5 bus p ease cmquott pus asiing an attawad 39s 2ar gt3 C3n 1 am of DLEI E3vgxat Ei war ygsrzafiis pit thaf wEi E the alz39tEzls3iJ r r lt W E i ifige 138 9B1OM104 Exhibit 1 continued 139 Page 6 9B10M104 Exhibit1 continued V U 332 mJ ii eze ie ge sa 1e39z z m a Nquot ier F 2 E39 3 p am mi we 2ea g e Wm we ksE m2 agt i39 1 f 73321 E g2us n 0 ifsamali 3as Elt rm wEa the axzrve mv sim aa Ii 3r 1Ei a 3 ma F ra 213 we I i s L wire ism 5 em Emw magi we ham Eihsa z sm39 sa S if gmat gziim z msym s1 Eso3i1ie a 2 ao3 V E39aFquoti is a239w Zl samp m mquot siiEr g p as quot an 3r E Eer39e Em SE gs m E39 to aquoteg1 3 e 53 3ga42 f p if ha zaquot iE57 aarampa 1t tm t g ili hzaajgshi 3 gzzmcii P gxeggezfse am Em to tmme ri iEz EsV i f18flt 3 3ii E E s3 2Eti213a39iro ai j HE 0 E z239iEt3 iZ a s32 th quota1r c3 39quot E E 2122 s ham 3 mr1rse of Ezra 39avscsai s rsae t e 2gra1 em M 1 Clue mezgzii Source NestI s Corporate Facebook Page accessed April 18 2010 140 Page 7 39 9B10M104 Exhibit 2 YOUTUBE STATISTICS C BiE 3 Et 139E5 23 iFa ra rites 4amp4 Rfa E 5f T1E Qeera e R3tEag 61 1 W5 B1ar31 2 iI3 Hrst emsihewmeri cm ec0meE 39l4 5393 I 221Err 38 1 1Et Uih gr i iratI 13m1 s1r I9 L39 39 Zi112 First sreferzrail fr1 m zs arasses 72 3m 93 E P mar 1 Emazu am er 3 wan 5 sTs5 Z f21ar 1 2 1 t F iztst em 3ewca er can gire aSrr7eae arg 5i3855 E mar 1 2 I11Zi First em ed139iedun quott i a 9 5a s 391quot 3s3r i3C3Ks3 1 112 Q Mair 1 E iiz First em eAr3 eSd cm gsreangeaampavrga1 351 3 f f1ar1 2f31i FiF3Wie3S9 Ermaquot 3 msia aziia aiavizce 6S 7 fszl3r12C2I1ALZi F irst zrefersrail ifrom Ya uTu be Hzmeaiga Ei3E3 p r1arquotF 231 FifSIamp i ma 3 anarm 31 gage EE2393 Source YouTube website accessed April 18 2010 141 Page 8 9B1OM1D4 Exhibit 3 NESTLE S STOCK PRICE MARCH 17 TO MARCH 23 2010 V1 ifs i A nH I K I Source Yahoo Inc accessed April 18 2010 142
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