Journal of Applied Business and Economics

North American Business Press Atlanta - Seattle – South Florida - Toronto

Editors Dr. Adam Davidson Dr. William Johnson

Editor-In-Chief Dr. David Smith

NABP EDITORIAL ADVISORY BOARD

Dr. Andy Bertsch - MINOT STATE UNIVERSITY Dr. Jacob Bikker - UTRECHT UNIVERSITY, NETHERLANDS Dr. Bill Bommer - CALIFORNIA STATE UNIVERSITY, FRESNO Dr. Michael Bond - UNIVERSITY OF ARIZONA Dr. Charles Butler - COLORADO STATE UNIVERSITY Dr. Jon Carrick - STETSON UNIVERSITY Dr. Mondher Cherif - REIMS, FRANCE Dr. Daniel Condon - DOMINICAN UNIVERSITY, CHICAGO Dr. Bahram Dadgostar - LAKEHEAD UNIVERSITY, CANADA Dr. Deborah Erdos-Knapp - KENT STATE UNIVERSITY Dr. Bruce Forster - UNIVERSITY OF NEBRASKA, KEARNEY Dr. Nancy Furlow - MARYMOUNT UNIVERSITY Dr. Mark Gershon - TEMPLE UNIVERSITY Dr. Philippe Gregoire - UNIVERSITY OF LAVAL, CANADA Dr. Donald Grunewald - IONA COLLEGE Dr. Samanthala Hettihewa - UNIVERSITY OF BALLARAT, AUSTRALIA Dr. Russell Kashian - UNIVERSITY OF WISCONSIN, WHITEWATER Dr. Jeffrey Kennedy - PALM BEACH ATLANTIC UNIVERSITY Dr. Jerry Knutson - AG EDWARDS Dr. Dean Koutramanis - UNIVERSITY OF TAMPA Dr. Malek Lashgari - UNIVERSITY OF HARTFORD Dr. Priscilla Liang - CALIFORNIA STATE UNIVERSITY, CHANNEL ISLANDS Dr. Tony Matias - MATIAS AND ASSOCIATES Dr. Patti Meglich - UNIVERSITY OF NEBRASKA, OMAHA Dr. Robert Metts - UNIVERSITY OF NEVADA, RENO Dr. Adil Mouhammed - UNIVERSITY OF ILLINOIS, SPRINGFIELD Dr. Roy Pearson - COLLEGE OF WILLIAM AND MARY Dr. Veena Prabhu - CALIFORNIA STATE UNIVERSITY, LOS ANGELES Dr. Sergiy Rakhmayil - RYERSON UNIVERSITY, CANADA Dr. Robert Scherer - CLEVELAND STATE UNIVERSITY Dr. Ira Sohn - MONTCLAIR STATE UNIVERSITY Dr. Reginal Sheppard - UNIVERSITY OF NEW BRUNSWICK, CANADA Dr. Carlos Spaht - LOUISIANA STATE UNIVERSITY, SHREVEPORT Dr. Ken Thorpe - EMORY UNIVERSITY Dr. Robert Tian – SHANTOU UNIVERSITY Dr. Calin Valsan - BISHOP'S UNIVERSITY, CANADA Dr. Anne Walsh - LA SALLE UNIVERSITY Dr. Thomas Verney - SHIPPENSBURG STATE UNIVERSITY Dr. Christopher Wright - UNIVERSITY OF ADELAIDE, AUSTRALIA Volume 15(2) ISSN 1499-691X

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This Issue

Exploring the Role of Public Policy in Promoting Holistic Ecotourism ...... 9 Dawn H. Pearcy, W. Keith Story

Eco-tourism is a growing industry that can potentially become a victim of its own success. This paper posits a model that incorporates social marketing, public policy, and industry mandates in an effort to understand how tourism consumer behavior can be made more sustainable. The concept presented builds on work by Weaver (2005) that recommends advocates of sustainable eco-tourist behavior use increased information combined with holistic experiences to help consumers achieve deep understandings of their destinations and the impact their behavior has on the eco-system.

The Impact of Social Media on the Fashion Industry ...... 17 Iris Mohr

The purpose of the paper is to address social media as a marketing strategy to manage market shrinkage in fashion and luxury markets. During the financial crisis of 2008, retailers faced a dilemma relating to both the economic environment and psychographic issues: how to convince consumers of fashion and luxury goods to purchase when even the wealthy cut back, and how to plan for spring when sales are declining at retail stores. To understand further social media, as a marketing strategy for managing marketing shrinkage for an upscale segment, a study was conducted on attendees of Mercedes Benz Fashion Week in New York to examine the relationship between social media and fashion and its relationship to fashion week. The author synthesizes extant knowledge on the subject, and provides recommendations for future research.

Short-run Driver Response to a Gasoline Price Spike: Evidence from San Diego, CA...... 23 Andrew Narwold, Dirk Yandell

Drivers’ response to an unexpected gasoline price spike is examined using daily data from San Diego County. Elasticities of demand are calculated for the very short run and are compared to prior short run and long run elasticity estimates. Public transportation use is also examined and a cross-price elasticity for bus travel is estimated. The immediate effects of a gasoline price spike are found to be close to zero, but results are broadly consistent with prior short-run estimates after 10 days.

Return and Volume and the 2008 Market Crash ...... 33 Bakhtiar Moazzami, Bahram Dadgostar

This paper examines the dynamic relationship between stock market trading volume and returns for four major stock markets: New York, Tokyo, London and Toronto using daily data covering March 1, 2003 to Nov. 1, 2012 period. We investigate the information content of volume for the stock returns. We find a positive contemporaneous relation between volume and absolute value of return in all markets. In addition, we find support for the proposition that lagged volume has predictive power for future absolute returns. We also investigate whether the 2008 market crash has had a significant impact on the relationship between the trading volume and return on all markets.

Business in Costa Rica: Trends and Issues ...... 38 Lisa Kahle-Piasecki

Costa Rica, a Central American country historically known for its coffee and banana exports, has a growing industry based on technology and ecotourism. While the country has enjoyed a steady increase in tourists largely from the United States, Nicaragua and Canada, U.S. companies have also discovered Costa Rica as a country with emerging opportunities. With United States businesses increasingly opening operations in Costa Rica, there are management concerns to plan for when conducting business in Costa Rica. This paper will explore practical issues for companies or individuals when opening a business or locating a branch operation in Costa Rica.

English Law: Window on Britain ...... 45 Jean Didier

This paper shares materials, pedagogy and experience from the author’s course for U.S. students studying a semester in the U.K. The course focused on basics of English law and legal history, with an additional effort to utilize the material to teach about English culture and values, and the interrelationship of law and culture. The information is imparted as a starting point for others planning to teach legal studies in the U.K., especially in London. It is also suggests comparative legal studies as a suitable course for intercultural learning at other study abroad venues.

The Financial Crisis of 2008: “It’s a Requirement to Leave Your Ethics at the Door.” ...... 57 Thomas W. Harvey

This article investigates the behavior within the financial services industry that contributed to the Crash of 2008 and the Great Recession of 2009 – 2010. Based on the theory of Adam Smith, it is not the typical academic paper as it analyzes the work of industry practitioners who wrote about the run-up of real estate and stock prices between 2003 –2009 and the ultimate collapse. It is also an examination of the role of government in the economy and the financial services industry. The intent is to initiate conversations about ethics in the Finance major of America’s colleges and universities.

Poor Predictive Power and the Unrealism of International Trade Models: Proposing a More Realistic (Behavioral Economics Based) Model ...... 72 Hamid Hosseini

Beginning with David Ricardo, if not Adam Smith, economists have developed numerous models to explain, and predicts, trade among nations. As I will demonstrate, these models have had poor predictive powers. It is possible to argue that neither gravity model, nor different versions of the comparative advantage doctrine, or even the more recent model developed by Paul Krugman, could explain international trade during the great recession that began in August 2007. For example, these models could not explain why between the first quarter of 2008 and the first quarter of 2009 global GDP fell by 4.5% while world exports declined as much as 17%. The scale and speed of that trade collapse poses a challenge to various international trade models. As I will demonstrate, this problem very much stems from lack of realism on the part of the assumptions of those models, the inadequacy and incompleteness of the causes of specialization in those models, or the neglect of trade finance in all those models. In this paper, attempt is made to develop a more realistic model that would overcome the shortcomings of the above international trade models. Prior to the development of my proposed model, I will review all of the above models and discuss the causes of specialization in them.

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Exploring the Role of Public Policy in Promoting Holistic Ecotourism

Dawn H. Pearcy Eastern Michigan University

W. Keith Story University of Memphis

INTRODUCTION

The tourism industry is a business sector that has great economic potential. It has global influence and is directly linked to over 50 other economic sectors (de Jesus, 2010). Tourism is not only an important to developing nations that depend on it for foreign exchange earnings (United Nations World Tourism Organization [UNWTO], 2012), but it also has social impact on how societies communicate, travel, and develop their cities (de Jesus, 2010). As a key component of the world economy, tourism is expected to grow to 1.6 billion in international arrivals in 2020, up from 903 million in 2007 (UNWTO, 2012). With continuous growth in the tourism sector over the last several decades, many have become concerned with the negative environmental and social outcomes associated with this trend. This concern has contributed to the prevalence of various forms of sustainable tourism, including ecotourism. While many definitions of ecotourism exist, The International Ecotourism Society (TIES) defines ecotourism as: “responsible travel to natural areas that conserves the environment and improves the well- being of local people” (TIES, 2012). According to Lu and Stepchenkova (2012), ecotourism accounts for 5-10% of the global travel market and is one of the fastest-growing subsectors within the tourism industry, with an annual growth rate of 5% worldwide. Academics and practitioners acknowledge that ecotourism has the potential to contribute to environmental, social/cultural and financial sustainability (Kruger, 2005; Ormsby and Mannle, 2006), and many countries around the world are involved in this sector. Honey (2006) proposes that overall, a properly executed ecotourism program will benefit the environment through protection and improvement, benefit the destination community, and benefit the tourists themselves. These three goals of ecotourism are not based on just profitability, and the tourism industry is pushing for more sustainable tourism practices via declarations from the United Nations World

Journal of Applied Business and Economics vol. 15(2) 2013 9 Tourism Organization (UNWTO, 2002) and certifications (UNWTO, 2003) that encourage measurement of a program’s environmental, social, and financial outcomes.

PURPOSE

Despite the growth of ecotourism, the literature is replete with debates, challenges, and critical questions about the true sustainability of the ecotourism sector. The impact of large numbers of travelers to protected areas, their effect on wildlife and natural surroundings, as well as socio-cultural issues associated with indigenous peoples living in ecotourism destinations are just some of the relevant concerns. In fact, Weaver (2005, p. 450) argues that “contemporary ecotourism is largely incapable of fulfilling its potential to achieve meaningful environmental and sociocultural sustainability” and contrasts the minimalist view on ecotourism with the comprehensive view. The purpose of this study is to build on the research of Weaver (2005) and related literature and explore the factors impacting more sustainable and comprehensive approaches to ecotourism, or “holistic” ecotourism. The goal of the study is to provide a preliminary framework for understanding how “holistic” ecotourism can be accomplished by examining two vital antecedents or influences.

LITERATURE OVERVIEW AND MODEL DEVELOPMENT

Conceptualizing Ecotourism Tourism can have a significant positive impact on a community, and there may be some negative or unintended consequences associated with tourism success that diminish social, cultural, or environmental resources over time. A key component of ecotourism is sustainability, and it is this perspective that drives the type of planning and development of natural resources, economic incentives, and social incentives for destination locations. It also allows for a framework of activities to be developed that provides for use of the environment and sharing of the resulting benefits with the local and regional community (de Jesus, 2010). Given this goal to increase the benefits of tourism, yet reduce the negative and unintended consequences of having a popular tourist destination, de Jesus (2010) proposes that ecotourism should have a positive contribution to the local economy and environment, develop the resources equitably, enhance the lives of the destination population, provide tourists quality experiences (that include some form of educational experience), and impact the natural environment and indigenous culture as little as possible. (de Jesus, 2010). According to Weaver (2005), there are two “types” of ecotourism, based on key characteristics related to objectives and outcomes. Weaver (2005) notes that under the minimalist view of ecotourism, the emphasis is on maintenance of the status-quo, the sustainability objectives focus on a specific site, and the learning opportunities are superficial. In contrast, Weaver (2005) identifies the comprehensive model, which takes a complete and fully global approach to developing, managing and promoting ecotourism destinations – one that cultivates opportunities for deep understanding of the ecotourism destination, transformation of behavior, and environmental and socio-cultural enhancement (not just conservation). While Weaver (2005) identifies these three elements as necessary in comprehensive ecotourism (termed “holistic ecotourism” here), his research did not identify/analyze influences on these elements. This study seeks to accomplish that in the following paragraphs, which provide an overview of the role of public policy in this realm. It should be noted that an additional element of Weaver’s comprehensive ecotourism model is a global approach. Clearly, this is an important factor given the international scope of ecotourism; however for the sake of brevity, it will be examined in a future study, which will provide for much more extensive research.

Public Policy - Social Marketing With one of the goals of ecotourism being to increase the adoption of sustainable travel behaviors by tourists, one approach to helping consumers develop/exhibit behaviors that enhance ecotourism destinations is through the use of social marketing. Lee and Kotler (2011, p. 26) define social marketing

10 Journal of Applied Business and Economics vol. 15(2) 2013 as "the use of marketing principles and techniques to influence a target audience to voluntarily accept, reject, modify, or abandon a behavior for the benefit of individuals, groups, or society as a whole". Often it is difficult to modify individual consumer behavior even though overall consumers believe that the behavior change will be beneficial. Social marketing strategies can provide necessary information and a sense of legitimacy than help activate the new behaviors that are desired by the marketing organization (Fox and Kotler, 1980) in order to promote their socially beneficial agenda. The traditional marketing mix of product, place, price, and promotion (McCarthy, 1960) is also used in social marketing to assist in changing consumer consumption behavior. In the case of social marketing, the products are the new ideas or behaviors the marketer wants adopted (Kurtz and Boone, 1987), the prices includes the monetary, social, and opportunity costs of adopting the new behavior (see e.g. Shrum et al., 1994). The place and promotion refer to the information channels and methods used to communicate the new ideas and expected behaviors which, in a tourism context, can include travel agents, transportation providers, and attraction management personnel. Kotler (1983) has recommended that this mix be extended to include partnerships, because some organizations may not have the resources or scale to make a significant impact alone, because policy, legislative, regulatory, or other structural changes may be needed to create the necessary incentive for behavior change. The task of implementing effective social marketing programs is not a simple one even if all of the marketing mix elements are utilized. The effort requires substantial resources – both human and financial, and therefore many tourism entities are too small to make a significant impact individually (Dinan and Sargeant, 2000). Consequently, public sector social marketing or social marketing via public-private partnerships could be put into place with government agencies collaborating with a wide range of tourism entities to promote “holistic” ecotourism. A successful example of the former is the Australian Commonwealth Department of Tourism’s “Go Wild Wisely” campaign (Blamey and Braithwaite, 2010). The premise behind the proposed research model is that (potential) tourists can only develop a deep understanding of ecotourism destinations, and their own role in enhancing economic, environmental and socio-cultural sustainability when they have access to complete and accurate information. Further, access to this information and enhanced knowledge is also considered a precursor to behavior changes (e.g., Joergens, 2006; Skanavis and Sarri, 2002). When applying the concept of social marketing to ecotourism, Dinan and Sargeant (2000) assert that the sector should work at targeting the “right” travelers, those consumers who are both economically viable and receptive to the messages intended to encourage their adoption of sustainable behaviors (Dinan and Sargeant, 2000).

Public Policy – Mandates According to Lee and Kotler (2011), the most challenging aspect of social marketing is that its success is contingent upon individuals’ voluntary adoption of the desired behavior(s). Consequently, in certain circumstances, it is necessary for government agencies at various levels to intervene in ecotourism matters to ensure that destinations are developed, managed, and maintained in a manner that is economically, environmentally, and socio-culturally sustainable, and that visitors engage in behaviors that enhance the ecotourism system. It is commonly argued that governments should assume a key role in advancing sustainable tourism (including ecotourism) by creating policies, providing incentives and developing regulations (Sofield, 2003; Nicholas, et al., 2009). In 2007, an international group of sustainable tourism experts met to review global progress and develop suggestions for the future given the imperative of climate change and increased global travel (Gossling, et al., 2008). This effort is another example of organizations, industry-based or government entities, seeking to develop tourism strategies that address social issues, regulatory change, technology and product innovation, and even the impact of transportation modes on energy consumption (Gossling, et al., 2008). Further, Doremus (2003) notes that ecological conservation often requires the enforcement of limits on human actions with governmental mandates, prohibitions, or restrictions on the manner in which certain activities can take place and consequences for violation (e.g., the establishment of the US

Journal of Applied Business and Economics vol. 15(2) 2013 11 Endangered Species Act). From these examples it can be implied that tourism industry, tourism scholars, and government agencies believe that in addition to the social marketing strategies discussed above, enforceable guidelines will be an important part of developing sustainable tourism. The research model, which is based on existing literature, appears in Figure 1. It is posited that public policy will positively influence various elements of the environment and society in ecotourism destinations, directly through mandates and indirectly through social marketing efforts. This model represents a starting point in understanding how the factors that impact various attractions’ and destinations’ move toward “holistic” ecotourism. Early testing of the model will involve conducting case studies to understand the role of these public policies in practice and will require participation on the part of various stakeholders, including government agencies, eco-tourists, tourism entities, and local residents.

FIGURE 1 RESEARCH MODEL

Public Policy

Social Marketing Mandates

Deep Transformation Environmental & Holistic Understanding of Behavior Social Enhancement Eco- tourism

DEEP (CONSUMER) UNDERSTANDING AND CONNECTION TO BEHAVIOR

According to Weaver (2005), the eco-tourism “product” can be placed along a continuum. Products that focus on elements of an eco-system such as Chinese Pandas or Australian Koalas (Kontoleon, Swanson, Wang, Xuejun, and Yang, 2002) are at one end, and products that focus on the ecosystem of an area, such as a coral reefs or short-grass prairies (Weaver 2005) on the other. The products that are focused on the eco-systems can be thought of as being “holistic” in that they drive experiences for the consumer that incorporates the entire eco-system as one entity. In order to develop behaviors in consumers that are more conducive to the goals of sustainable tourism, Weaver (2005) suggests consumers should be provided learning opportunities as part of their product experience. These learning opportunities can vary in intensity and formality, ranging from suggestive signs to lectures and printed materials. Regardless of the formality of the information presentation, learning opportunities that provide a “deep understanding” of the impact of tourist behavior on the eco-system being visited can have a transformative effect and encourage more sustainable behaviors by the tourist (Fennell, 1995, 1999; Tisdell and Wilson, 2001). These transformative learning opportunities should provide information that is focused on themes that drive a holistic view of the eco- tourist and their role in environmental and cultural sustainability of the product (Ham, 1992; Ham and Krumpe, 1996; Weiler and Ham, 2001) being consumed.

12 Journal of Applied Business and Economics vol. 15(2) 2013 It is thought that increasing public knowledge about sustainable behaviors will increase sustainable behaviors (Devine-Wright, 2004). With regards to the travel literature, there are additional authors that suggest that there is a connection between increased consumer knowledge and pro-environmental behavior. Dolnicar, Couch, and Long (2008), Johnson (2006), Amendah and Park (2008), and Lee and Moscardo (2005) all posit a connection between the awareness and knowledge of consumers and a change in behaviors related to environmental intentions. Research done by Harriot (2002) shows that tourists to the Great Barrier Reef indicate that their consumption decisions would have been different had they been better informed about the impact of their behavior on the environment. Miller et al. (2010) found that the consumer connections between tourism and the environment were low because popular behaviors such as water or energy conservation were “not considered relevant to tourism”. These results are consistent with work done by Becken (2007), Bohler, et al. (2006), and Gossling et al. (2006) which all indicate a low consumer understanding of tourism’s impact on the environment. Miller et al. (2010) also found that consumers knew what pro-environmental behaviors were and even recognized some of the financial benefits, but with respect to tourism, they were unsure of how to implement the behaviors in a way that they thought effective or financially beneficial. Although research shows that consumers have a lack of information with respect to behavior impacts on tourist destinations, a simple increase in information will not achieve the desired behavior change (Miller et al., 2010). In addition to “static” data meant to inform about general behavior impacts, feedback that provides a more tacit connection between behavior and environmental outcomes can be an effective tool for initiating behavior change. These connections can be manifest through consumer incentives designed to “reward” desired behavior, or through social experiences designed to develop social norms related to the desired behaviors (Olli, Grendstad, and Wollebaek, 2001).

ENVIRONMENTAL AND SOCIAL ENHANCEMENT

The social experiences that some use to develop social norms and increase desired behaviors among tourism consumers involve tourists getting “hands on” with making a direct impact on the destination ecosystem. The practice of ecological restoration (ER) is a strategy used by managers of tourist destinations to get visitors involved in reducing or correcting the adverse impact of tourist accommodations and infrastructure (Mehta, 2006). This strategy is particularly desirable in that it addresses some of the key goals of eco-tourism – financial viability, protecting the environment and local cultures, and a rewarding learning opportunity for tourists (Honey, 1999; Kruger, 2005). Companies that specialize in ER tours are increasingly joining with environmentalist to design and implement programs incorporating the eco-tourist as part of an environmental solution (Irwin, 1995). These tours are also vehicles for providing the tourist with conservation-focused messages (Campbell and Smith, 2006) and experiences tourists need to get the deep understanding suggested by Weaver (2005).

SUMMARY

The growth of eco-tourism has sparked a debate about the sustainability of an industry that inherently increases its impact on the environment and societies it touches simply through its success. In order to reduce the negative consequences of eco-tourism, Weaver (2005) suggests that solutions have a holistic point of view, provide opportunities for tourists to develop understanding of the destination that leads to transforming behaviors, and incorporate some sort of management that addresses the adverse effects of increased tourism. By incorporating these three tenets, one can get closer to implementing holistic ecotourism. The model presented in this paper discusses how public policy and social marketing can be leveraged to develop a framework that can help tourism practitioners and tourism scholars develop strategies that enhance the sustainability of holistic eco-tourism. More research is needed to better understand the interaction of information, behavior change, and consumer experience to determine their effects on consumer desire to be more environmentally conscious.

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16 Journal of Applied Business and Economics vol. 15(2) 2013

The Impact of Social Media on the Fashion Industry

Iris Mohr St. John’s University, PA

INTRODUCTION

During the financial meltdown in 2008, retailers were faced with a dilemma that is partly economic and partly psychographic: How to convince upscale consumers to purchase when the wealthy are cutting back? How to plan for spring when sales are off in stores like Neiman Marcus, Saks Fifth Avenue, and Nordstrom? Luxury goods seemed all but resistant to economic downturns. Even in Paris, the mood at the time turned cautious. Retailers informed designers they would delay orders for spring, and place smaller orders. Neither designers nor retailers expected improvements. Consequently, a growing number of designers sought new marketing strategies to appeal to customers’ emotions. Fast forward, after years of paralysis as a result of the recession, on Madison Avenue, a gage of New York retail health, business improved. Nearly fifty stores opened, including a diverse mix of European luxury labels, contemporary brands, hipper American designers, concepts stores, and long lasting stores (Wilson, 2012). According to Clifford (2011), even in hard economic times, the high-end, inconspicuous, and fully priced products sell. The recent economic crisis prompted the affluent population–—the top 20% of income earners representing 60% of the market–—to refocus on real value and great classics, and to pay the expected price (Kapferer, 2012). Says Max Azria, the fashion designer of BCBGMAXAZRIA, known for dressing top celebrities, "Today we have to be totally crazy and make stuff that stands out," he said. "It takes so much more to get a consumer's attention because they're more careful about how they spend their money” (Lutz, 2012). In hard economic times, customers tend to cut back on purchases, since they lack confidence in their future. The purpose of this paper is to examine social media as a marketing tool for connecting brands with their target market, an approach for tackling market shrinkage in the luxury segment, and as a ‘missing link’ in existing business models. A study was conducted on attendees of Mercedes Benz Fashion Week in New York to examine the relationship between social media and fashion and its relationship to fashion

Journal of Applied Business and Economics vol. 15(2) 2013 17 week. The author synthesizes extant knowledge on the subject, and provides recommendations for future research.

LUXURY, FASHION, AND SOCIAL MEDIA

The usage of social media technology by luxury brands surged in 2009. Technology encourages customers to interact with brands. These customer interactions build the brand by increasing awareness, involvement, and engagement; thus, adding to brand recall and stimulating purchases. Tweets, blogs, and social networks like Facebook, Twitter, YouTube, Instagram, and Pinterest offer fashion brands ways to connect with audiences. Though many fashion brands initially believed social networking would weaken the relationship with consumers, social media is now viewed as an opportunity to improve customer relationships and to ultimately capture a larger audience. For example, the timing was right for Gucci’s multicultural social network site, “Guccieyeweb.com” for the launch of a new sunglasses collection targeting digital generation customers. Gucci updates its Facebook site several times a day and sends Twitter tweets (Kim and Ko, 2012). The emergence of social media (e.g., Facebook, Twitter) has boosted interest in word of mouth and viral marketing among luxury brands. Word of mouth (WOM) – interpersonal communication about products and services between consumers – is one of the most influential sources of marketplace information for consumers (Arndt, 1967; Alreck & Settle, 1995). When WOM travels on the Internet, it can be viral and most powerful, regardless of whether the information is good or bad. For followers, it is becoming increasingly challenging to sort out the facts, since the immediacy of information is extreme with no standard to determine the truth. The spread of information brings people to a common sphere to exchange views. Los Angeles day-to-day celebrity wear, for example, has become a worldwide phenomenon, partly due to social media legitimizing the casual look. Vintage stores, showcasing T shirts and jeans, permeating the Los Angeles casual style, are the retail niche of consumers found now throughout the world. Fashion is everywhere, mostly due to the internet. “Blogs” offer consumers an almost unlimited space for self-expression on the Internet (Kozinets, 2006). Blogs are defined as personal websites, “usually maintained by an individual with regular entries of commentary, descriptions of events, or other material such as graphics or video, where entries are commonly displayed in reverse-chronological order” (Wikipedia, 2009). Unlike fashion-focused magazines and television shows, there are millions of fashion blogs worldwide that are updated regularly with new fashion trends. The blog’s effectiveness is due to its strong individual, personal, popular, and elitist point of view. Its engaging experience offers readers the opportunity to voice opinions and challenge fashion critics. Brands view popular bloggers as the new journalists and influencers. The advent of agencies representing bloggers points to the evolving influence of fashion blogs. Once considered fashion-obsessed amateurs, style bloggers have matured into fashion trendsetters and the savvy marketers command four- and five-figure fees from brands. New agencies like Digital Brand Architects in New York represent fashion and lifestyle bloggers, brokering endorsement deals with fashion labels, signing up advertisers and, in some cases, booking lucrative television commercials. Nowadays even mainstream agencies like Creative Artists Agency represent powerful bloggers (Kurutz, 2011). In the past two years, there is a growth in fashion apps for the iPhone, iPad, and iPod. These apps offer customers up-to-the-minute deals, information on the latest fashion trends, the convenience of shopping directly from an iPhone, iPad or iPod, and ease of social sharing. Pose, for example, is a fashion app full of blogger images and ideas. Users can score the latest looks from fashionistas and trendsetters as well as share favorite fashion finds and outfits. Even more, like Facebook, users interact with styles, and share Twitter Pose tweets.

18 Journal of Applied Business and Economics vol. 15(2) 2013 LUXURY BUSINESS MODELS

A multitude of business models are now embraced by the fashion industry: the luxury business model, the fashion business model, and the premium or super premium business model. Fashion houses that dominate worldwide, such as Lois Vuitton, Chanel, Gucci, Hermes, and Ferrari share a common unique business model which differs from other industries (Kapferer, 2012). The popular luxury business model rests on strict principles that maintain the uniqueness of luxury and preserve the non-comparability of those luxury brands that follow these guidelines (Kaprik and Scott, 2010). Interestingly, there are companies not classified as luxury like Apple; yet, still apply elements of this model (Kapferer, 2012). Kaferer and Bastien (2009) offer these principles, the anti-laws of marketing, as follows:

• Luxury represents the local culture and refined art de vivre.

• Do not advertise to sell: Luxury communicates a dream.

• Communicate to non-targets: non-owners must recognize the quality craftsmanship.

• Maintain full control of the value chain: luxury quality can only be delivered if the brand has 100% control.

• Maintain full control of distribution: Distribution is one-on-one service. The experience must be exclusive.

• Never issue licenses: Licensing translates in loss of control and increases the risk of consumer dissatisfaction.

• Always increase the average price: never trade down nor cut the luxury brand’s prices.

• Develop personal relationships with clients: Luxury means treating all clients as VIPs.

A second business model among high-end labels includes the fashion business model, which delocalizes production in search of low-cost labor forces. Unlike the luxury business model, fashion does not sell timelessness. Instead, once the fashion season ends, stores slash prices to eliminate inventory in order to replenish with new merchandise. As for pricing, in the luxury business model, average prices should always go up because there are enough newly rich consumers to buy the product. A third business model among more high-end labels is the premium or super-premium business model that is based on a brand’s willingness to create a premium “best” product. Makeup, for example, increases its popularity by earning prizes through magazines like Allure, The Oprah Magazine, Cosmopolitan, and others. Unlike luxury, an art which refuses to bear any comparison, super-premium brands build their fame and social media following from it. Despite the value in these business models, within an ever-evolving luxury landscape, firms must continually find new ways to connect with customers, build strong relationships, and increasing social engagement to drive growth. New Innovative business models must incorporate social media to allow firms to build strong customer relationships and encourage loyalty, and interact with customers through new channels, formats, or revenue models. It is imperative for luxury marketers to continue to build up their presence on social media platforms that they already use and look to expand to new platforms to engage audiences. Additionally, luxury marketers must think how they can reach key customers with each social media platform, harness it to suit the needs of both the brand and the consumer, and how to tailor their message to compel customers to explore deeper, and on the path to purchase or to opt-in to ongoing communication.

Journal of Applied Business and Economics vol. 15(2) 2013 19 METHODOLOGY

The objective of the present study was to gain specific insight about fashion professionals’ usage of media in evaluation of fashion, and its relationship to fashion week. Mercedes Benz fashion week was selected as the context of study. This research context was selected because of the concentration of fashion experts attending the event. For the majority, attendees either have to be members of the press or fashion industry. This elite group is social hub in itself, requiring membership through a rigorous application demonstrating work in the industry. Mercedes-Benz Fashion Week is New York City's single largest media event, taking place twice a year (February and September) at Lincoln Center, one of the most well-known arts and cultural institutions in the world. The event provides top designers an international platform to showcase their collections to more than 100,000 industry insiders from around the world, including buyers, editors, retailers, celebrities, VIPs, etc. With more than 80 designer shows over eight days, it is known as the premier event worldwide where style, beauty, supermodels, and celebrities come together to celebrate the best in fashion.

Data Collection and Analysis A study was conducted between 5/17/11 to 6/15/11 on Mercedes Benz fashion week attendees to examine the influence of media on fashion views, and its relationship to Mercedes Benz Fashion Week fashion week. A total of 2,082 email invitations to Mercedes Benz Fashion Week attendees, of which 134 questionnaires were initiated, and the final including 74. Sample T Test was performed to analyze the influence of media on fashion week attendees. One-way frequency tables for the variables in the data set were created to understand the relationship between media and Mercedes-Benz Fashion Week.

Findings In general, the study showed strong, positive, significant effect of fashion related media, including social networks (e.g., Facebook, Twitter, and MySpace), magazines, newspapers, and blogs in intensifying fashion week attendees views about fashion. To add, the information provided by all media was found to be essential and important. Even more, the influence of the media identified was essential and important in evaluating the quality of the shows and/or designers. The majority sought advice or information prior to attending Fashion Week, sought advice or information after attending Fashion Week, and sought advice or information before and after attending Fashion Week. When seeking out the media in evaluation fashion during Fashion Week, the majority of respondents noted the information provided was either essential or important. As far as usage of media in the evaluation of the quality of the shows seen and/or designers in general, there was a strong influence. Most interesting is that attendees found the evaluation of media prior to the show accurate in assessing the quality of the show. These attendees visit the media sites often, classify themselves as influential in fashion, and consider themselves a good source of fashion advice, offering a great deal of information, and convincing others of their fashion ideas.

Limitations Though the relatively low response rate makes it difficult to draw significant conclusions, this initial study suggests that further investigation be carried out to increase our understanding of the relationship between social media, fashion brand evaluations, and influence on new fashion trends. Given the strong impact of social media in molding the opinions of professionals at Mercedes Benz Fashion Week, coupled with their influence in impacting the opinions of bloggers, this initial study calls for further research to increase the understanding of this influence for improving fashion business models.

20 Journal of Applied Business and Economics vol. 15(2) 2013 FUTURE RESEARCH

Though the research results are limited, it is clear based on this initial study that it is critical for new business models to incorporate ways to connect with customers, build strong relationships, and increasing social engagement to drive growth. Thus, further investigation should be carried out to better understand the social media association with luxury products to build strong customer relationships and to encourage loyalty, and to interact with customers through new channels, formats, or revenue models. It is imperative for luxury marketers to continue building their presence on social media platforms they currently use, and expand to new platforms for engaging audiences. A review of the literature indicates that while researchers have explored the relationship between social media and viral marketing, research has focused on its impact (i.e., on diffusion and sales; Godes and Mayzlin, 2004, 2009; Goldenberg et al., 2009). Less attention has focused on the causes of viral marketing, what drives people to share content, and why certain content becomes viral. Most recently, Burger and Milkman (2012) investigated the link between article characteristics and blogging. Their research suggests that similar factors drive viral marketing and blogging: emotional, positive, interesting, and anger-inducing and fewer sadness-inducing stories are likely to drive the most blogged list. Additionally, they found practically useful content is marginally less likely to be blogged about, which may be partly due to the nature of information. The researchers point out that while movie reviews, technology perspectives, and recipes all contain useful information, it is a commentary so there may be less blogger added value in contributing his or her spin on the issue. Future work should examine how fashion media content characteristics become viral. When attempting to generate word of mouth, marketers often target influentials as in the case of Mercedes Benz Fashion Week attendees (e.g, media professionals, celebrities, socialites). To the extent that these influentials have strong social ties, their influence is greater than others. Rather than targeting these influentials, Burger and Milkman (2012) indicate that it may be more beneficial to focus on crafting contagious content so it becomes viral. Future work might examine the relationship between online content and viral marketing in shaping customer behavior in the luxury marketplace, and incorporating these elements into new innovative business models.

CONCLUSIONS

The paper focused on a particular challenge faced by many marketers of luxury brands – how to attract new customers in a shrinking marketplace. This paper first outlined the relationship between luxury, fashion, and social media. Next, the paper addressed how technology development benefits the world of fashion by attracting customers to interact with the brands. After, a multitude of luxury business models were identified: the luxury business model, the fashion business model, and the premium (or super) business model. Despite the value in these business models, this paper pointed to their limitation in failing to address social media as key in connecting and building strong relationships with customers, and increasing social engagement to drive growth. New innovative business models must incorporate social media to allow firms to build strong customer relationships and encourage loyalty, and interact with customers through new channels, formats, or revenue models. Given that social media has a strong impact among media professionals of Mercedes Benz Fashion Week, and the fact that their views spread on line, offering opportunities for bloggers to formulate second tier expert views of fashion, it is essential that we develop a deeper understanding of this influence to improve fashion business models.

REFERENCES

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Journal of Applied Business and Economics vol. 15(2) 2013 21 Arndt, J. (1967). Role of product-related conversations in the diffusion of a new product. Journal of Marketing Research, 4(3), 291–295.

Berger, J., & Milkman, K. (2012). What Makes Online Content Viral?? Journal of Marketing Research, 49(2), 192-205.

Clifford, S. (2011, August 4). Even marked up, luxury goods fly off the shelf. New York Times, A1.

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Lutz, A. (2012, September 6). Celebrity Designer Max Azria Tells Us How Fashion Houses Are Coping With The Bad Economy. Business Insider, 1.

Kapferer, J. (2012). Abundant rarity: The key to luxury growth. Business Horizons, 55 (5), 453-462.

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Karpik, L., & Scott, N. (2010). Valuing the unique. Princeton, NJ:Princeton University Press.

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Kozinets, R.V. (2006). Netnography 2.0. Handbook of Qualitative Research Methods in Marketing, ed. Russell W. Belk, Northampton, MA: Edward Elgar Publishing Inc, 129-55.

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Wilson, E. (2012, August 15). Downtown Comes Uptown: Madison Avenue. New York Times, E1.

Wikipedia (2009). Blog. http://en.wikipedia.org/wiki/Blog.

22 Journal of Applied Business and Economics vol. 15(2) 2013

Short-run Driver Response to a Gasoline Price Spike: Evidence from San Diego, CA

Andrew Narwold University of San Diego

Dirk Yandell University of San Diego

INTRODUCTION

In October 2012 California suffered a series of supply shocks in the gasoline market. There were two major events. The first was a fire at a Chevron refinery in Richmond (near San Francisco) that dramatically reduced its capacity. The Richmond facility has a capacity of 243,000 barrels per day, and typically refines over 8% of the total gasoline output supplied to the Petroleum Administration for Defense District 5, of which California is a part. The second shock was a power outage that shut down an ExxonMobil refinery in Torrance (near Los Angeles). The Torrance refinery has a capacity of 149,000 barrels per day. The sudden decrease in supply caused a significant increase in retail gasoline prices. The October price spike was unprecedented, even given California’s isolated and volatile gasoline market. Retail prices jumped about 57 cents within one week, about a 14% increase. This sudden price spike is comparable only to the results seen after natural disasters like Hurricane Katrina or superstorm Sandy. How do drivers respond to an unexpected and significant gasoline price increase? We examine this question using data from San Diego County.

CALIFORNIA GASOLINE PRICES

California gasoline prices are typically at least 30 cents per gallon higher than the national average. Higher state gasoline taxes account for about 20 cents of that gap, and a large portion of the remainder is explained by California’s air quality regulations that require a higher quality gasoline to reduce air pollution. The special blend used in California is not used in other nearby states so production shortfalls cannot easily be offset by bringing in refined gasoline from elsewhere.

Journal of Applied Business and Economics vol. 15(2) 2013 23 California, along with the rest of the nation, has experienced a recent increase in the volatility of gas prices. National average gasoline prices rose nearly 50 cents a gallon in the first two months of 2013 alone, after a slow decline in late 2012, when seasonally adjusted energy prices fell. The price of gasoline has a large impact on family budgets since gasoline purchases represent a large portion of monthly spending for many families. Transportation and transportation services comprise a large fraction of the national economy, so insights on how consumers react to sudden gas price changes are important to policy makers and forecasters in this increasingly volatile market. In this study we concentrate on data from San Diego County. Using daily data, the average price of regular unleaded gas in September 2012 was $4.116 per gallon. The daily average price over the month was quite steady, with a maximum of $4.140 and a minimum of $4.094. In October the average price jumped to $4.414 per gallon. The peak daily average price was $4.708, reached on October 7. The minimum in October was $4.024. Figure 1 shows the average daily regular unleaded retail gasoline price for September and October of 2012 for San Diego County. In this study we examine how drivers in San Diego County responded in the short run to this sudden spike in gasoline prices.

FIGURE 1 AVERAGE UNLEADED RETAIL GAS PRICE, SAN DIEGO COUNTY, SEPT-OCT 2012

PRIOR LITERATURE

There are many papers that have estimated short-run and long-run price elasticities for gasoline, including several meta-studies that summarize a large number of prior results. Espey (1996) examined 101 different studies in a meta-analysis and finds that the short-run average price elasticity of demand for

24 Journal of Applied Business and Economics vol. 15(2) 2013 gasoline is -0.26. She defines the short run to be one year or less. In the long-run (longer than 1 year) she finds an average price elasticity of demand of -0.58. More recent work suggests that short-run price elasticities are lower now, and have decreased over time. For example, Hughes, Knittel, and Sperling (2008) examine data over time to analyze short-run changes in elasticity. By comparing two different time periods, they find that the short-run gasoline price elasticity decreased from a range of -0.21 to -0.34 in the late 1970s to between -0.034 and -0.077 in the early 2000s. Some of this decrease is explained by changes in consumer behavior, partly driven by real income growth and preferences for suburban living, which increases the need to commute. Other factors influencing elasticity include technology advancement and government policies to increase fuel efficiency, such as the national Corporate Average Fuel Economy program, which have increased the productivity of each gallon purchased. A 2008 Congressional Budget Office study reported a short-run retail price elasticity of about -0.06. In the long run, however, consumers would be expected to respond more to a price increase because they would have more time to make choices that take longer to implement, such as buying a more fuel- efficient car. The CBO reports estimates of about -0.40 for the long run elasticity of demand for gasoline, but this would not be fully realized unless prices remained higher for a long time – up to 15 years – as the stock of consumer vehicles gradually is replaced with more efficient substitutes. Other studies have examined the impact of changing gasoline prices on vehicle traffic or vehicle miles travelled. Goodwin, Dargay and Hanly (2004) find that if the real price of fuel permanently increases by 1%, the volume of traffic will decrease about 0.1% within a year, up to an eventual reduction of about 0.3% within about five years. Graham and Glaister (2002) report that the short-run elasticity of traffic with respect to price is about -0.15 and the long-run value is about -0.30. As these studies report, demand is less inelastic in the long run. Driver response in the long run to higher gasoline prices can take the form of a new more fuel-efficient car or moving to a location closer to work. These are generally not feasible options in the short run, but some lifestyle changes can be made in the short run, such as forming carpools, using public transportation, or consolidating tasks to reduce the number of miles driven. Few studies examine the very short run, which is the focus of this paper. We use daily price and traffic volume data to estimate driver response within the first one or two weeks after a price spike. In the very short run, some discretionary trips can potentially be rescheduled or eliminated, and public transportation can be used as a substitute to driving. We examine the extent to which these options reduce driving and calculate appropriate price elasticities to measure driver responsiveness to unexpected higher gas prices.

MODEL AND DATA

We wish to examine how drivers respond to a sudden and sizable increase in fuel cost. The standard economic prediction is that higher gas prices would lead to reduced gas use and a possible shift to substitutes. The effect is likely to be small, however, since demand for gasoline is very price inelastic, especially in the short run. Gasoline use by freeway drivers can be reduced by making fewer trips. We measure this effect with highway traffic vehicle counts in San Diego, California, detected by electronic traffic sensors and reported by the California Department of Transportation (CalTrans). Public transportation may be a substitute to car travel, so bus ridership before and after the price spike was examined for all routes served by the San Diego Metropolitan Transit System (MTS). The data used in this study can be thought of as the result of a natural market experiment. The price spike has generated data that would not have been easy to obtain otherwise, and the time span is so short that it is not necessary to control for changes in population, income, or other demand- or supply-side variables. We use the following data: (1) Daily average gas price for San Diego County for September-October 2012; (2) Daily vehicle counts recorded by all California Department of Transportation (CalTrans)

Journal of Applied Business and Economics vol. 15(2) 2013 25 District 11 (San Diego County) highway traffic sensors for September-October 2012; (3) Daily bus ridership data for all routes served by the San Diego Metropolitan Transit System for September-October 2012. The values of all three variables were also obtained for September and October 2011 to help control for any short-run month-to-month variation.

RESULTS

Embedded sensors in San Diego County freeways record traffic volume. Daily traffic counts from between729 and 1244 individual sensors was obtained for each day from September 1 to October 31, 2012, collected from all of the 13 different freeways in CalTrans District 11 (San Diego County). Traffic volume varies by day of the week (Saturday and Sunday are well below average, for example) so sensor data for September and October was paired by sensor and by day of week. The first Monday in September was matched with the first Monday in October, for example. Two holidays were removed: Labor Day in September and Columbus Day in October. A paired t-test was performed using the 30,974 unique day/sensor pairs, comparing the September (S) volume to October (O). Each difference, D, is defined as

Dij = Sij – Oij where the subscripts i and j denote the day and sensor number, respectively. Index i ranges from 1 to 26, and j ranges from 1 to between 729 and 1244. The mean difference should be positive if October traffic volume is lower than in September, as we predict. Table 1 shows the paired two sample test result.

TABLE 1 2012 TRAFFIC VOLUMES

September October Difference T Statistic Mean 44030.3881 43202.8846 827.5036 42.7201 Variance 1289496040 1242788149 Observations 30974 30974

The observed mean difference is small but highly statistically significant (t = 42.72). The October reduction by an average of 827.5 vehicles per sensor per day represents a 1.88% reduction from September. When aggregated by day, the October daily volume was less than in September on 24 of the 26 paired days examined, as shown in Figure 2. To check whether such a decrease from September to October is typical, traffic data from the same two months in 2011 was examined using the same non-holiday paired comparison. Although mean daily traffic volume in 2011 is similar to 2012, no September to October difference in traffic volume was found (t = 0.37). The 2011 results are shown in Table 2 and Figure 3.

TABLE 2 2011 TRAFFIC VOLUMES

September October Difference T Statistic Mean 42881.4708 42873.4364 8.0345 0.3737 Variance 1304497890 1277284429 Observations 31106 31106

26 Journal of Applied Business and Economics vol. 15(2) 2013 FIGURE 2 VEHICLES/DAY DIFFERENCE, ALL FREEWAY SENSORS AGGREGATED PER DAY, SEPTEMBER – OCTOBER 2012

FIGURE 3 VEHICLES/DAY DIFFERENCE, ALL FREEWAY SENSORS AGGREGATED PER DAY, SEPTEMBER – OCTOBER 2011

BUS RIDERSHIP

If public transportation is a substitute for driving then an increase in gasoline price should increase mass transit ridership. There are 98 regular bus routes serving the San Diego area provided by the Metropolitan Transit System (MTS). Daily ridership data was obtained for all routes in September and October for 2011 and 2012. A paired comparison of average daily ridership by route from September to October should generate a negative difference if ridership increased. The 2012 data show a mean difference of -143.2 riders per route, which is an 8.96% overall increase (see Table 3). This increase in ridership is statistically

Journal of Applied Business and Economics vol. 15(2) 2013 27 significant (t = -6.05). The same pattern was not observed in 2011, in fact the sign of the difference was positive (t = 1.696). The 2011 results are in Table 4. Figures 4 and 5 show the differences graphically.

TABLE 3 2012 BUS RIDERSHIP

September October Difference T Stat Mean 1598.3830 1741.5800 -143.1970 -6.0491 Variance 3821417.25 4400641.39 Observations 98 98

TABLE 4 2011 BUS RIDERSHIP

September October Difference T Stat Mean 1639.3850 1615.9456 23.4394 1.6958 Variance 3958461.96 3844000.76 Observations 98 98

FIGURE 4 BUS RIDERSHIP CHANGE BY ROUTE, SEPTEMBER – OCTOBER 2012

28 Journal of Applied Business and Economics vol. 15(2) 2013 FIGURE 5 BUS RIDERSHIP CHANGE BY ROUTE, SEPTEMBER – OCTOBER 2011

ELASTICITIES

In the models below we estimate elasticites with respect to vehicle traffic counts, but these will be a close approximation to the gasoline price elasticity if the vehicle mix remains constant over the time period being examined. However, it may actually underestimate the true gasoline price elasticity. It is likely that higher short-run fuel prices will lead some drivers to use less gasoline even if they drive the same number of miles. This is possible by driving slower, maintaining their vehicle better, or selecting the family compact car instead of the SUV for an errand.

Static Model There are two common models used to estimate gasoline elasticities, a static model and a dynamic model (Lin and Prince, 2010). The static model examines gasoline demand (or vehicle traffic counts as a proxy) as a function of gas prices (P), income (Y), and other determinants of gasoline demand (X):

D = f ( P, Y, X )

In our very-short run model we assume that Income and other variables are constant, so the static model collapses to a function of price alone. Since time is the variable of interest, lags are introduced to see how recent past prices influence gasoline use. Consider the following model, which uses vehicle traffic volume to measure drivers’ response to higher gasoline prices, where n represents a time lag in days:

log VehCountt = b0 + b1 (log_GasPrice)t-n + b2 (Sat) + b3 (Sun)

Journal of Applied Business and Economics vol. 15(2) 2013 29 Sat and Sun are dummy variables for Saturday and Sunday, and VehCount is the average daily vehicle traffic count, aggregated over all traffic sensors in the county. The double log model has been found in prior studies to be more appropriate than a linear model for gasoline demand (Espey 1998). The coefficient b1 thus represents the elasticity of vehicle volume with respect to gas price. Given that gasoline demand is price inelastic we expect b1 to be between 0 and -1. Prior studies have shown that demand is more inelastic in the short run than in the long run. Very short run elasticities can be estimated by varying n, the time lag in days, in this model. We find a negative coefficient in every case, but close to zero in the first few periods. The coefficient value increases in magnitude monotonically as the time lag increases. Thus the elasticity of vehicle travel becomes less inelastic over time, consistent with prior studies of the long run vs. short run. The p-value also decreases monotonically, and elasticity estimates starting with the 7-day lag begin to be significant at the 0.10 level. In the very short run the responsiveness of vehicle travel to higher gas prices is close to zero. Within ten days the elasticity approaches -0.30, consistent with prior estimates of the short run gasoline price elasticity. Results are shown in Table 5 and Figure 6.

TABLE 5 OLS, VARIOUS LAGS ON LOG (GASPRICE) DEPENDENT VARIABLE: LOG (VEHCOUNT)

Lag Coefficient Std. Error t-ratio p-value

(days) log_GasPrice 0 -0.02613 0.106195 -0.2460 0.80657

log_GasPrice-1 1 -0.05542 0.107818 -0.5140 0.60936

log_GasPrice-2 2 -0.07256 0.105708 -0.6864 0.49544

log_GasPrice-3 3 -0.09970 0.106866 -0.9329 0.35517

log_GasPrice-4 4 -0.12638 0.107916 -1.1711 0.24701

log_GasPrice-5 5 -0.14806 0.108726 -1.3618 0.17937

log_GasPrice-6 6 -0.15436 0.107233 -1.4395 0.15637

log_GasPrice-7 7 -0.18473 0.107523 -1.7181 0.09223 * log_GasPrice-8 8 -0.21383 0.107463 -1.9898 0.05245 * log_GasPrice-9 9 -0.27138 0.100838 -2.6913 0.00989 *** log_GasPrice-10 10 -0.30108 0.100152 -3.0062 0.00432 ***

(The coefficients for the dummy variables Sat and Sun are significant at the 0.01 level in each of these models.) * significant at the 10% level ** significant at the 5% level *** significant at the 1% level

Dynamic Model In a dynamic model, the impact of all prior time periods can be included in the estimate of the current elasticity. Consider a Koyck lag dynamic model, which includes a variable for the lagged dependent variable:

log VehCountt = b0 + b1 (log_GasPrice)t-n + b2 (Sat) + b3 (Sun) + b4 (log VehCount)t-(n+1)

30 Journal of Applied Business and Economics vol. 15(2) 2013 In this form the coefficient b1 is the static price elasticity and b1/(1- b4) is the dynamic elasticity which incorporates the effects of all prior periods. Assumed in this model is that the impact of prior periods decreases geometrically.

FIGURE 6 ELASTICITY OF TRAFFIC VOLUME VS. GAS PRICE OVER TIME

TABLE 6 DYNAMIC MODEL ELASTICITIES

lag, n b p-value b p-value b /(1-b ) 1 4 1 4 0 -0.01169 0.88972 0.22669 <0.00001 *** -0.01512

1 -0.02607 0.78282 0.17399 0.00032 *** -0.03156

2 -0.07249 0.50482 0.02326 0.62257 -0.07421

3 -0.11086 0.29102 -0.11170 0.02162 ** -0.09972

4 -0.15097 0.10285 -0.19910 0.00001 *** -0.12590

5 -0.14479 0.18496 -0.10040 0.19220 -0.13158

6 -0.13224 0.15439 0.28861 0.00003 *** -0.18589

7 -0.15948 0.09138 * 0.19855 0.00005 *** -0.19898 8 -0.21949 0.02760 ** 0.14124 0.00689 *** -0.25559 9 -0.27778 0.01002 ** 0.00695 0.88735 -0.27972

Journal of Applied Business and Economics vol. 15(2) 2013 31 Results are similar to the static model in that the estimated elasticities are near zero in the first few days after the price spike, gradually increasing in magnitude as consumers have time to adjust their driving behavior. Estimated coefficients for b1 and b4 from the dynamic model are reported in Table 6. The estimated dynamic elasticity b1/(1- b4) is still monotonic, changing from near zero in the first few days to about -0.28 after nine days.

CONCLUSION

In October 2012 a sudden gasoline price spike occurred in California. Southern California drivers responded by making fewer trips and by increasing their use of public transportation. An average gasoline price increase of 7.24% in October 2012 compared to September led to a 1.88% decrease in freeway vehicle traffic volume. These aggregate changes suggest a short-run price elasticity of -0.26, which is consistent with the short-run estimates of elasticity summarized by Espey (1996). The 7.24% average gasoline price increase was accompanied by an 8.96% increase in bus ridership, suggesting a cross-price elasticity of 1.24 for public transportation. Changes in both vehicle traffic counts and bus ridership were significant over this period. Driver response to higher gas prices was very small in the first few days after the price spike. This is to be expected since most drivers do not buy gasoline every day and the impact of a higher price may not be felt until their next stop at the pump. Price elasticities in the first few days after the spike were close to zero and not statistically significant. Over time the response increased and became significant by the 7th day after the price increase. By the end of 10 days the elasticity value approaches -0.30, consistent with prior short-run elasticity estimates.

REFERENCES

CBO (2008). Effects of Gasoline Prices on Driving Behavior and Vehicle Markets. Congressional Budget Office. http://www.cbo.gov/sites/default/files/cbofiles/ftpdocs/88xx/doc8893/01-14- gasolineprices.pdf.

Espey, M. (1996). Explaining the Variation in Elasticity Estimates of Gasoline Demand in the United States: a Meta-analysis. Energy Journal, 17, (3), 49-60.

Goodwin, P., Dargay, J. & Hanly, M. (2004). Elasticities of Road Traffic and Fuel Consumption with Respect to Price and Income: a Review. Transport Reviews, 24, (3), 275-292.

Graham, D. J. and Glaister, S. (2002). The Demand for Automobile Fuel: a Survey of Elasticities. Journal of Transport Economics and Policy, 36, (1), 1-26.

Hughes, J., Knittel, C. & Sperling, D. (2008). Evidence of a Shift in the Short-run Price Elasticity of Gasoline Demand. The Energy Journal, 29, (1), 113-134.

Lin, C.-Y. C. and Prince, L. (2010). Gasoline Price Volatility and the Elasticity of Demand for Gasoline. http://www.des.ucdavis.edu/faculty/Lin/gas_price_volatility_paper.pdf.

32 Journal of Applied Business and Economics vol. 15(2) 2013

Return and Volume and the 2008 Market Crash

Bakhtiar Moazzami Lakehead University

Bahram Dadgostar Lakehead University

INTRODUCTION

Many studies have examined the relationship between stock returns and volume. Gul and Javed (2009) examined the relationship between trading volume and performance of stock exchange index on a given day in the Pakistani market. Copeland and Copeland (1998) explore the contemporaneous and lead- lag relations of market returns using the Dow Jones global industry indexes. Copeland (1976) suggest that a latent variable, representing the rate of information arrival to the market, jointly affects price variance and volume, causing contemporaneous movements between the absolute value of returns and trading volume. Empirical work, surveyed in Karpoff (1987), provides support for this prediction in both equity and future markets. Suominen (2001) argues that the information content of volume is useful in determining the extent of information asymmetry in the markets. The idea is that there exist a positive relationship between volume and subsequent price movements and traders that use that information i their strategies achieve better trading results. The objective of the present study is to examine the relationship between return and volume in four major markets using a long time-series data spanning from March 1, 2003 to Nov. 1, 2012. More specifically, we examine the predictive power of volume for both the magnitude and direction of stock price movements, i.e., absolute value of return and returns per se. We also examine whether the 2008 market crash has had any significant impact on the return and volume relationship.

MODEL

To examine the linkage between volume and absolute value of returns, following Foster (1995), we construct the following structural model (Figure 1):

Journal of Applied Business and Economics vol. 15(2) 2013 33 FIGURE 1 FOSTER’S STRUCTURAL MODEL

Vt = α0 + α1 Rt + α2 Vt-1 + α3 Vt-2 + u1t Rt = β0 + β1Vt + β2 Vt-1 + β3 Rt-1 + u2t

Rt denotes return calculated as log price changes at time t and Vt denotes the log of trading volume at time t. We treat volume and absolute returns as endogenous and therefore use Instrumental Variable method as a GMM estimator to avoid problems of simultaneity bias. In addition, the use of a GMM framework produces heteroskedastic-consistent estimates by correcting the covariance matrix of the consistent IV estimator. Statistical significance of α1 and β1 provides support for the presence of contemporaneous relation between volume and absolute returns. Significance of β2 indicates that lagged volume has predictive power for future absolute returns.

EMPIRICAL RESULTS

Before estimating the above models, we need to examine the univariate properties of the series used in this study. Proper statistical inference based on the above models is contingent upon the stationarity of the underlying variables used in the models. To examine the univariate properties of the variables used in this study, we subjected them to a series of tests. First, we used the augmented Dickey-Fuller (ADF) test which included a constant and lags of first differences as regressors as suggested by Dickey and Fuller (1979, 1981) and Said and Dickey (1984). The optimum lag length is determined by the procedure suggested by Ng and Perron (1995). It is well known that the Dickey-Fuller test has low power. Elliot, Rothenberg and Stock (1996) proposed a variant of the ADF test, referred to as ADFGLS, in which the series are transformed by a generalized least-squares regression. A Monte Carlo study by Ng and Perron (2001) suggests that the ADFGLS test is more powerful than the standard ADF test. Therefore, in the second stage, we used ADFGLS to examine the time series properties of the rates used in this study. In fact, these two tests should be treated as complementary rather than substitutes. Results reported in Table 1 show that all test statistics are highly significant suggesting that series used in this study are stationary.

TABLE 1 UNIVARIATE PROPERTIES OF RETURNS AND VOLUME

ADF ADFGLS S&P500 log (return) -64.64 -24.14 log(volume) -22.65 -2.68 FTSE log (return) -15.38 -8.69 log(volume) -9.31 -5.21 NIKKEI log (return) -14.68 -35.72 log(volume) -9.28 -3.61 TSX log (return) -15.47 -14.84 log(volume) -5.92 -7.23

34 Journal of Applied Business and Economics vol. 15(2) 2013 Next, we estimated Model 1 using GMM estimator. Results are reported in Table 2. T-statistics are in parentheses.

TABLE 2 GMM ESTIMATION OF MODEL (1) (2003-2012)

Coefficient FTSE NIKKEI S&P500 TSX 1.79 1.46 5.42 α0 3.77 (13.23) (12.71) (8.86) (18.80) 0.03 0.03 0.03 0.07 α1 (6.14) (8.98) (7.84) (11.03) 0.56 0.50 α2 0.58 (29.46) (28.84) 0.62 (32.49) (26.92) 0.29 0.21 α3 0.24 (12.13) (14.93) 0.31 (16.18) (11.39) -0.8 -11.39 -9.83 β0 (0.78) -5.79 (7.568) (13.41) (10.97) 0.45 0.95 0.83 0.61 β1 (6.37) (9.16) (8.54) (10.82) -0.38 -0.38 -0.8 -0.06 β2 (5.4) (3.62) (2.81) (2.45) 0.22 0.16 0.28 β3 0.27 (13.71) (11.21) (7.97) (14.72)

Table 2 shows that the estimated α1 and β1 are positive and highly significant in all markets suggesting the presence of a positive contemporaneous relation between volume and absolute returns in all markets. In addition the estimated β2 is statistically significant in all markets supporting the proposition that lagged volume has predictive power for future absolute returns. It is of interest to examine whether the 2008 market crash has had any significant impact on the relationship between return and volume. Results of estimating model (1) for the 2003-2007 and 2009-2012 periods are reported in Table 3. Focusing on the period prior to the 2008 market crash, Table 3 shows that α1 and β1 are positive and highly significant consistent with the results obtained for the full sample. Similarly, the estimated β2 for all markets is statistically significant suggesting that past volume has predictive power for future absolute returns. Turning to the results for the period after the 2008 crash, we observe that volume and return remain contemporaneously correlated. However, the estimated β2 is no longer significant in any of the markets suggesting that information in past volume can no longer help predicting future returns. This is a significant finding suggesting a change in the relationship between volume and return in the post 2008 crash period.

CONCLUDING REMARKS

It is commonly held that large trading volumes are related to increasing prices, while falling prices correspond to low trading volume. Such relationship suggests that the direction of price change is related to the magnitude of trading volume. The present paper examined the above relationship between trading volume and return in four major stock markets. We found that the absolute value of returns and trading volume are contemporaneously correlated. We also found significant support for the proposition that trading volume has predictive power for stock returns for the full sample and the period before the 2008 market crash. This lends support to the sequential information flow model of Copeland (1976). We found that the predictive power of volume for stock return disappears after the 2008 market crash.

Journal of Applied Business and Economics vol. 15(2) 2013 35 TABLE 3 GMM ESTIMATION OF MODEL (1)

March 1, 2003 to Dec. 31, 2007 Jan.1, 2008 to Nov. 1, 2012 FTSE NIKKEI S&P500 TSX FTSE NIKKEI S&P500 TSX 1.76 5.76 6.81 3.66 9.47 α0 8.27 (14.40) (8.38) 1.98 (7.03) (13.76) (12.29) (12.44) 4.97 (9.62) (15.26) 0.06 0.04 0.08 0.07 0.06 0.08 α1 (5.38) (4.75) 0.08 (8.99) (5.89) (7.38) (10.32) 0.04 (5.47) (7.66) 0.55 0.66 0.50 0.48 0.49 0.53 0.36 α2 0.49 (17.36) (19.77) (24.24) (19.41) (15.70) (16.33) (17.02) (11.72) 0.11 0.30 0.19 0.19 0.19 0.14 α3 (3.92) (10.78) 0.25 (9.18) (7,27) (6.17) (6.52) 0.24 (7.73) (4.62) -0.31 -2.86 9.47 -13.96 -11.44 -22.07 -12.57 β0 -3.56 (2.66) (0.41) (3.25) (15.26) (7.94) (7.03) (8.44) (6.56) 0.35 0.45 0.08 0.74 1.63 0.72 β1 (5.21) (4.58) 0.78 (9.32) (7.66) (7.78) (10.28) 1.01 (6.43) (7.82) -0.35 -0.62 0.35 -0.018 -0.59 -0.02 β2 -0.16 (2.32) (3.56) (7.35) (11.72) (0.19) (1.56) 0.03 (0.18) (0.27) 0.20 0.04 0.14 0.04 0.10 0.13 β3 (7.25) (1.49) 0.03 (1.08) (4.62) (1.30) (3.22) 0.03 (0.79) (4.25)

REFERENCES

Copeland, M., and Copeland, T. (1998). Leads, Lags and Trading in Global Markets. Financial Analysis Journal, July/August, 70-80.

Copeland, T. E. (1976). A Model of Asset Trading Under the Assumption of Sequential Information Arrival. Journal of Finance, 31, 1149-1168.

Dickey, D. A. and Fuller W.A. (1981). Likelihood ratio statistics for autoregressive time series with a unit root. Econometrica, Vol. 49, 1057-72.

Dickey, D. A., and Fuller, W. A. (1979). Distribution of the estimators for autoregressive time series with a unit root. Journal of the American Statistical Association, 74, 427-431.

Elliott, G., T. J. Rothenberg and J. H. Stock (1996). Efficient tests for an autoregressive unit root. Econometrica, 64: 813–836.

Foster, A.J. (1995). Volume-Volatility Relationships for Crude Oil Futures Markets. Journal of Futures Markets, 15, 929-951.

Gul, Faid and Tariq Javed, (2009). Relationship Between Trading Volume and Stock Exchange Performance: A Case from Karachi Stock Exchange. International Business & economics Research Journal, Vol. 8, No. 8, 13-20.

Karpoff, J.M. (1987). The Relation Between Price Changes and Trading Volume: A Survey. Journal of Financial and Quantitative Analysis, 22, 109-126.

36 Journal of Applied Business and Economics vol. 15(2) 2013 Ng, S., and Perron, P. (1995). Unit root tests – ARIMA models with data-dependent method for selection of the truncation lag, Journal of American Statistical Association, 90, 268-281.

Ng, S., and Perron, P. (2001). Lag length selection and construction of unit root tests with good size and power, Econometrica, 69, 1519-1554.

Said, S. E., and Dickey, D. A. (1984). Testing for unit roots in autoregressive-moving average models of unknown order, Biometrika, 71, 599-607.

Suominen, M. (2001). Trading Volume and Information revelation in Stock markets. Journal of Financial and Quantitative Analysis, 2001, 36, 546-565.

Journal of Applied Business and Economics vol. 15(2) 2013 37

Business in Costa Rica: Trends and Issues

Lisa Kahle-Piasecki Tiffin University

INTRODUCTION

The Republic of Costa Rica is a Central American country bordered by Nicaragua to the north and Panama to the south. It lies between the Caribbean Sea and Pacific Ocean. Costa Ricans, or Ticos, as they call themselves, have the highest standard of living in Central America with purchasing power per capita income of about $11,500 U.S. (U.S. Department of State, 2012). Costa Ricans also have a life expectancy that is higher than the U.S. (Firestone, Miranda, & Soriano, 2010). There are several possible reasons for this. Costa Rica is a country without a military, primary education is free and compulsory, the health care system is universal and Ticos are said to lead a generally stress-free life (Firestone, Miranda, & Soriano, 2010). Costa Rica was historically known for its coffee and bananas, but pineapples have surpassed coffee as the number two agricultural export (U.S. Department of State, 2012). The number one export is microchips and due largely to Intel’s microprocessor facility near San Jose. This accounts for almost 20% of all exports and 4.9% of Costa Rica’s gross national product (GlobeAware, 2010). With their high literacy rate of 95% (Central Intelligence Agency, 2012), political and social stability, high quality of life, and low levels of corruption (Rodriguez-Clare, 2001), businesses may find it attractive to locate here. Additionally, Costa Rica’s nature and wildlife is extensive, so businesses related to ecotourism and the environment have a growing tourist market.

CULTURE AND DEMOGRAPHICS

Costa Rica has a population of around 4.6 million people (Central Intelligence Agency, 2012) with about 1.4 million people living in the capital city of San Jose. Of this population, 98% classify themselves as white or mestizo, which is a mix of Spanish and African roots, and 2% as black or indigenous (GlobeAware, 2010). While Spanish is the official language, English is frequently spoken, particularly in the resort areas and larger cities.

38 Journal of Applied Business and Economics vol. 15(2) 2013 Most Costa Ricans, 76%, are of the Roman Catholic Religion (Central Intelligence Agency, 2012) and conservative with traditional roles for men and women (GlobeAware, 2010). Women and blacks were given the right to vote in 1949, the same year the army was dismantled, giving Costa Rica the distinction of the only country that does not have an army (GlobeAware, 2010).

FOREIGN INVESTMENT

Costa Rica’s investment climate is considered favorable, leading to high foreign direct investment that is actively sought and led by two Costa Rican agencies, the Foreign Trade Promotion Corporation (PROCOMER) and the Costa Rican Investment and Development Board (CINDE; U.S. Department of State, 2011). In terms of ease of doing business, Costa Rica’s economy is ranked 110 on an index from 1 to 185 (World Bank, 2012). A high ranking, with one being the highest, on the ease of doing business index, means the regulatory environment is more conducive to the starting and operation of a local firm. During the last 20 years, a growing number of multinational companies have established manufacturing plants in the country, leading to the development of a technology and knowledge-driven industry (Rodriguez-Clare, 2001). In 1995, U.S. based company, Ameritage Carrying Case, established a second production facility offshore in Costa Rica rather than in Asia, based on the Central American nation’s skilled workforce, English language knowledge, geographical proximity and time zone alignment with the North American market and stable political environment (Music Trades, 2011). Other manufacturing facilities include electronic sector companies such as Intel, Hewlett Packard, IBM, Remec, Conair, and Sensortronics, and medical devices sector companies Abbott and Baxter. Much of the shift in the country’s main exports from agriculture to microprocessors is the result of Intel’s decision in 1996 to build a major manufacturing plant in Costa Rica. Intel’s initial investment of $300 million put Costa Rica on the map as an attractive location for other technology firms (Nelson, 2008). The attraction of Intel to Costa Rica was largely due to then Costa Rican President Jose Maria Figueres’ concentrated efforts to incorporate Costa Rica into the global economy by attracting high- technology investment (Nelson, 2008). This investment has become a well-known example of a “best practice” to follow in attracting foreign direct investment (FDI) to promote national development. After Intel’s initial investment, other investors from nontraditional sectors, such as medical devices, were also attracted to Costa Rica (Nelson, 2008). Costa Rican exports continue to show positive growth. In November 2012, exports increased to $10.4 billion from $9.7 billion in 2011, representing an 8.2% increase (Arias, 2012). This increase exceeded the annual goal by over 7%. While the majority of exports go to the U.S. - 38.9% - exports to the European Free Trade Association (EFTA) and European Union (EU) are increasing. Exports to EFTA increased by 95.2% and exports to the EU increased by 8.7%. The increase of exports to EFTA is in agriculture and medical devices but exports to the EU are fueled by growth in products like integrated circuits (Arias, 2012). Although the exports of products have increased, the Costa Rican economy is undergoing a profound and rapid transformation in which services are playing an increasing key role (Gonzalez, 2012). Exports of services such as finance, information technology development and support and customer service have more than doubled in the past decade representing 32% of total exports in 2011 (Gonzalez, 2012). The FDI in the services sector, has grown each year on average 6.5%, and increased from 27.2% in 2000, to 54.4% in 2011 (Gonzalez, 2012). Some of this increase is attributed to multinational companies such as Amazon, IBM, and Proctor and Gamble (Gonzalez, 2012). Increasingly, India is locating service operations in Costa Rica in the information management and knowledge management areas. Costa Rica has exceeded a record for the third year in a row in high technology FDI. Forty new high technology investment projects decided to establish operations in Costa Rica in services, life sciences, advanced manufacturing and clean technology sectors (Costa Rican Investment Promotion Agency, 2012). The 2012 figures show a new record for Costa Rica and represent over a 17% increase in FDI from 2011 (Costa Rican Investment Promotion Agency, 2012).

Journal of Applied Business and Economics vol. 15(2) 2013 39 ECOTOURISM

Ecotourism, defined as “tourism intended to promote ecological awareness and to limit damage to the environment” (Agnes, et.al., 2002), started in Costa Rica in the 1980’s and boomed in the 1990’s. During this time, Costa Rica gained a reputation as an ecotourism destination. In 1999, Costa Rica had 940,000 tourists annually and by 2011, that number rose and broke a record of 2.2 million visitors annually mostly from the U.S., Nicaragua and Canada (Costa Rica Tourism Board, 2011; Norman, 2011). While the ecotourism or sustainable tourism industry has provided needed jobs and income for many Costa Ricans, it also has some disadvantages, such as increasing the numbers of tourists, which leads to more building, and development of infrastructure. More building and development can lead to the destruction of important habitats for wildlife and fauna. Additionally, Costa Rica must fund more personnel to enforce laws that exist to protect the environment. As the reputation as an ecotourism destination grew, the country had a reason to preserve their forests and began instituting laws and regulations to protect wildlife. Costa Rica is considered a leader among Latin American countries in the design and development of a system of payment for environmental services (Russo & Candela, 2006). Costa Rica provides financial compensation to landowners for the ecosystem services provided by their forested lands. The payment for environmental services (PES) program started in 1996, and has received credit for helping to reverse the country’s deforestation rate and for enhancing Costa Rica’s image as a green country (Johns, 2012). Since 1997, the PES program has been providing payments to more than 4,400 farmers and forest owners for reforestation, forest conservation, and sustainable forest management activities (Russo & Candela, 2006). At one time, Costa Rica had one of the highest deforestation rates in the world (Johns, 2012). Land was cleared for agricultural and cattle ranching and other areas of development. This rampant development is the focus of the well-known novel, La Loca de Gandoca, or The Madwoman of Gandoca (Rossi, 1992/2006). In this fiction story, based on an actual case, the main character narrates the events that led to an environmental and legal case in which residents of a remote place in Limon the Caribbean province in Costa Rica, try to save a wildlife refuge from commercialization and eventual destruction. The destruction of the refuge for tourist and residential development, was heavily criticized by some for uncontrolled development. Since that time, multinational companies in the tourism and hospitality industry have located in Costa Rica and have found it beneficial to publicize and promote efforts to be socially responsible (U.S. Department of State, 2011). Even companies outside of the tourism area such as U.S.-based multinational Intel, pursue efforts to be socially responsible. Intel was a finalist for the U.S. State Department’s Award for Corporate Excellence in 2009 and 2010 because of its outstanding corporate social responsibility program in Costa Rica (U.S. Department of State, 2011). Marriot Corporation, a Fortune 1000 company, currently has six properties in Costa Rica. Marriott seeks to “take responsibility for the environmental impact of our business operations” (Marriott, 2012, “Environment”) by focusing on five key elements of environmental responsibility; (1) energy, water, waste and carbon, (2) supply chain, (3) green hotels, (4) engaging guests and associates, and (5) conservation. The location in Los Suenos, Costa Rica is known for its sustainable practices. Some environmental initiatives at the location include; bar soap that is discarded in the guest rooms is donated to a local tour company to wash horses, the golf course has trees that are designed to be environmentally friendly, and the hotel associates weekly participate in beach cleaning (Marriott, n.d.). Boutique hotels and resort hotels also publicize and promote their socially responsible practices. Family-owned hotel, El Establo, located in the cloud forest of Monteverde, has a commitment to the environment and sustainable responsible practices. The property participates in certification for sustainable tourism (CST) that measures a property’s impact on one or more of the following; environment, community, cultural-heritage, or the local economy (Certification for Sustainable Tourism, 2012). At El Establo, when entering and exiting a guest room, electricity is turned on and off with the door key. In order to lock a guest room door, a key must be removed from a panel on the wall, which will automatically turn off all lights in the guest room.

40 Journal of Applied Business and Economics vol. 15(2) 2013 The CST program was developed by the Sustainability Programs Department of the Costa Rica Tourist Board and the Costa Rica National Accreditation Commission and designed to differentiate businesses of the tourism sector. The program is regulated by the Costa Rican National Accreditation Commission (Certification for Sustainable Tourism, 2012).

MANAGEMENT ISSUES

In a relatively short period of time, Costa Rica has established a reputation as a global provider of information and communication technology products and services (Mata, Matarrita, & Pinto, 2012). The growth in this industry has led to a growing demand and shortage of Costa Ricans that are qualified to work in the country’s computer industries. Mata, Matarrita, & Pinto (2012) found that the growth for occupations in the industry is high and there are more positions available than employees to fill them. With more U.S. multinational companies considering Costa Rica as an area to establish operations, issues for training U.S. employees to go abroad should be a priority. Today’s business climate is one of fierce competition. Employees of large, global and multifunction organizations as well as small businesses are faced with increasing professional workloads and risks brought on in part by globalization (DeLong, Gabarro, & Lees, 2008). When establishing an operation in another country, companies should consider preparing an employee for the transfer by first determining their existing global and cultural awareness, preparing them for the specific country assignment through language training, explaining practical information on the country such as expected living conditions, housing, mail, transportation, electricity, and technology issues, and perhaps one of the most significant job-related issues is to pair them with a global mentor, an individual already living in the country who can assist the employee with the informal and formal needs of the job in order to increase the chances of success for the expatriate. Between 16 and 40% of U.S. international workers fail to complete their international assignments (Human Capital Institute, 2006). Of those who do complete the assignments, between 30 and 50% are considered ineffective or marginally effective. Current estimates show U.S. companies spend approximately $2 billion per year related to failed or ineffective overseas workers (Human Capital Institute, 2006).

GLOBAL AWARENESS

Corporations understand that to survive in today’s competitive business environment, they must move in the global marketplace and prepare their managers for international assignments (Swain, 2007). In addition to managers having an understanding of the possible language differences; daily living conditions, such as transportation, technology and housing, managers must have global capabilities with a global mindset to be effective (Swain, 2007). Javidan, Teagarden, & Bowen (2010) found that global leaders need a global mindset to succeed overseas. This mindset comprises three areas of capital; intellectual, psychological and social. The intellectual capital comprises the general knowledge and capacity to learn, it is the global business savvy, cognitive complexity, and cosmopolitan outlook. The psychological capital is a manager’s openness to differences and capacity for change, it includes a passion for diversity, thirst for adventure, and self-assurance. The social capital is the ability to build trusting relationships with and among people who are different from you. This is the intercultural empathy, interpersonal impact, and diplomacy of an individual (Javidan, Teagarden, & Bowen, 2010).

Global Mentoring Global mentoring programs are becoming more important as workers are asked to take international assignments (Human Capital Institute, 2006). Mentoring can be a very effective performance intervention to use with employees (Horvath, Wasko, & Bradley, 2008; Kahle-Piasecki, 2011; Kram, 1985; Murray, 2006; Nancherla, 2008). In a survey of Fortune 1000 firms, Kahle-Piasecki (2011) found that mentoring programs are increasingly offered in companies as a way to transfer knowledge and develop future

Journal of Applied Business and Economics vol. 15(2) 2013 41 leaders. One new form of mentoring that could be useful for a business in today’s climate of global competitiveness is electronic or e-mentoring. Although Kahle-Piasecki (2011) found that only a small number of Fortune 1000 companies are using e-mentoring, with the increasing importance of technology in the workplace including social networks, online collaboration and mobile applications, global e- mentoring could be very significant in developing a successful transition for a foreign assignment. Global e-mentoring can be defined as the virtual pairing of a more experienced individual with a less experienced individual in a relationship that crosses cultural and geographic boundaries and is formed and maintained initially through the use of digital tools. For this purpose, global e-mentoring can pair a potential expatriate, the mentee or less-experienced individual, with a more experienced individual who is an established resident of the future country – the mentor. In order for this type of relationship to be effective, mentors need to possess a very good understanding of the local culture (Elkin & Elkin, 2008). Also, the key to success in a mentoring program is the monitoring and programming elements (Doles, 2008). Assigning a manager to facilitate, monitor and evaluate the program will help develop and maintain the relationship (Cole, 2004).

CONCLUSION

Costa Rica is a country that has growing opportunities for FDI specifically in the areas of technology and ecotourism. During the last several decades, U.S. technology, electronic, and medical service companies as well as other countries and industries have begun establishing operations in Costa Rica. This has resulted in a shortage of Costa Rican workers with the necessary knowledge and skills to work in the technology industry (Mata, Matarrita, & Pinto, 2012). With the recent location of U.S. companies in the country, managers should consider training planned expatriates to work abroad by developing and encouraging a global awareness and pairing the employee with a mentor who is a resident in the future country assignment. The training of future expatriates to have a global awareness by pairing them with a global e-mentor, for example, will result in lower costs of sending employees abroad, higher performance productivity, and more effective business operations.

REFERENCES

Agnes, M. et. al. (Ed.). (2002). Webster’s new world college dictionary (4th ed.). Cleveland: Wiley Publishing, Inc.

Arias, L. (2012, December 20). Costa Rican exports surpass annual goal. TicoTimes, Retrieved from http://www.ticotimes.net/Current-Edition/News-Briefs/Costa-Rican-exports-surpass-annual- goal_Thursday-December-20-2012

Central Intelligence Agency. (December 5, 2012). Costa Rica, The World Factbook. Retrieved from https://www.cia.gov/library/publications/the-world-factbook/geos/cs.html

Certification for Sustainable Tourism. (2012). Sustainable tourism CST: Certification for sustainable tourism in Costa Rica. Retrieved from http://www.turismo-sostenible.co.cr/en

Cole, A. (2004). Exploring the relationship between human resource development functions and the mentoring process: A qualitative study. (Doctoral dissertation, Barry University, 2004). UMI No. 3143321.

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Costa Rica Tourism Board. (2011). Tourism statistical yearly report 2011. Retrieved from http://www.visitcostarica.com/ict/pdf/anuario/Statistical_Yearly_Report_2011.pdf

DeLong, T., Gabarro, J., & Lees, R. (2008, January). Why mentoring matters in a hypercompetitive world. Harvard Business Review, 115-121.

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Mata, F. J., Matarrita, R., & Pinto, C. (April 2012). Assessing computer education in Costa Rica: Results of a supply and demand study of ICT human resources. CLEI Electronic Journal, 15(1), 1-18.

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Journal of Applied Business and Economics vol. 15(2) 2013 43 Music Trades. (2011, December). Ameritage: Global manufacturing with a twist. The Global 225, 100- 102.

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44 Journal of Applied Business and Economics vol. 15(2) 2013

English Law: Window on Britain

Jean Didier College of Saint Benedict - Saint John’s University

INTRODUCTION

I imagine I was not alone: a legal studies professor in a business program, with considerable knowledge of U.S. and commercial law and some knowledge of international law, but with limited exposure to the domestic law of other countries such as the U.K. I had the opportunity to teach a study abroad course in the U.K. for my liberal arts university but wasn’t sure how to match my knowledge base with the interests and abilities of thirty U.S. and international students, most of whom had no prior legal studies training and perhaps little interest in international or domestic business. Their varied majors included theater, photography, mathematics, biology, peace studies, and literature, as well as accounting and business. U.S. law was only peripherally relevant to their study abroad experience. My knowledge of international law was too commercial for this group and did not focus on the host country in any event. I certainly had no experience with contemporary law in the U.K. But I seldom miss an opportunity to teach about the law and therefore would not relinquish legal studies as the course topic. My particular solution was to teach a course that addressed the sources and administration of English law in a general sense, with vignettes of substantive law areas as suggested by current events or matters of particular student interest. The course focused on basics of English law and legal history, with an additional plan to utilize the material to teach about English culture and values, and the interrelationship of law and culture. This paper is intended to share materials, pedagogy and experience from that course as a starting point for others planning to teach legal studies in the U.K., especially in London. It is also suggests comparative legal studies as a suitable course for intercultural learning at other study abroad venues. Parts II and III give descriptions of the legal and cultural content of the course, respectively. In Part IV, the lessons learned from the experience are discussed and summarized. Since teaching a study abroad course for the first time may be as much of a learning experience for the professor as the students, most of these lessons are my own.

Journal of Applied Business and Economics vol. 15(2) 2013 45 LAW CONTENT

An apt description for the course might be:

“English Law (and Culture):”1 The United States and England share the heritage of a common law system developed by the English over the centuries. Many of the underlying concepts in English law would be familiar to lawyers in the United States. But time and varied circumstances have also resulted in differences between the two systems. This course will explore selected topics in English law, incorporating historical, sociological, topical, and literary works as a window to British culture.

The use of “England” and “English” is not an oversight. “English law” refers to the law and legal system of England and Wales. This is one of three separate legal systems existing in the United Kingdom. The other two systems are those of Scotland (Scots law) and Northern Ireland (Roach, 2012).

English Common Law and Its History An introduction to the workings of the common law provided a ready starting point for legal studies in this course. English common law could be introduced much as in a U.S. legal environment course. The terminology of precedent, stare decisis, stare rationibus decidendis, ratio decidendi and obiter dicta all came from much the same playbook I had studied in law school (Roach, 2012). In fact, many cases from early law school were English and were obviously applicable (Legrand, 1997).2 Initially, I planned to use historical cases to teach common law, but ultimately I used a contemporary case (Levi v Bates, 2012), with modifications. An older case would have been more useful to illustrate the development of the common law, as will be discussed later. But Levi v. Bates (2012) introduced issues of harassment, privacy and defamation, which were active topical issues in the British press. Material on the distinction between the civil law and the common law can also be adapted from U.S. legal environment courses. I found this topic especially important in England for the opportunity it provided to introduce the mixed web of civil and common law that the U.K. functions within, both internally and internationally. Scotland is part of the U.K., but Scots law is civil, not common. law. Yet, Parliament is a source of law in many areas for Scotland (Roach, 2012). The European Union is a source of law for the U.K. which supersedes inconsistent domestically produced U.K. law (Roach, 2012). E.U. law reflects the civil law systems used by most of its members (Legrand, 1997). At the same time, Britain retains strong ties with common law countries such as the U.S. and member states of the Commonwealth. These distinctions are not insignificant. As Prof. Pierre Legrand (1997) has noted, “(t)he civil law and common law discourses, each with its own internal grammar, must be apprehended as reflecting different world-views” (p.62). The complexity that these contrasting legal approaches create in international relations for Britain provide a topic for class discussion.3 Course assignments and discussion on the history of the common law introduced the shared historical roots of the English, U.S. and Commonwealth legal systems.4 It was difficult to determine how much of this material to cover in the course. Personally, I found it fascinating and think a history of English law could be an alternate study abroad course. Even in the limited form used in this course, it was instructive. A text by Professor Van Caenegem (1988) provides a useful introduction of this history and analysis of the law’s development. He attributes the unique development of England’s law to the centralization of the courts, the writ system with an established bench of judges, and the development of evidentiary processes such as juries, not tied to divine intervention. 5

a. The centralized courts were subsequently studied as part of the English legal system. The writs took too much development to study in depth in this course (Baker, 2010; Milsom, 1981; Simpson, 1995).

46 Journal of Applied Business and Economics vol. 15(2) 2013 b. But as we studied torts, it still seemed possible to see the English courts working within the confines of precedent more than a U.S. court might. The concept of the writ and its role in the development of the common law could also tie with this. In a course with greater emphasis on torts, the references below offer historical cases that might be developed to illustrate this further. c. Change of methods of proof in the development of the common law illustrated very nicely a cultural shift in England and elsewhere from trial by ordeal, battle and compurgation to the increased use of juries for fact finding (Milsom, 1981). The oath itself remained, but for different purpose (Van Caenegem, 1988). Later, as they toured the Royal Courts of Justice, my students noted that the oath was still used, but the witness swore on a text appropriate to his/her religious belief.

If a study abroad course addressed contract law in greater depth, the history of the methods of proof, and of contract actions in general, might be useful. In the course, a brief period was given to discussion of the vision of medieval community life offered by the descriptions of compurgation and trial by ordeal (Milsom, 1981; Van Caenegem, 1988). But further coverage of English contract law, or of common law history, might also review the transition from subjective to objective intent in English common law. Charles Spinosa discusses the record of this transition found in Shakespeare’s Merchant of Venice, (1994). William O. Scott’s discussion of bonds, forfeitures and vows in the same play provide another opportunity to use literary material in the course (2004).

Sources and Administration of English Law Class study of the sources and administration of English law were combined with field trips to relevant sites. The students’ textbook provided a written outline of these topics, but it made more sense to the students once they had visited the locations. England (the U.K.) does not have a written Constitution in the fashion of the U.S., but many of the rights considered “constitutional” in the U.S. can be found in English law.7 In England, most rights that we would think of as “constitutional” are derived from Parliamentary acts, the common law, or even custom (Roach, 2012). Therefore, just as in the U.S., due process concepts are familiar: public trials are the norm and the independent “watchdog” role of the media is valued (Mullis, 2010; U.K. Ministry of Justice, “Royal Courts of Justice frequently asked questions”). The concept of rights versus the government can be conveyed to students visually with a trip to see the Magna Carta at the British Library, or the field where it was signed at Runnymede. The library has multiple copies of the document and a short interpretive display (British Library, “Magna Carta- treasures in full”). Therefore, Parliament, not a constitution, is the “supreme law of the land” in England (Roach, 2012). It is not merely the “legislative branch” of a tri-partite system of checks and balances, as in the U.S. and generally the courts have no right of judicial review over its actions (Roach, 2012). What is striking is how accessible the activities of this central source of power are to the British people. Tours of the buildings are offered to the public each Saturday and on weekdays, the building is open to educational tours. Floor debates and committee sessions are open to the public (U.K. Parliament, “Visiting”). After a weekday tour, my students waited a few hours to watch a House of Lords debate on the Defamation Bill we were studying in class (U.K. Parliament, “Defamation Bill 2012-2013”). On the user-friendly Parliament website, one can follow Parliamentary activity and subscribe for advance daily notices of house and committee activity on legislation. As I received e-mail notice of the next actions on the Defamation Bill, I could schedule myself to attend floor debates or committees, watch a stream of the event from the Parliament website, or check Parliament TV. My students commented on how they enjoyed the Prime Minister’s question session televised on Wednesdays. The report of debates, questions and other proceedings in the House of Commons and House of Lords are reported in Commons Hansard and Lords Hansard, respectively. These are available online (U.K. Parliament, “Publication and Records”). Open public access to the centralized court system of England facilitates further study of the common law and its administration. Courts of all levels can be found in London and, as in the U.S., are generally

Journal of Applied Business and Economics vol. 15(2) 2013 47 public (U.K. Ministry of Justice, “Royal Courts of Justice frequently asked questions”). My students toured of the Royal Courts of Justice, which can be arranged through the Tour Organiser (U.K. Ministry of Justice, “Justice Tours”). Virtual tours of the Rolls Building are also available (U.K. Ministry of Justice, “HM The Queen Opens the Rolls Building”). While my students watched cases in the Queen’s Bench Division, criminal matters are perhaps of greater interest to students and easier to understand. If combined with a course on “constitutional” or human rights, criminal courts like Old Bailey might be of interest. 8 The Supreme Court is also open to the public (Constitutional Reform Act 2005, s 40). A contrasting view of London can be seen in the Magistrate (or Justice of the Peace) courts (City of London, “Magistrates’ Court,” 2013). These are presided over by non-lawyers, and many criminal cases are heard here. As noted in the course textbook, “the rationale behind putting laypersons on the bench is the same as that behind the use of the jury: it allows everyday members of the community to become involved in the justice system and reinforces the notion of a participatory democracy” (Roach, 2012). On the website for the Royal Courts of Justice, it is possible to subscribe to a service listing all matters before each court on any particular day, as well at the times and courtrooms (U.K. Ministry of Justice. “Daily Court Lists”). The listing does not disclose case type, which despite my efforts to find additional information, I could only divine by making guesses from the court assignment and case name. Higher profile matters are noted in the press. While observing cases, one needs to be mindful of rhythm of the English term calendar. For the Queen’s Bench Division of the High Court of Justice, I noted that matters seemed to finish or wane with the cycle of the term. Students can observe this cycle visually as Michaelmas term opens with fanfare in October (U.K. Ministry of Justice. “Practice direction 39B-court sittings”; U.K. Ministry of Justice. “Queen’s Remembrancer”). The legal professionals of England are an integral part of the process. Guided tours through the Inns of Court are available, some from former barristers.9 The closed clusters of Inns and Chambers- such a contrast to the open halls of Parliament and Courts- echo the composite of expertise that Professor Van Caenegem described as so critical to the development of the common law (1988). In my experience, English legal professionals exhibited a public service disposition similar to lawyers in the U.S. A solicitor kindly came to my class and shared his insight on English law and the role of Anglo-American law in international business. To further illustrate the barrister system and to provide contrast to actual court observation, I had considered assigning readings from “Rumpole of the Bailey” by John Mortimer. But time constraints did not permit me to track down a chapter or a section from the popular BBC televised version that fit with other course content. This traditional English barrister-solicitor model is also undergoing change. The Legal Services Act of 2007 allows legal services to be provided through “alternate business structures” and by some non-lawyers (Legal Services Act 2007: Legal Services Board. “Welcome to the Legal Services Board”). Another source of law, rare now but apparently dominant in Anglo-Saxon times, is that of custom. It is now fixed by statute to be a custom which must have existed since “time immemorial” and in my research the cases found were most often akin to prescriptive or adverse possession cases in the U.S” (Regina v. Oxfordshire County Council, 1999; Roach, 2012).10 In addition to domestic sources, English law is now influenced by international sources, such as the European Union (“E.U.”) and the European Convention on Human Rights (“ECHR”) (Roach, 2012). Section 2(1) of the European Communities Act 1972 gives “directly applicable or effective E.U. law precedence over domestic law” (Roach, 2012, p.91). Regina v. Secretary of State for Transport, ex parte Factortame Ltd.(1992) provides illustration (Roach, 2012, p.91). In this case, the E.U. Common Fisheries Policy had provided for national fishing quotas to be fixed. Spanish fishing firms attempted to avoid these quotas by registering as U.K. vessels. When U.K. law (the Merchant Shipping Act 1998) fixed nationality, residence and domicile requirements for legal and beneficial owners, charterers, and managers and operators of fishing vessels registered on a its register so as to restrict these practices, Spanish vessels such as the Factortame challenged the law as discriminatory under E.U. law. On 25 July 1991, the European Court held that although member states could determine in accordance with the rules of international law the conditions for the registration of vessels on their registry and the right to fly their flag, they still had to comply with (European) Community law. The Court further held that the U.K.

48 Journal of Applied Business and Economics vol. 15(2) 2013 requirements were contrary to Community Law. This influence of the E.U. is not fully accepted in the U.K. (European Communities Act 1972 (Repeal) Bill 2012-13; Everson, 2010; Gardner, 2010). The English courts have also applied and enforced the ECHR, which requires English law be consistent with rights protected in the ECHR, as discussed in the following section.

Selected Areas of Law The particular topics of substantive law selected for the course were negligence, employment (and discrimination) and “defamation/media.” The course textbook provided the necessary background for each of these topics. Employment law was selected because of the contrast it offers to U.S. employment contracts. English law imposes implied and express terms to employment contracts that protect employees from termination and compensate longer term employees if laid off. Temporary employees have rights to benefits. Maternity and paternity leaves can extend for 52 weeks, in some circumstances (Roach, 2012). Negligence and defamation were selected because they are examples of English law that use similar terminology to their U.S. counterparts, but with some differences that effectuate very different results. Defamation was also selected because it was in the contemporary news. The active British press facilitated the use of current events for the course. In addition to major line newspapers, a lively free press provides papers at the Underground stations and many commuters read the news morning and evening (All You Can Read. com. “London Newspaper List,” 2001-2013). Some of these papers are quite sensational, but they often comment on political issues as well as celebrity matters and sports. If the news involves telephoto pictures of an underdressed Duchess of Cambridge, as it did in the Fall of 2012, the story would be well covered. But coverage in the print, television and electronic media also included discussions about the rights of the press in these matters, privacy, revived consideration of press harassment of the late Princess Diana, and examples of different press and privacy policy through the E.U. (Alleyne, 2012; Harassment Act 1997). The news regarding defamation of Lord McAlpine and his subsequent lawsuits also occurred during this time (Sears, 2012). The Leveson Inquiry and Report on the role of the print media was a major topic (Leveson, 2012). The Defamation Bill was before Parliament. In summary, the media gave considerable coverage to discussion of the appropriate role of the media/rights of expression when in conflict with rights of privacy and reputation. News coverage and multiple sources for explanation of the basic law made it easy to pull these issues into the classroom. At first glance, English defamation law tracks its U.S. counterpart: there must be a defamatory statement (one that tends to “lower the claimant in the estimation of right-thinking members of society generally”) it must be published, and it must refer to the claimant (Mullis, 2010, pp.1381-1382; Roach, 2012, p.431). But U.S. law generally places the burden of establishing the truth of the statement on the claimant, not the defendant. In England, falsity is presumed in the claimant’s favor: analogous to the presumption of innocence in a criminal matter (Mullis, 2010, p.23). The defendant must prove truthfulness, as part of the defense of “justification.” Nor is opinion as strong in defense. The English defense of “fair comment” requires that a defendant who expresses an opinion establish the comment was made without malice, on a matter of public interest and that it was an honest expression of opinion based on facts which are substantially true or privileged (Mullis, 2010, p.209; Roach, 2012). The strong protection of reputation in English law (Mullis, 2010) is alleged by some to stifle scientific debate. The fear of expensive lawsuits11 and possible damages can chill speech, even if the defense ultimately succeeds (El Naschie v. Macmillan Publishers Ltd. ,2012). Common concerns about defamation law in England are highlighted in the provisions of the Defamation Bill before Parliament in 2012-2013: • claimants must show that they have suffered serious harm before suing for defamation • removal of the current presumption in favor of a jury trial • provision of a new defense of "responsible publication on matters of public interest"

Journal of Applied Business and Economics vol. 15(2) 2013 49 • increased protection to operators of websites that host user-generated content, providing they comply with the procedure to enable the complainant to resolve disputes directly with the author of the material concerned • provision of new statutory defenses of truth and honest opinion to replace the common law defenses of justification and fair comment.

The incorporation of the ECHR into English law by the Human Rights Act (1998) has considerably impacted English defamation law. English courts are required to read statutes in a way that is compatible with the Convention and, if they cannot, they are to declare the relevant legislation incompatible. If the English court finds that an existing law does not infringe on the ECHR, a litigant can “provided he has exhausted the domestic remedies available to him, apply to the European Court of Human Rights for a finding that the relevant decision of the domestic court has infringed on one or more of his Convention rights” (Mullis, 2010, p.3-4). While reputation is not expressly included in the ECHR, the European Court on Human Rights and the domestic English courts recognize reputation as a right which, as an aspect of private life, is protected by Article 8 of the ECHR. Freedom of expression is protected by ECHR Article 10 (Mullis, 2010). Neither of these Articles has primacy over the other, leaving the courts and Parliament to balance the respective interests. As stated in the case of Re S (A Child):

"...The interplay between articles 8 and 10 has been illuminated by the opinions in the House of Lords in Campbell v MGN Ltd [2004] 2 AC 457. … What does, … emerge clearly from the opinions are four propositions. First, neither article has as such precedence over the other. Secondly, where the values under the two articles are in conflict, an intense focus on the comparative importance of the' specific rights being claimed in the individual case is necessary. Thirdly, the justifications for interfering with or restricting each right must be taken into account. Finally, the proportionality test must be applied to each. For convenience I will call this the ultimate balancing test" (2005, par. 17).

Similarly, the legislation supported in Lord Leveson’s Report on the print media provides for a form of press regulation to protect reputation, among other interests (Leveson, 2012). While the English and U.S. defamation law are so similar in language and concept, they are quite different. When contrasted to protections for the press in the U.S. First Amendment and cases such as New York Times Co. v. Sullivan (1964), reputation appears to have greater protection in English law. In comparison, U.S. law provides weaker protection for reputation. In English law, reputation is carefully protected with a “presumption of innocence” and freedoms of expression and the press have no a priori status. It is a legal divergence such as this that can be a subject for class discussions about culture.

CULTURAL CONTENT

A society's cultural values are embedded in its laws and institutions (Baptista, 2007; Licht, 2001; Licht, Goldschmidt and Schwartz, 2005). The course took advantage of this interrelationship. Over the summer, the students were assigned readings and written discussion questions from the text Cultures and Organizations, Software of the Mind, by Geert Hofstede, Hofstede and Minkov. (2010) (collectively referred to as “Hofstede”). While many other cultural schemas are available, Hofstede’s schemas are long established, focus on organizations and explain typical ties between particular political-legal systems and particular dimensions. The written assignment asked the students to compare the dimension scores found by Hofstede for the U.K., the U.S., and certain diverse ethnic groups found in London.12 At the end of the semester, the students were asked to reflect on possible relationships between traditional British cultural values and the English law and legal system.

50 Journal of Applied Business and Economics vol. 15(2) 2013 Dimension scores from Hofstede are shown in the table below. As demonstrated, this theoretical approach not only places the U.S. and U.K. in the same cultural category in every instance, but also scores them very close to one another within the categories to which they are assigned. Hofstede's original work posited four categories, or “cultural dimensions” which were purported to cover the essential cultural issues that affected behavior in work and organizations, though two more categories were added later. These were determined by statistical analysis of the responses an international group of workers gave to a standardized questionnaire. Hofstede uses one dimension to measure the extent to which a given culture is “collectivist” or “individualist.” "Collectivism pertains to societies in which people from birth onward are integrated into strong, cohesive in-groups, which throughout people's lifetime continue to protect them in exchange for unquestioning loyalty" (Hofstede, Hofstede, & Minkov, 2010, p. 92).

TABLE 1 SELECTED CULTURAL DIMENSION SCORES

Dimension U.S. U.K. India Poland Jamaica Dimension Range IND 91 89 48 60 39 6 - 91 MAS 62 66 56 64 68 5 - 110 PDI 40 35 77 68 45 11- 104 UAI 46 35 40 93 13 8 - 112

Individualism is the opposite of collectivism, and "pertains to societies in which the ties between individuals are loose: everyone is expected to look after him- or herself and his or her immediate family only" (Hofstede et al., 2010, p. 92). The U.S. and U.K. are rated very similar on this score. Indeed, they rank as the first and third most individualistic countries, respectively, in a sample of 76 nations (Hofstede et al., 2010, p. 95). Hofstede finds a culture’s score on the individualism dimension, referred to as its “IND” score, has impact on the relationship of the individual to the state. “In the individualist society, laws and rights are supposed to be the same for all members and to be applied indiscriminately to everybody...” (Hofstede et al., 2010, p. 126). Hofstede finds, in part, that in an individualist society everyone is expected to have a private opinion, everyone has a right to privacy, higher human rights ratings, ideologies of individual freedom prevailed over ideologies of equality, and autonomy is the ideal (2010). On the second dimension, Masculinity-Femininity (MAS), the U.K. and U.S .also score relatively the same. “A society is called masculine when emotional gender roles are clearly distinct: men are supposed to be assertive, tough, and focused on material success, whereas women are supposed to be more modest, tender, and concerned with the quality of life. A society is called feminine when emotional gender roles overlap: both men and women are supposed to be modest, tender, and concerned with the quality of life" (Hofstede et al., 2010, p.140). Hofstede notes that in masculine societies there is support for the strong, society is corrective, the political game is adversarial with frequent mudslinging, and few women are in elected positions (Hofstede et al., 2010, at p.180 Table 5.6). While still very similar, there is a slightly larger distinction between the U.K. and U.S. on the third dimension of power distance (PDI). Both nations have very small power distance, but of the two, the U.K.is the lower. My students reported observations of this in their internships. Power distance is defined as "the extent to which the less powerful members of institutions and organizations within a country expect and accept that power is distributed unequally" (Hofstede et al., 2010, p.61). It is therefore the value system of the less powerful members (Hofstede, 2010). Hofstede reports that small power distance results in the expectation that the use of power be legitimate and follow criteria of good and evil; that all

Journal of Applied Business and Economics vol. 15(2) 2013 51 should have equal rights; that power is based on formal position, expertise, and the ability to give rewards; and that scandals end the political careers of those involved (Hofstede, 2010, p.83 Table 3.5). There is a greater distinction between the dimensional scores of the U.S. and U.K. (albeit still small) in the fourth dimension, uncertainty avoidance (UAI). The U.K. score is lower or less risk avoidant. Hofstede defines UAI as "the extent to which the members of a culture feel threatened by ambiguous or unknown situations. This feeling is, among other manifestations, expressed through nervous stress and a need for predictability: a need for written and unwritten rules" (Hofstede et al., 2010, p.191). Hofstede states that in a society with weak uncertainty avoidance there will be fewer and more general laws and unwritten rules; that if laws cannot be respected this they should be changed; that citizens are competent toward authorities; that citizen protest is acceptable; that civil servants do not have law degrees; that citizens are interested in politics; that citizens trust politicians, civil servants, and legal system, that the burden of proof for identifying a citizen is on the authorities, not vice versa; and there is tolerance even of extreme ideas (Hofstede et al., 2010, p.223 Table 6.5). These dimensions and the respective ratings for the U.S. and U.K., gave the students opportunity to consider and discuss the relationship between cultural values and law. In particular, it gave them the opportunity to think about what English law might reveal about the English. For example, scholars have found low uncertainty avoidance consistent with the features of English common law (Hofstede et al., 2010, p.218; Legrand, 1997). The sensitivity of the common law for the facts of each case might not work as well in a high UAI culture. One author has referred to findings that the English “feel definitely uncomfortable with systems of rigid rules” to the point of having “an emotional horror of formal rules,” and that the English “pride themselves that many problems can be solved without” such rules (Legrand, 1997, p.50). The fully developed and defined rules of the civil law system might be too much for a low UAI culture (Legrand, 1997). The website and physical access to government, as well as apparent high news readership, even the existence of the BBC all might be help citizens who are interested in politics. In all of these cultural discussions it was necessary to help students keep a perspective on the use of cultural values. What Hofstede describes is, in part, desired states of society; stable beliefs of the group about how the world should be. A society may not always follow expected norms and any individual behavior cannot be assumed to do so. In sessions before travelling to the U.K., the students were given an exercise to help them use cultural values and other generalizations as a point of inquiry, rather than as a conclusion. The exercise practices using generalizations as hypotheses, or “questions with an observable component” (Paige, 2010). Much of what was discussed in this course, because of its relationship to English law, was "traditional" culture. But being in London particularly the students saw a diverse population. Further discussion might be had about how the English common law system might not be as well suited to recent immigrants from societies with different cultural values and how English law might address this. In England and elsewhere, for example, arbitration and mediation allow the parties opportunities to fashion processes that better fit their cultural values. Examples are the use of mediation/arbitration for family dispute resolution and inheritance issues.

LESSONS LEARNED

England, especially London, provide a hospitable study abroad venue for comparative law. Because of the shared legal history and language, perhaps also because of the similar cultural values, it is possible to “follow” and learn English law to some extent. The centralized and public legal system provides opportunities for “legal” field trips. The two foci used in this course- an overview of the legal system and an examination of selected topics- each provided a different window to British culture and both were useful. The selected topics required more effort to teach and learn. But they revealed divergences between U.S. and English law that raised interesting questions about British culture. For example, the law suggests that reputation matters so much more in traditional British culture than it does in the U.S. As a result, I was curious to observe the

52 Journal of Applied Business and Economics vol. 15(2) 2013 phenomenon of “reputation” in Britain and to find clues of what this might mean (if anything) in terms of cultural values. The experience of this course suggests that undergraduate “comparative legal studies and culture” may travel to other study abroad venues as well. In the case of a legal mono-linguist such as me, this may require a much generalized approach to the host legal system. But even if the language or the legal system of the host country is not amenable to ready comprehension, there is much to learn in the comparative study of civil and common law, their respective histories, and the cultural values of the host country.

ENDNOTES

1. The original course description in the catalog was slightly different. 2. Particular English cases may be searched and accessed at BAILII: The British and Irish Information Institute. See References, below. 3. Consideration of the possible cultural aspects of common law and civil law might provide alternate perspective to U.K debate about continuance in the E.U. and the European Court of Justice, but this was not researched. Examples of this debate can be readily found in Parliamentary documents, European Court of Justice and English cases on human rights and the popular press. (European Communities Act 1972 [Repeal] Bill 2012-2013), (Everson, 2010) & (Gardner,2010). 4. Students commented that they had not realized this common background of the U.S. and English legal systems. 5. While Van Caenegem focuses on actions of the Norman Henry II, he does not deny the previous Anglo- Saxon legal institutions which they overlay. Student excursions to the Tower of London and Dover Castle provided context for discussion of the two contemporary cultures. 6. The textbook used was Roach (2012). Of the four suitable textbooks I reviewed, Roach was selected for its inclusion of recent restructuring of the English court system and the establishment of the Supreme Court. 7. Many of these rights are also protected in the European Convention on Human Rights (ECHR), as discussed in following sections herein. Another alternate legal studies course in Britain might address compare what in the US we would refer to constitutional issues, either directly or comparatively. This allows the addition of material from the ECHR. 8. Judges and barristers are also more likely to wear wigs and robes- as the students expect- in criminal matters. But students should be warned that cell phones and other electronics are not allowed in Old Bailey and there are no lockers or other places to stow them. (City of London, “Central Criminal Court”). The Royal Courts of Justice, Rolls Building and Old Bailey are conveniently proximate. 9. A tour for my class was arranged privately, but this is available from a group such as the Blue Badge Guides. 10. A study abroad course in rural England might focus on customary, real property and inheritance law. 11. The losing party pays attorney’s fees in English courts. (Roach, 2012) 12. The diversity of London (recent census data show the population of London to be 44.9% white British) (U.K. Office for National Statistics) India, Poland and Jamaica are the emigration points for significant ethnic groups in London. (U.K. Office for National Statistics) Time did not allow for considered examination in this course of how English law might respond to cultural diversity. The scores of these groups are left in the Table to suggest additional scope in comparative law in a study abroad course.

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56 Journal of Applied Business and Economics vol. 15(2) 2013

The Financial Crisis of 2008: “It’s a Requirement to Leave Your Ethics at the Door.”

Thomas W. Harvey Ashland University The Foundation for Ethics in Financial Education

INTRODUCTION

The theory that this paper rests on goes back to 1776 and the publication of An Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith. Smith (2012, originally 1776) believed in the invisible hand of the market; that is, markets should be able to control themselves and resolve any problems or imbalances within them. He also believed in the right of the individual to pursue his/her own self-interest as long as that self-interest did not infringe upon the rights and liberties of others. A conclusion to be drawn, then, is that economic agents will behave in a civilized and ethical way in the conduct of their business. Boatright (2008) defined ethics in financial matters as moral norms that apply to business activities in the financial markets and in financial institutions, especially to those persons involved in management. Boatright (2008) continued that financial activity is governed by detailed rules and an expectation of a high level of integrity which he defined as personal values, moral beliefs, and a commitment to doing the right thing, even when it would be inconvenient or painful. Little has been done in the academic literature to examine this question, particularly in the understanding of the behavior of the banks, rating agencies, regulators, and Fannie Mae and Freddie Mac that led to the financial crisis of 2008 - 2009 and the response of federal government to it. There is, however, a considerable amount in the literature on Adam Smith and his moral philosophy which has been thoroughly explored (Hawtry and Johnson, 2010; Mussa, 2009; Keep, 2003). Further, there does not appear to be much, if any, reaction in the literature to what happened in the years leading up to the Crash of 2008 in terms of Smith’s (2012, originally 1776) position on the role of government in the economy. In his mind, the system of natural liberty leaves the government only three duties: defense of the country, administration of justice, and maintenance of certain public works (Smith, 2012, originally 1776; Morgan, 2009; Heilbroner, 1986). It is interesting to note that one of Smith’s prized students was Benjamin

Journal of Applied Business and Economics vol. 15(2) 2013 57 Franklin who, with an understanding of Smith’s theory, was the architect of the republic of the United States, based upon this concept of limited central government. Obviously, the United States government went significantly farther in 2008 - 2009 than what Smith and Franklin envisioned, and the question becomes one of Smith’s reaction to it. We will never know, but what we do know is that Smith actually argued against his own theory of the invisible hand and the pursuit of self-interest as he recognized the “dark side” of human beings and their capability for excess and corruption (Smith, 2012, originally 1776). Smith’s understanding came out of the Scottish Enlightenment of the mid-1700s and the combination of the belief in man’s intrinsic goodness and the skeptical suspicion about human intentions and motives (Herman, 2001). In studying the behavior of the financial system in 2005 – 2009, the market and the regulators held on to the Smith’s idea that the market would correct the excesses and corruption that led to the crisis itself (Morgenson and Rosner, 2011; McLain and Nocera, 2011). However, in this situation, there simply would not have been time for it to make the necessary corrections as the speed with which the crisis occurred was unprecedented. That said, much of what happened in 2008 was caused by Wall St. firms clinging to the outputs of the quantitative econometric models and a belief that those models were right with the market being wrong (Morgenson and Rosner, 2011; McLain and Nocera, 2011). That was the same behavior that brought down Long-Term Capital Management (LTCM) in 1998 (Lowenstein, 2000) from which Wall St. did not learn as the housing market fell apart in 2006 and 2007. So, on the one side, we have the regulators like the Chairman of the Federal Reserve System, Alan Greenspan, saying the markets are right, but we also have the executives at Bear Stearns, Lehman Brothers, and AIG saying that those same markets were wrong (Morgenson and Rosner, 2011; McLain and Nocera, 2011), a serious disconnect. This paper will not be the traditional empirical academic paper as it draws on literature of practitioners who were close to the financial disaster of 2007 – 2009 and the events that led up to it. It focuses on behavior and resonates with the understanding of Michael Gelband of Lehman Brothers who said “You cannot model human behavior with mathematics” (McDonald and Robinson, 2009). It is based on the work of practitioners such as Secretary of the Treasury Henry M. Paulson, Jr.; MSNBC’s Maria Bartiromo; well-known business author, Roger Lowenstein; and others. Can their accounts of what happened be biased? Yes, they can and probably are. My purpose, however, is to bring the ethical issues that Adam Smith knew were possible to the forefront of academic financial thinking so that we might avoid another circumstance like this that cost people their jobs, destroyed neighborhoods, and ruined life savings as the stock market crashed (Financial Commission Inquiry Report, 2011). It will also focus on the role of government in the economy as what may be good in theory may not be so good in practice. Adam Smith believed that, aside from the three proper roles of government, any other kind of government interference would have all sorts of unwanted consequences (Herman, 2001). Herman (2001) continued that, throughout history, governments, with the best of intentions, have become involved in economic activities of their countries, often with disastrous results. The best example in the U.S., prior to 2009, came after the stock market crash of 1929 and the subsequent Great Depression. At that time, the Federal Reserve Bank lowered the money supply and raised interest rates which curtailed consumer consumption even more than had been the case. The result was prolonging the hardship of millions of Americans. In this case, the Fed should have done just the opposite, lowering interest rates and increasing the money supply to stimulate consumption. That would have resulted in increased productivity, more jobs, lower unemployment, and higher tax revenue. In the view of noted economist Milton Friedman (2002, originally 1962), government exists, and is required, to preserve freedom, but, by concentrating power in just a few political hands, government is a threat to individual liberty. Bartiromo (2010) argued that free markets should be just that, free markets, a function of capitalism as it was designed to be by Franklin, John Adams, Thomas Jefferson and the rest of the founders. Her conclusion is that capitalism is the system that protects individual rights as alternative forms of economics (monarchy, socialism, communism) have failed. At its core, she believed, capitalism has the power to give people hope. But, capitalism can also be abused without the appropriate checks and balances.

58 Journal of Applied Business and Economics vol. 15(2) 2013 Wall St. (the financial system) exists to transfer capital from those who have it to those who want it (Lewis, 2010). It was becoming apparent in the summer of 2007 that the efficiency and effectiveness of that allocation of capital was starting to be a problem when two (2) of Bear Stearns’ hedge funds went bankrupt (Morgenson and Rosner, 2011; McLain and Nocera, 2011; Kelly, 2010). Obviously, there was serious damage done to the fortunes of their investors as their investments were now worthless. The banking system is fundamental to trade and commerce, but, in 2007, it was heading toward insolvency and a lack of liquidity which would curtail that trade and commerce. Lewis (2010) posed the question…when banking stops, credit stops…when credit stops, trade stops…when trade stops? We would find out in 2008 and 2009. At one point, when trade did, in fact, stop in 2008, the city of Chicago had but eight (8) days of chlorine for its drinking water (Lewis, 2010, 222). The financial crisis was caused by the reckless and corrupt behavior of people in Washington, D.C., the banking system, and corporate America (Morgenson and Rosner, 2011). It is a story of greed; corporate corruption; and lies told by politicians, corporate executives, bankers, regulators, borrowers, and the rating agencies. McDonald and Robinson (2009) went a little farther as they contended that it was caused by massive and systemic accounting fraud and pure corporate wrongdoing. In the words of Lehman Brothers executive Eric Hibbert: “It [was] a requirement that you leave your ethics at the door.” (McLain and Nocera, 2011, 87). The problem was, according to Treasury Secretary Henry M. Paulson, Jr. (2010), was newly- developed and highly-complex financial and credit products (credit default swaps and mortgage backed securities, respectively). It was exacerbated by an ineffective and inefficient regulatory system that was created early in the 20th century that was ill-equipped to deal with those new, complex products. The banks created securities (bonds) by packaging up home mortgages and then selling them in bits and pieces (called tranches) to investors (McLain and Nocera, 2011). They would sell these mortgage-backed securities (MBS) to Wall St. firms to remove the risk from their own balance sheets and, incidentally, to earn large fees (Paulson, 2010). This was complicated by the behavior of the agencies that existed to gauge risk and rate the MBS (Moody’s, Fitch, and Standard and Poor’s) that, according to McLain and Nocera (2011), put profits ahead of what was right. In order to generate large fees, these agencies would rate the tranches as triple-A, the highest investment grade, signifying little or no risk when they did not know how much risk was really in them. Effectively, they were being paid by the same people whose bonds they were rating. The higher the rating, the more fees the rating agencies were paid. Boatright (2008) maintained that financial and economic decisions should be made on a rational understanding of the trade-off between risk and reward. Parties in a transaction should have a good understanding of both. That is, economic exchanges are considered fair if both sides make a rational choice, but that did not happen in 2005 – 2008 because many of the participants in the events that led to the crisis were unsophisticated about the transactions in which they were involved, and many of the products were too complex for even the sophisticated investor to understand. With that said, Boatright (2008) did believe that an acceptable role of government is to correct market failures, so, in his mind, the actions of the government in 2008 – 2009, were merited. The debate about that continues. Smith (2012, originally 1776), being influenced by David Hume, understood that human rationality was an oxymoron and that people determine what they want on the basis of emotion, notably envy, greed, hope, anger, and fear. It is up to society to manage those emotions through accepted rules, conventions, and customs that are understood by all and become the basis of a society’s behavior. Bartiromo (2010) brought it to the present day saying that capitalism is based on public trust and the idea that people will play fair. Morgan (2009) countered that free markets encourage greed and manipulation which are foreign to Smith’s moral philosophy. Morgan (2009) continued that avarice and moral failure, along with the inability of the government to regulate the banks, were very evident in the crisis which shook confidence in the world’s financial markets which led, almost by definition, to a cessation of credit in the financial markets and stoppage of trade. The nation had not experienced anything like that in over seventy-five (75) years. Perhaps, this time was even worse because of the interconnectivity of the world’s financial institutions.

Journal of Applied Business and Economics vol. 15(2) 2013 59 But, the crisis did one more thing. It called into question the extent to which individual and corporate behavior should be subject to government intervention and the impact of that intervention on the crisis itself (Morgan, 2009). The problem, in Morgan’s view, was the failure of government to understand and control the types of credits being extended by the nation’s financial institutions. That resulted in some unsound banking practices, notably taking on an unsustainable amount of debt and assuming excessive risk, two conditions that are dangerous by themselves but which are lethal in combination. And, moreover, the government was at the forefront in enabling banks and other financial institutions to make loans to people who had bad credit and/or could not afford them (McDonald & Robinson, 2009).

BACKGROUND

We are all aware of the financial collapse/crisis in 2007 through 2009, but I doubt that many people have a clear understanding of the reasons behind it or the consequences of it. Fox (2009) wrote that not only did the financial markets fall apart, but also that rational market theories had been rendered useless. That is, irrationality became pervasive in the world’s financial markets, especially in the United States which infected the rest of the world. Consider these comments from the Chairman of the Federal Reserve, Ben Bernanke…

“Mr. President, we are witnessing a financial panic.” (Paulson, 2010, 255) “Tell the Hill we’re fixing to have a meltdown.” (257) “We’ve passed the point of what the Fed and Treasury can do on their own.” (257) “It’s a matter of days before there is a meltdown in the global financial system.” (259)

Bernanke sounded perfectly rational as he described completely an irrational situation that was caused by irresponsible behavior. It all started in 1993 when the Department of Housing and Urban Development began telling the banks to lower their credit standards in order to increase home ownership among lower to moderate- income families (McDonald and Robinson, 2009). If they did not comply, they could be cited under the Community Reinvestment Act of 1977 and would face penalties for any noncompliance. So, the bank had to make an ethical choice: lower its standards and make loans to people who probably should not have them or face prosecution by the federal government which could result in fines. Most lowered their standards, compromising their principles. Then, later in the 1990s, two events occurred that would shape the activities which led to the Crash of 2008. First, early in its second term, the Clinton Administration adopted the National Homeowner Strategy which was designed to increase home ownership in the United States by 8 million properties over the next several years (McClain and Nocera, 2011). All of a sudden, people who had not been able to have a home could have one. There were certainly ethical considerations in those decisions, as home ownership had become a right, not a privilege. In the spring of 1998, the other event occurred that would change the face of banking forever when Citicorp bought Travelers Insurance to go along with its acquisition of the investment banking firm, Smith Barney (McDonald and Robinson, 2009). These were clearly violations of the Glass-Steagall Act of 1933 which forbade the conduct of investment banking and commercial banking by the same institution. Glass-Steagall had been the law of the land since the Great Depression when it was learned that banks had been using their customers’ deposits to purchase stocks on margin. That was all well and good as long as the market was going up. But, we all know what happened in October, 1929, with the stock market crash which eventually bankrupted hundreds of banks, taking their customers’ life savings with them. Glass-Steagall said that would never happen again but with its repeal, history would rhyme in 2008 – 2009 with the events of 1929. On November 12, 1999, President Clinton signed the Financial Services Modernization Act that repealed Glass-Steagall (McDonald and Robinson, 2009) which would result in financial ruin, even though he was well aware of the purpose of this act that was passed in 1933. Advisors to the president

60 Journal of Applied Business and Economics vol. 15(2) 2013 thought that repealing Glass-Steagall was a good idea (Bartiromo, 2010) as the thought was that things were different in the late 1990s than they were in the 1930s. Perhaps they were with respect to technology, but the critical element that was missed was that human nature does not change just as Adam Smith had foretold (Smith, 2012, originally 1776). Then, in 2000, Congress passed the Commodity Futures Modernization Act which explicitly removed derivative financial instruments called credit default swaps (CDS) from the eyes of any regulator (McDonald and Robinson, 2009). These derivatives were designed by traders at JP Morgan as a hedge against the risk that asset prices would decline and would be at the center of the crisis as traders began to use them as bets against the survival of firms like Bear Stearns, Merrill Lynch, AIG, and Lehman Brothers. As the value of those firms declined, the value of the CDS increased so another ethical issue appears. On the one hand, free market economics says that traders should be able to move in and out of investment positions with no intervention. On the other, if they attempt to profit at the expense of an entire firm like Lehman Brothers, does that cross the ethical line? The technology bubble of the late 1990s burst in early 2001 sending the NASDAQ to levels from which it hasn’t recovered. In September, the country experienced the attacks on the World Trade Center in New York, sending shock waves through the financial markets. To try to restore order and confidence in the markets and to stimulate spending, the Federal Reserve cut interest rates to unheard of levels which had an unintended consequence. If interest rates are low, it is easier to buy a house which people started to do, especially with the passage of the Financial Services Modernization Act and the implementation of the National Homeowners Strategy. In 2002, the term “subprime lending” was not used very much, but companies like Household Finance were seeing loan volume increase significantly (McClain and Nocera, 2011). Its mortgage brokers were offering a 15 year fixed-rate loan, disguised as a 30 year loan which meant that the annual percentage interest rate was really 12.5%, not the 7% that was being promised (McLain and Nocera, 2011). Household Finance was not a commercial bank, so it could not take deposits to support the loans it was making. That meant it had to borrow money in the open market to be able to lend. So, Household would borrow in the market at one rate and would turn around and lend it at a higher rate. All was well if the demand stayed high, but if it did not and incoming cash declined, Household would have a problem repaying the borrowings which is exactly what happened. What also needs to be remembered is that Household was not regulated by the Federal Reserve since it was a finance company. Therefore, what we had was an unregulated finance company borrowing in the open market and making loans to people who could not afford them, charging a deceptive interest rate. This was being done all over the country because the government mandated that these loans be made. The regulatory system had no jurisdiction over these transactions which allowed its lenders to do whatever they pleased since they knew no one was watching. But, that posed another ethical question that would be repeated thousands of times. Is it ethical to lend money to people who probably cannot repay the loan and to charge them a deceptive interest rate? There was another problem: foreign investment in the United States. Countries such as China and India were becoming economic powerhouses and needed someplace to invest their excess liquidity. The U.S. bond market was an attractive investment, so the Chinese and the Indian governments invested heavily in the U.S. So, America had too much liquidity, very low interest rates, too much leverage, and increases in both the value of the stock market and real estate that could not be sustained. However, because so many people were making so much money, everyone chose to ignore the signs. Prices, they thought, would continue to increase. Figure 1 (Rose and Hudgins, 2013) is a depiction of the way in which the subprime loans were made, financed, packaged, and sold. It is shown here to demonstrate the flow of money (represented by the arrows) through the financial system. If any one of the flows stops functioning, the entire process would come to a halt. That would happen in 2008.

Journal of Applied Business and Economics vol. 15(2) 2013 61 FIGURE 1 (ROSE AND HUDGINS, 2013)

By 2004, Ameriquest was the largest subprime lender in the United States as since 2001, loan volume had grown twelve (12) times to $82.7 billion (McLain and Nocera, 2011). Leaving their ethics at the door, the lenders knew that the default rate would be high, so they imposed arduous terms on its borrowers many of whom would not have qualified for a loan previously. According to one of the loan officers, management at Ameriquest “condoned, encouraged, and participated in extensive document alteration, manipulation, and forging in order to see more loans” (McLain and Nocera, 2011, 130). The people at its corporate headquarters acted as if the company was a paragon of virtue rather than a place that “oozed with sleaze and fraud” (133). They were making loans with no down payment and no income verification to borrowers with low credit scores. They pooled the loans and securitized them into mortgage-backed securities (MBS), as shown in Figure 1, to be sold to the Wall St. banks like Lehman Brothers for a profit which would then turn around and sell them to the hedge funds like LTCM, also at a profit. The creditworthiness of the borrower mattered little as long as the loan could be sold, effectively transferring the risk at a profit, and, in the process, leaving their ethics at the door. By 2005, 75% of subprime loans had some sort of floating rate, usually fixed for the first two years (McLain and Nocera, 2011). What these “shadow” banks like Household Finance did not disclose to the borrower was that this very low fixed rate, say 2%, would reprice in two (2) or three (3) years to 7% or 8%. Very often, this increase was not disclosed to the customer. One in four mortgages in the first half of the year were “interest only” loans which meant that the customer did not have to repay any of the principal, a practice unheard of in more conservative times. Further, 68% of the adjustable rate mortgages (ARMs) originated by Countrywide Financial and Washington Mutual Savings had no or low documentation requirements (McLain and Nocera, 2011), another practice that went against traditional lending standards. But, money makes people do funny things, and there was plenty of money in the system. Angelo Mozilo, the Chairman of Countrywide Financial, sincerely believed in providing loans to low and middle income Americans, but he had a dangerous way of making them (Morgenson and Rosner, 2011). His model eliminated down payments and pared back the required documentation so that loans could be approved in minutes. Countrywide also sold these loans at a profit, but instead of going to Wall St., Fannie Mae was its biggest customer. As earnings at Countrywide grew from $1.7 billion in 2000 to

62 Journal of Applied Business and Economics vol. 15(2) 2013 $8 billion in 2003, the focus became market share fueled by corrupt lending practices that yielded huge bonuses for Mozilo and his mortgage lenders. In 2004, Countrywide was making 200,000 loans a month, selling 26% of them to Fannie Mae. However, by September of that year, one in eight Countrywide loans was problematic; six months later, it was one in five. The typical borrower at Countrywide had a reading level of sixth grade, and some were completely illiterate. How, then, could they understand the documents that they were signing; that is, if there were any? The lending officers laughed at the doubtful condition of many of the loans, $12.7 billion of which were sold to Fannie Mae in 2005. These were NINJA loans which stood for no income, no job, and no assets (MacDonald and Robinson, 2009). Countrywide employed brokers rather than having its own lending staff to interact with potential borrowers (Morgenson and Rosner, 2011). That meant that they were independent contractors who were concerned only about their commissions and not about the relationship with the customer which certainly was not the way proper banking had been done in the past. Furthermore, as shown in Figure 1, the established investment and commercial banks like Lehman Brothers, created special purpose entities (SPEs) to which they could transfer loans that were going bad which took them off their balance sheets. Much like what occurred at Enron, these SPEs hid defaulting loans so that, in the case of Citicorp and Wachovia, the regulators could not see them which made the banks look stronger than they really were, another ethical issue. Legal, yes, but it was still an ethical issue. In 2003, Freddie Mac was charged by the SEC with managing its earnings and irregular accounting practices of which Fannie Mae was charged as well (Morgenson and Rosner, 2011). Both were supplying money to companies like Countrywide that were making loans to people who could not afford them, thereby contributing to the situation that would ultimately fall apart. Fannie had overstated it earnings by $9 billion between 2001 and 2004, and, according to the SEC, its accounting did not comply “in material respect” to generally accepted accounting principles (McLain and Nocera, 2011, 179). Ultimately, Fannie paid a $350 million civil penalty to the SEC and $50 million to the U.S. Treasury. The question becomes, why they would artificially inflate the earnings. The answer is that there is empirical evidence that earnings and stock price are correlated (Johnson and Zhao, 2012; Cheng, Warfield, and Ye, 2011; Bali, Demirtas, and Tehranian, 2008). The higher the earnings, the higher the stock price which enriches shareholders, including management.

DISCUSSION

By September, 2008, Secretary Paulson was sure that if Fannie and Freddie were allowed to continue their current practices, they would take down the U.S. financial system and very likely the global economy (Paulson, 2010). His solution was to place them into receivership, effectively making these private companies wards of the federal government. Since Fannie and Freddie were independent companies, but with ties to the federal government, their failure, he understood, would result in tens of billions of dollars being lost by investors, loss of confidence in the federal government of the United States, and a possible run on the dollar. Fannie and Freddie were severely undercapitalized which would force the federal government to provide additional equity dollars and put taxpayers at risk. The federal government was the only institution in the world that could do that, but at what cost? Simultaneously, real estate prices continued to increase (McDonald and Robinson, 2009). Since those prices were continuing to rise, if the homeowner found that the mortgage payment could not be made, the home would simply be put up for sale. Someone would come along and purchase it for more than the original price, the bank would be repaid, and the new homeowner would move in. That worked as long as housing prices kept increasing. But, as we all know, asset prices can come down as well, which they did. When that would happen, the flow of money depicted in Figure 1 (Rose and Hudgins, 2013) would stop, effectively seizing the financial markets.

Journal of Applied Business and Economics vol. 15(2) 2013 63 However, the investment banks like Bear Stearns and Lehman Brothers kept buying the mortgage- backed securities (MBS) from the “shadow” banks since they knew they could repackage them and sell them at a profit to the hedge funds (Kelly, 2010; McDonald and Robinson, 2009). The problem was that they were borrowing in order to buy them and seemed to forget the fact that those borrowings would have to be repaid. What would happen, then, if the value of the asset that was purchased declined to less than the amount borrowed to make the purchase? The bank would have to borrow again just to pay off the original loan, a very dangerous practice that would not have seemed possible twenty (20) years earlier. But, their models said that could not happen. Unlike the commercial banks like Citicorp and JP Morgan Chase that were regulated by the Federal Reserve and Office of the Comptroller of the Currency, the investment banks such as Bear Stearns and Lehman Brothers and the “shadow” banks like Countrywide Financial and New Century were not regulated at all (Paulson, 2010). That allowed them to do whatever they pleased as they did not have to report to, or be examined by, the regulators. But, there was another problem: the Chairman of the Fed during the housing bubble, Alan Greenspan believed, in the tradition of Adam Smith, that the financial markets could fully monitor and police themselves (Lowenstein, 2010). He and other senior members of the Fed believed that financial executives could be trusted to do the right thing for the system, for their shareholders, and for themselves (Morgenson and Rosner, 2011). Apparently, they had forgotten the lesson of Long-Term Capital Management. Further, they failed to recognize the speed at which the crisis was occurring which meant that the markets would not have time to react. The Fed failed to stem the flow of toxic mortgages while they permitted greater easing of credit and lowering of interest rates which would lead to greater freedom on the part of the commercial banks. And so, financial institutions made, bought, and sold mortgage securities they never examined, and did not care that they were defective since they knew that no one was watching. While Fed trusted the bankers to do the right thing, there was so much money to be made that practically guaranteed that they would do the opposite. Once they realized no one was, in fact, watching and they could do whatever they wanted, greed took over, and reckless behavior became the norm (Morgenson and Rosner, 2011). And noted in Figure 1, the rating agencies were involved as well as they gauged the possibility that the bonds would default before their maturity (Morgenson and Rosner, 2011). Mortgage-backed securities, converted into credit default obligations (CDOs), could not have been marketed and sold without their approval. Investors relied on them completely. For most of their existence, prior to this time, the reputation of the rating agencies had been impeccable (Lowenstein, 2010). It was the job of Moody’s, Standard and Poor’s, and Fitch, to review any bond offering like CDOs for the risk of default before it went to market, giving the issue a rating, with AAA being the highest investment quality. So, if the rating agencies said the security was AAA, investors thought there was no, or very little, risk of default associated with it. Early on, the rating agencies charged the firms that were buying these bond issues, but changed that practice to charge the issuer. It was a lucrative business that presented a potential conflict of interest which was realized as more and more mortgages were securitized. The mortgage bankers at Lehman Brothers and the other investment banks decided that they would pay the fees being charged by Moody’s, for example, only if they liked the rating their new security received. If they did not like it, they would take the issue to Standard and Poor’s or Fitch. Further, the bank would analyze the new tranche until the financial outcome was favorable at which time it would send the package to the rating agency, stipulating what rating it wanted and what fee it would pay. The higher the rating, the higher the fee that the rating agency would receive. At the height of the mortgage frenzy, Moody’s put a AAA rating on thirty (30) securities a day. In 2006, $83 billion in securities rated that highly were ultimately downgraded (Lowenstein, 2010). The rating agencies either did not understand the risk, or they ignored it because of the fees. All they seemed to care about was maximizing the number of deals they could do for the Wall St. banks and collecting the fees (McLain and Nocera, 2011). They sacrificed their own integrity and ethics by putting profits ahead of what was the right thing to do (McLain and Nocera, 2011). Retired Moody’s president, Brian Clarkson, testified before the Financial Crisis Inquiry Commission “Moody’s sacrificed rating

64 Journal of Applied Business and Economics vol. 15(2) 2013 quality in an effort to grow market share” (117).They were handing out AAA freely by the hundreds, even as underwriting deteriorated, when they had never done that with AAA previously (Morgenson and Rosner, 2011). And, then, there was AIG. The largest insurance company in the world, AIG did business in just about every country, had $1 trillion in assets, and made huge investments in credit default swaps (CDS). These were insurance policies that were taken out by firms like Bear Stearns and Lehman Brothers to eliminate the risk that the value of the mortgage-backed securities that they purchased would decline. But, more dangerous, they were also purchased by speculators who were making bets that these firms would fail (Bartiromo, 2011). The executives and traders at AIG mistakenly believed that housing prices would always increase, never thinking that the associated mortgages would default (McLain and Nocera, 2011). So, if asset values would drop, AIG would be forced to pay the claims of the holders of the CDS. This was serious risk exposure as the value of the CDS in 2006 was $26 trillion, up from $800 million in 2001 (McDonald and Robinson, 2009). Deals were becoming so complicated that even those making them at AIG did not really understand the risk involved with them (McLain and Nocera, 2011). In July, 2007, Goldman Sachs filed a claim with AIG for $1.8 billion and simultaneously bought $575 million in credit default swaps that would pay off if the value of AIG’s stock would decline. As the value of the CDOs began to decrease, AIG was forced to pay on claims to those who held them which started a liquidity crisis that would ultimately cost the American taxpayers $182.3 billion to bail out AIG. (Ultimately, AIG repaid the federal government the amount of $205 billion in 2012.) AIG’s auditor, PriceWaterhouseCoopers, saw how management’s poor risk management was causing a material weakness, but it did not acknowledge the risk and the losses that they knew were coming. Further, they ignored what was happening in the markets, preferring to believe their econometric models much like the behavior at LTCM several years earlier. In January, 2008, PriceWaterhouseCoopers did declare that AIG had that material weakness in its internal controls over financial reporting and oversight which AIG disclosed in an SEC filing the next month. Later in February’s earnings release, the company wrote down $11.5 billion, not the $1.2 billion it had announced in its earnings guidance. The short sellers attacked AIG which sealed its fate as they would profit if the price of AIG’s shares went down. Going “short” means that the investor profits if the value of his/her investment declines. Henry Paulson, Jr., the Secretary of the Treasury, knew that AIG was a disaster as it did business in every part of the global financial system (Paulson, 2010). If it failed it would take other financial services companies around the world with it due to that interconnectivity. This was not something that the Secretary could let happen. His dilemma was one of principle as Paulson was a free market financier in the tradition of Adam Smith, but he knew that the failure of AIG was not an option and that the U.S. government was the only institution in the world that could rescue it. Sacrificing his personal principles, knowing that the system was on the verge of collapse, he arranged with Ben Bernanke, Chairman of the Federal Reserve for an $85 billion bridge loan under Section 13(3) of the Federal Reserve Act of 1913 (Paulson, 2010). This section permitted the Fed to inject capital into firms it did not regulate under “unusual and exigent circumstances.” It would cost the American taxpayers another $97 billion to save AIG. Seeing this, the credit markets were shutting down in a classic flight to quality in which traders wanted U.S. Treasuries for safety or to hedge the risk of their other securities. The commercial paper market was freezing and a sense of panic was becoming more widespread. The first visible sign that something was wrong occurred in the 4th quarter, 2006, when HSBC, the British bank, was forced to post $10.6 billion to its loan loss reserve in anticipation of defaults on the subprime portfolio (Paulson, 2010). In April, 2007, it would be bankrupt. Also, in the spring of 2007, the “shadow” bank, New Century Financial, declared bankruptcy followed by another warning when the two hedge funds at Bear Stearns failed that summer, leaving investors with worthless claims. Matthew Tannin and Ralph Cioffi of Bear were subsequently indicted on charges that they were misleading their clients by asking them to invest more in the funds when they, themselves, were actually selling out. Tannin and Cioffi were tried in federal court in lower Manhattan and were acquitted by a jury of their peers of

Journal of Applied Business and Economics vol. 15(2) 2013 65 profiting at the expense of their clients. Their behavior was certainly unethical and immoral but apparently not illegal. But the flow of money in Figure 1 kept going, but it would not be for long. In August, 2007, American Home Mortgage Investment Corporation, another “shadow” bank, filed for Chapter 11 of the U.S. Bankruptcy Code (Bartiromo, 2010). About the same time, interest rates on the subprime loans started to reprice to higher levels. As a result, large numbers of borrowers were facing default since they were no longer able to make their mortgage payments (Bartiromo, 2010). By this time, one in four Countrywide loans was in default (Bartiromo, 2010) which would eventually bring it down as well. Executives at Countrywide knew, as their lending brokers were making the subprime loans, the consequences could be quite severe, but they kept originating them for the profits they brought. As an example, Countrywide had made a loan to a sales executive claiming to earn $8,700 per month who had been unemployed since 1989, but he qualified for a home worth $398,000. An account executive for GNG Investments in Santa Clara, CA turned out to be a janitor making $3,901.58 per month but qualified for a loan of $600,000 (McLain and Nocera, 2011). Additionally, on August 7, 2007, BNP Paribas of Paris, France, stopped redemptions on funds holding mortgage-backed bonds, the reaction to which was a tightening of European credit markets. That would lead to a severe liquidity problem (Paulson, 2010) which forced the European Central Bank to inject $130 billion into BNP. The problem was now recognized as worldwide. Risk had been building up significantly in the system, the housing bubble was reaching its highest point, Wall St. firms were churning out CDOs by the thousands, subprime lenders were still making loans to those who could not afford them, and the regulators were nowhere to be seen. Everything was interconnected as shown in Figure 1 (Rose and Hudgins, 2013) and was very dangerous for the financial system, the country, and the world. In March, 2008, the outcome of the behavior of the previous seven (7) years presented itself. It was Thursday, March 13, and the management of Bear Stearns realized it had a serious problem as its liquidity position was deteriorating rapidly (Kelly, 2010). Bear Stearns had been characterized as dysfunctional, driven by greed and internal politics, but management, on this day, was struggling with a volatile stock market, decreasing home values, and the loss of its lenders and clients. Just a year earlier, the firm’s stock price was $172 per share. It was booking a record number of mortgage-backed securities as housing prices continued to rise. But, the housing market was coming apart with foreclosures becoming the norm. Just like the other investment banks, Bear had purchased mortgages from the “shadow” banks and securitized them into bonds (CDOs) which they then sold to the hedge funds, taking the resultant fees (Kelly, 2010). All was well as long as housing prices kept increasing since, even if the borrower found that the principal and interest payments were not affordable, the house could be sold for more than the purchase price, and the bank would be made whole. Now, however, loan demand was decreasing, and management was leery of making new loans. Since there was nothing to sell, therefore, they were unable to transfer the risk. That also restricted incoming cash flow. The firm was leveraged at 30 to 1 which meant that it had $30 of debt for every $1 of equity as it used to borrow between $10 billion and $20 billion per day, repaying it the next. Management wondered if its usual lenders would be there on Friday, March 14, and questioned whether they would be able to repay the loans they already had on the books. They began to consider that default was an option. The stock price had fallen to $65 per share. They were told that ING, a regular lender, had refused credit, and cash was being depleted as more clients left. At the start of the week, Bear had $18.1 billion in cash; by Thursday, that amount was down to $5.7 billion, and it owed Citicorp $2.4 billion. Without a rescue by the government or a merger with another financial institution, management knew that bankruptcy was certain. In that event, employees would be cut off; assets would be seized, shareholders would lose everything, and bondholders would get nothing either (Kelly, 2010). Due to the interconnectivity of the world’s financial markets and financial institutions, the failure of Bear Stearns would rattle the global economy. Timothy Geithner, the president of the Federal Reserve Bank of New York, and Ben Bernanke of the Fed devised a way to get the firm to the weekend in the form of a bridge loan from JP Morgan, backed by the balance sheet of the Fed (Kelly, 2010). But, things

66 Journal of Applied Business and Economics vol. 15(2) 2013 were getting worse as the firm also owed $11 billion to several hedge funds which it did not have. The stock fell on Friday to $30 per share as the short sellers attacked again. On Sunday afternoon, March 15, the announcement was made of the deal with Morgan at $2 per share, backed by the Fed (Cohan, 2009). Bear Stearns had brought it on itself with $30 billion in bad mortgage loans, too little diversification, too much leverage, and the failure of its hedge funds the previous summer (Kelly, 2010). But, the market helped destroy it as well, as speculators were making huge bets on Bear’s failure with billions of dollars of credit default swaps, short sales, and put options. The rumor on Wall St. was…when the markets opened on Monday, now that they got Bear, was Lehman Brothers was next? Right after Bear Stearns failed, David Einhorn, president of Greenlight Capital launched a direct attack on Lehman Brothers by shorting the firm’s shares (McDonald and Robinson, 2009). Einhorn believed that Lehman was in serious danger since it was leveraged 44 times. So, the mortgage bankers were borrowing in the short term to buy long-term securitized mortgages from the “shadow” banks just as had been the case at Bear. Einhorn saw this happening, suspected accounting fraud as well, saw an opportunity, and began shorting the stock. For second quarter, 2008, Lehman lost $2.8 billion which was the first loss it experienced since 1994 (McDonald and Robinson, 2009). Accordingly, the stock price began to drop as traders saw a similar pattern to what happened at Bear six months earlier. The firm had $680 billion in assets and $660 billion in liabilities, and began to see the cash flow stream from its domestic lenders diminishing. Thus, paying interest on its debt became problematic, so Lehman began to borrow internationally which resulted in increased interest costs, putting additional pressure on the income statement. To make matters worse, the firm was holding $7 trillion in credit default swaps as the insurer and the commercial paper market, on which Lehman relied for daily cash flow, was freezing. In a seemingly unrelated circumstance, the frozen commercial paper market caused Jeffrey Immelt, the CEO of General Electric, to tell Secretary of the Treasury Henry Paulson that he had about one week’s worth of cash, or GE would go under (Paulson, 2010). The consequences of that were unthinkable. Following David Einhorn’s lead, Wall St. started shorting Lehman’s stock, a sure sign that the end was near. On July 11, 2008, IndyMac Bank of Los Angeles, CA, failed, with thousands of poorly-documented subprime loans on its balance sheet (McDonald and Robinson, 2009). Fannie Mae was near collapse, and Lehman’s share price was down 75% for the year. Management at Lehman, including CEO Richard Fuld, knew that they would probably have to sell the firm, but even with an offer from the Korean Development Bank, for some reason, Fuld turned it down. He did not know, or failed to realize, that fueled by greed and the pursuit of the large bonuses, Lehman Brothers was on its own. But, he did have some interest from Barclay’s (McDonald and Robinson, 2009). On September 7, 2008, Fannie Mae and Freddie Mac were nationalized by the U.S. Congress which sent a shock wave through the economy (McDonald and Robinson, 2009). JP Morgan Chase, that cleared transactions for Lehman, demanded an additional $5 billion in collateral, or it would freeze Lehman’s accounts. The firm could not access the commercial paper market, so the outlook was very bleak. CEO Richard Fuld tried to structure a deal with Bank of America (BoA), but BoA wanted Merrill Lynch and the trillion dollars that it had under management in its retail division. He reached out to Secretary of the Treasury, Henry Paulson, but the Secretary wasn’t interested. And, then, on Saturday, September 13, it was just about over when Barclays backed away (McDonald and Robinson, 2009). There were three possibilities for saving Lehman Brothers. First, it could merge with another financial institution, but that did not seem likely. Second, it could appeal to the government for a federally-sponsored bailout, but neither the Treasury nor the Federal Reserve had the power to do that. Third, it could declare bankruptcy and cause the greatest financial crisis the world had ever seen. In fact, Sen. Chris Dodd, Democrat from Connecticut and Chair of the Senate Banking Committee, told Paulson not to bail out Lehman (Paulson, 2010) which left only one very unpopular and dangerous alternative. Everyone thought that the government would intervene as it did with Bear Stearns, but Treasury would have no part of it (McDonald and Robinson, 2009). The bankruptcy would be the largest in U.S. history, but no one knew what that would mean. At 2AM on September 16, Lehman Brothers filed for

Journal of Applied Business and Economics vol. 15(2) 2013 67 bankruptcy protection. By Tuesday, September 17, fear gripped the world’s financial system as the credit markets froze, effectively halting the flow of money, as demonstrated in Figure 1 (Rose and Hudgins, 2013). The markets were in a complete crisis of confidence, and no one could remember traders being so scared (Paulson, 2010). The world was petrified and on the danger of a complete financial collapse. The Dow Jones Industrial Average, which had been over 14,000 six months earlier dropped to 8,451 and was going even lower. One hundred forty (140) banks closed their doors in 2009, with another one hundred fifty-seven (157) failing in 2010 when just fifty had gone out of business from 2001 through 2008 (FDIC, 2012). The unemployment rate jumped from 5.0 in 2008 to 9.9 in 2009, before falling slightly to 9.4 in 2010 (Bureau of Labor Statistics, 2012). IRA and 401(k) portfolios were decimated, leaving thousands of Americans wondering how they would be able to retire. The Financial Crisis Inquiry Commission was created by the Fraud Enforcement and Recovery Act of 2009. Its purpose was to examine the causes and effects of the financial crisis of 2008 and to report to the President, Congress, and the American people (Financial Crisis Inquiry Commission, 2011, xi). It concluded that the crisis was a fundamental financial failure that created chaos all across the country…26 million Americans out of work; 4 million homes lost due to foreclosure; 4.5 million homes in foreclosure process, or late with payments; $11 trillion in household wealth destroyed in retirement and savings accounts (Financial Crisis Inquiry Commission, 2011, xv – xvi). America was in trouble, and no one could save it or operate without the aid of the federal government, but again, at what cost? The episode changed the face of the American financial system as the collapse of the derivatives market eliminated billions of dollars from the value of U.S. corporations, not to mention those retirement accounts. Bear, Merrill, the “shadow” banks, Fannie and Freddie, the rating agencies, and Lehman had brought it down. In the aftermath, it will take years to repair the reputation of the financial services industry because of the behavior it exhibited in the years before the crisis.

CONCLUSION

Secretary Paulson was not done as he had to deal with what was, in reality, a broken worldwide financial system. But, in the short-term, he had to determine what to do with AIG which was effectively insolvent (Paulson, 2010). The Secretary of the Treasury convinced Congress to give him $85 billion of the taxpayers’ money in a bridge loan to bail out the troubled insurance giant. He also knew he had to get liquidity back into the market, so he also asked Congress for $700 billion to be injected into the capital structures of the nation’s largest banks. The idea was to buy the toxic CDOs, but the problem was identifying the ones that were, in fact, toxic. A CDO tranche could contain hundreds of loans of different amounts, maturities, terms and conditions, and credit status of the borrower. The injection, known as the Troubled Asset Relief Program (TARP), failed on the floor of the House at the first reading. At the news, the Dow Jones Industrial Average collapsed and the Chicago Board of Trade Volatility Index (VXO) stood at 76.94 which a level that was unheard of. The higher the VXO, the more volatility in the market (financeyahoo, 2012). The world’s financial markets were experiencing a complete crisis in confidence, and no one could remember when traders were as scared as they now were. The world, according to Paulson (2010), was petrified. Maria Bartiromo was teaching at Stanford on a fellowship, at which time her students challenged her to defend capitalism (Bartiromo, 2010). They wondered about the value of the free market and questioned whether or not the financial system really worked as it was intended. She responded that there was little doubt that the low interest rates, too much liquidity, and excessive leverage, along with greed and recklessness, had damaged the system and the country. We return to Adam Smith. The idea that markets are always right and that they police and correct any sensed wrongs was being seriously questioned as they certainly did not do that in 2008. Capitalism is dependent on the public’s trust of the financial services industry and the financial system, and the notion that people will play fair. But, they don’t, and things had gone very wrong, prompting the government to step in and save the nation’s banks. Milton Friedman maintained that capitalism is required for freedom (Friedman, 2002, originally 1962). But, the debate continues about the nature of capitalism and the proper role of government. Thus, I raise

68 Journal of Applied Business and Economics vol. 15(2) 2013 these questions with my students at Ashland (OH.) University: What is the nature of capitalism? What is the role of the federal government? Is the theory proposed by Adam Smith lost for the ages? Or, do we need a different model? The weekend changed Wall Street not because of the bank failures, but because it was a stunning moment when the confidence of the nation and the world was shattered (Bartiromo, 2010), something that had not been seen since 1929. On June 25, 2010, Congress passed the Dodd-Frank Act in response to the crisis (Bartiromo, 2010). Many in the financial services industry were fearful that it would be a harsh reaction to the behavior that caused it, but it turned out to be a political solution and not true reform. No matter what regulations are in place, they can be ignored if people have a motivation to do so, and money is a powerful incentive. Bartiromo (2010) concluded that basic questions had to be asked: Have we learned our lesson? Are we going to be able to avoid another September 2008? Capitalism requires free markets, as Adam Smith theorized. It protects individual rights and has the power to give people hope. The financial crisis occurred because many people in the financial system left their ethics at the door and because the system itself abandoned its integrity. The incredible increase in wealth, the irresponsible high risk leveraging, and the dearth of reason and stabilization caused the failure of Bear Stearns, Lehman Brothers, Merrill Lynch, Wachovia, and the “shadow” banks like Countrywide and New Century Financial. Citi almost collapsed as well. In response, the American people must restore fundamental values and allow integrity to guide and protect the country (207 - 208).

LIMITATIONS

There are obvious limitations to this paper. First and foremost, there is little numeric data to support it, and I am not sure that there ever will be. However, we can look at the statistics published by the Financial Crisis Inquiry Commission about the jobs that were lost, the homes that were in foreclosure, and the wealth that was lost and see the result of the Crash of 2008. What we cannot model is the behavior that caused it. All we have is the work of the practitioners who have been cited to learn of the practices and activities of those who were involved in it. I accept that their accounts may be biased but accept it because they were there and were so much closer to it.

EPILOGUE

The question becomes…are the free markets of Adam Smith good only in theory? Are they so complex and complicated that there has to be intensified government regulation? As we survey the situation in 2008 – 2009, the only institution that could save the American and world financial system was the United States government.

Paulson (2010) also had some observations as he concluded On the Brink. Congress has to balance profit-driven market forces and regulations to harness them for common good. With that in mind, he cited crucial lessons to be learned from the financial crisis of 2008 – 2009.

• Our regulatory system remains a hopelessly outmoded patchwork built for another day and age (439).

• The financial system contained far too much leverage, as evidenced by inadequate cushions of both capital and liquidity. Much of the leverage was embedded in largely opaque and highly complex financial products (439-440).

• The largest financial institutions are so big and complex that they pose a dangerously large risk (440).

Journal of Applied Business and Economics vol. 15(2) 2013 69 But, there was one more lesson, and it concerns ethics. Was it ethical for the “shadow” banks to make loans to those whom they knew could not repay them? Was it ethical for the commercial banks, Fannie and Freddie, and the investment banks to leverage themselves so dangerously high to purchase the securitized assets from the “shadow” banks? Was it ethical for the rating agencies to rate those tranches as investment grade based on the fee they received from the banks? Was it ethical to hide those toxic assets in special purpose entities just to keep them off the banks’ balance sheets? Was it ethical for executives at the commercial and investment banks to continue to pay themselves huge bonuses when they knew that there was trouble ahead? Lehman Brothers executive Eric Hibbert was right when he said: “It [was] a requirement that you leave your ethics at the door.” (McLain and Nocera, 2011, 87).

REFERENCES

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Journal of Applied Business and Economics vol. 15(2) 2013 71

Poor Predictive Power and the Unrealism of International Trade Models: Proposing a More Realistic (Behavioral Economics Based) Model

Hamid Hosseini King’s College

INTRODUCTION

During the last few centuries, economists have developed various models to explain trade among nations. These models, which have assumed that trade essentially takes place among nations and not firms or individuals of various countries, have included Adam Smith’s notion of absolute advantage, the Ricardian model of comparative advantage, the Heckscher – Ohlin model, the Samuelson – Jones specific factor model, the gravity model developed by Tinbergan (in 1962), Paul Krugman’s model which emphasizes economies of scale and product differential, and others. In these models, trade among nations, thus international specializations can be explained by various factors. For example, while for Smith and Ricardo trade among nations and specialization would occur on the basis of labor productivity, in the H-O model, specialization among nations takes place on the basis of each country’s resource endowment, in the gravity model trade between two countries is directly related to the size of GDPs of those two nations and inversely related to distance between those two countries. No doubt, all these causes have been relevant in explaining international trade to some extent. However, all these models have had poor predictive powers. For example, neither gravity model or any other models can explain international trade during the great recession that began in August 2007. For, as between the first quarter of 2008 and the first quarter of 2009 GDP fell by 4.5%, exports declined by 17%. The scale and speed of that trade collapse poses a challenge to various models of international trade. In my view, this very much stems from lack of realism on the part of those models – in their

72 Journal of Applied Business and Economics vol. 15(2) 2013 simplistic assumptions, or in the inadequacy and incompetence of the cause of specialization those models assume. This paper argues that by adhering to the attributes of behavioral economies we can explain the world economy better and overcome the shortcomings that the above models face in their predictive powers. Thus, this essay, after describing some of the shortcomings of the above models, will try to construct a more realistic model of international trade. Prior to constructing the model, we will demonstrate that trade for the most part takes place among firms, and that firm may face various difficulties, including perceptual problems and the role that trade finance plays for individual exporting firms.

THE UNREALISM OF THE ABOVE TRADE MODELS

Although Adam Smith emphasized the benefits of free international trade and the need for countries to specialize on the basis of labor productivity in his theory of absolute advantage, it was David Ricardo who began to model international trade among nations on the basis of comparative advantage and labor productivity. The two country, two commodity model, one factor Ricardian model of international trade is very simplistic in its assumptions, among them that international specialization takes place on the basis of labor productivity alone. While the importance of labor productivity in international specialization cannot be ignored, however, the Ricardian model makes misleading assumptions and predictions in numerous ways. The Ricardian models, for one thing, assumes perfect specialization in each country, an assumption which cannot be observed in the real world. Because the Ricardian model is a one-factor model, it ignores that differences in resource endowment too can be a cause international trade. The Ricardian model does not also acknowledge the impact of international trade on income distribution within trading countries. As a result of this unrealistic assumption, in effect, the Ricardian model incorrectly assumes that each trading country as a whole always gains from international trade. In the Ricardian model, while labor, as the only factor of production, is unable to move internationally (which, obviously is not totally true), it is assumed to be is mobile domestically, being able to move from one industry to another. This domestic mobility will guarantee that individuals (as workers) will not be hurt by international trade. As a result, in the Ricardian model of international trade, not only that all countries which participate in international trade would benefit from global trade, but also assumes that international trade would also benefit every individual within participating countries – i.e. no effect on distribution of income. This assumption is not accurate, since international trade has substantial effects on the distribution of income within each country, and that benefits of international trade are often uneven. Why? We have to remember that resources (including labor) cannot more from one industry to another immediately and without cost, and that different sectors’ demand for resources (including labor) are not exactly the same. As the works of Paul Krugman and others have demonstrated, economies of scale too can be viewed as a cause of global specialization. By ignoring this point, the Ricardian model cannot explain the large trade flows between apparently similar countries. While the H-O model of international trade, by allowing for more than one factor of production, can be viewed as an improvement over the Ricardian model, it is also simplistic in its assumptions, thus, has had problems making accurate empirical prediction of the pattern of international trade. This explains the (1953) Leontief paradox, demonstrating the inability of the H-O model in explaining trade of the United States visa vs. other economies, and the 1987 (global) test by Bowen, Leams, and Sveikavan which was done for twenty seven countries. This model, with simplistic assumptions of constant returns to scale, perfect competition, international immobility of the factors of production, and the same technology for the same good in both (all) countries, assumes that the county that is abundant in a given factor exports the good whose production is intensive in that factor (i.e. H-O theorem), and international trade leads to factor – price equalization. The assumptions of the gravity and other trade models too are not very realistic. For example, while GDP and distance, assumed by gravity model as determinants international trade, are important, there are other factors that are ignored by the model.

Journal of Applied Business and Economics vol. 15(2) 2013 73 TRADE TAKES PLACE AMONG FIRMS

Certainly, labor productivity, resource endowment, economies of scale, and GDP size and distance among nations affect international trade. However, we should realize that international trade, with some exceptions, usually takes place among firms (usually multinational enterprises). Those exceptions being when a nation’s resources are owned by the government, or when governments regulate or control all or aspect of international trade. The first of these includes various oil exporting countries, like Saudi Arabia, where oil resources, the bulk of their international trade, are owned by the government. The second example includes a country such as the United States or the European union members, when regulating aspects of their international trade. For example, because of U.S. sanctions, American firms cannot trade with Cuba, North Korea, or Iran (or, starting with July 1, 2012, firms within the EU cannot purchase oil from Iran). Outside of these two exceptions, trade usually takes place among firms, and trade theory among firms is very much influenced by other factors. The so-called new trade deals with firms as the basis of international trade. However, in my view, for firms to be successful exporters, two factors, not mentioned by this new body of thought, become significant. One factor, somehow related to perceptional abilities is what some writers have called psychic distance. The second factor, a financially-based factor, is based in what is called trade finance. Both of these factors have been ignored by various models of international trade, including the latest ones. If firms are viewed as agents of international trade, it is important to realize that not all firms within a country have the same opportunity to engage in international trade. It is also important to realize that firms doing trade with other nations face a much more complex environment than if they were trading with firms within the same country; this complexity often leads to a great deal of uncertainty. Traditional models of trade have ignored these types of complexity and uncertainty. Traditional models of international trade have more or less assumed some type of comparative advantage, i.e. differences in opportunity costs of production, for trading nations. While for the Ricardian version these differences emerge from differences in labor productivity in different countries, in the Heckscher-Ohlin version comparative advantage among nations stems from differences in the endowments of the factors of production among nations. In newer models, comparative advantage may emerge from economies of scale, etc. if especially the first two factors were the only causes of international specialization and international trade, then most if not all firms in a country with comparative advantage would engage in international trade. Yet, as emphasized by Andrew Bernard, Bradford Jenson, Stephen Redding, and Peter Schott, that is not the cast at all. As those authors argued in their 2007 Journal of Economic Perspective essay, “Of the 5.5 million firms operating in the United States in 2000, just 4 percent were exporters. Among these exporting firms, the top 10 percent accounted for 96 percent of total U.S. exports”. Obviously, the firms engaged in more exporting must have various advantages that those with less exports or nor exports lack. The firms that export more must have advantages that would allow them to overcome some of the difficulties and complexities associated with international trade.

PSYCHIC DISTANCE AND INTERNATIONAL TRADE

As stated earlier, firms, as agents of international trade, face a complex environment dealing with both exporting and importing as compared to their engagement in the home market. In fact, this fact was acknowledged by writers as early as 1956, when economist W. Backerman, in his The Review of Economics and Statistics paper, discussed what became known as psychic distance as a barrier to international trade. To him, in addition to geographical barriers (such as distance, which emphasized in the Gravity Model) psychic distance too can be a factor in international trade. (1956, p.36). Some ten years later, in his 1966 book an Econometric Study of International Trade Flows, H. Linnemann too viewed it as a barrier to international trade, which Joliet and Hubner defined as: “The perceived distance between the home country and a foreign country, resulting from the differences in terms of cultural, business, and political differences, i.e. in language, political and legal systems, trade practice, etc.” (2003, p.5).

74 Journal of Applied Business and Economics vol. 15(2) 2013 Although psychic distance as a topic had been discussed by Beckerman in 1956 and by Linnemann in 1966, it gained prominence in the mid-1970s with the introduction of what has become known as internationalization theory in international business. This was done by the members of the Uppsala School in Sweden, in the works by Johanson and Vahlne (1977) and others. Johanson and Vahlne viewed language, culture, political systems, level of education, etc. as factors influencing the internationalization process. To those writers, firms are likely to begin their internationalization expansion, such as trade, into countries that are psychically close, before gradually expanding into countries that are psychically distant. To Johanson and Vahlne, because of the complexity issue, (insufficient knowledge, etc.) the first step in the internationalization process is “exporting to a country via an agent, later established a sales subsidiary…”. (1977, p.24). Obviously, this entry sequence for the firm engaging in international trade will begin in psychically close markets, to be followed into more psychically distant markets. In a manner similar to the proponents of behavioral economics, members of the Uppsala School, viewed psychically distance consists of factors that prevent or disturb firm’s learning about and understanding of foreign environment. (Nordstrom and Vahlne, 1994, p.43). The 1998 description of D.J. Lee too is similar to a description by someone adhering to behavioral economies, since, to him, psychic distance stems from perceptions about both cultural and business difference of home and foreign markets. (1998). To demonstrate these differences, Nordstrom and Vahlne even developed a psychic distance index, measuring those differences, between Sweden and various other countries. Using the same methodology, Romen and Shenkar found that Canada and the United States were almost the same. (See O’Grady and Lane, 1996, p.312). As some writers have argued, perceptions associated with psychic distance may even lead to the opposite results. Using psychic distance index, one would expect that Canadian firms having more success trading with firms in the United States. However, in their 1996 study, O’Grady and Lane found that Canadian firms which entered the United States market experienced a great deal of failure. This is what O’Grady and Lane called psychic distance paradox. (1996, p.31). The explanation those two authors gave for that paradox was as follows: “Instead of psychically close countries being easy to enter and to do business in, we argue that perceived similarities can cause decision makers to fail because they do not prepare for the differences”. (p.10). In other words, “These mental maps or preconceived ideas of the United States, and what it would be like to do business there, created barriers to learning about this new market”. (p.325).

INTERNATIONAL TRADE AND TRADE FINANCE

As stated before, the decline in world exports during the great recession that began in 2007 was much more than the decline in world GDP – while the value of world GDP fell by 4.6%, world exports fell by 17%. As suggested by Mary Amiti (2009, p.1), this decline in exports could not be explained by the gravity or other internal trade models. This demonstrates the fact that firms engaged in international trade are also affected by trade finance, a factor ignored by various international trade models. More specifically, this suggests that the health of banks and other financial institutions providing trade finance to firms which engage in international trade has a much larger effect on exporting than it has on domestic sales. This should be obvious since exports are much more sensitive to financial shocks like the one occurring during the great recession, since exports have much more default risk and higher working capital requirements than domestic sales in any country. Since firms engaging in exporting typically lack the ability or willingness to evaluate and measure default risk themselves, it explains why those firms often turn to banks to provide payment insurance and guarantees, and work with banks or other financial institutions to acquire credit or exporting guarantees. In fact, Mark Aubrin (2007), using data from the Joint-IMF-OECD-World Bank Statistics on External Debt, estimated that 90 percent of international trade transactions involve some form of credit, insurance, or guarantee issued by a bank or financial institutions. This is what is typically called trade finance, in other words “the use of financial intermediaries to manage an exporter payment risked terms”. (Ibid, p.2) In fact, the role of trade finance in international trade was very much seen in the case of Japanese economic crisis during the 1990s.

Journal of Applied Business and Economics vol. 15(2) 2013 75 Trade finance matters much more for international trade than domestic trade, because international trade is much more sensitive to financial shocks. International transactions are often viewed as much more risky than domestic transactions for at least two reasons. First, firms engaged in international trade have difficulty understanding and using foreign legal systems in the event of default or delay in payment. Second, “exporters often have much less information about counterparty risk and therefore are less willing to extend trade credit themselves”. (Amiti, p.6). As a result of these two factors export insurance is an enormous business. Of course, exporters also use trade finance since international trade takes a great deal more time to execute. These factors demonstrate the importance of trade finance, explaining why 90% of international trade transactions involve some type of credit, insurance, etc. Why did international trade collapse after 2007? One may attribute that the rise of trade barriers. While there was an increase in the rhetoric of protection, in 2008 and 2009, however, as suggested by Mark Wynne, “there is very little evidence to date that this rhetoric translated into more restrictive trade policy”. (2009, p.6). It seems that policy makers among more industrialized countries have absorbed the lesson of the Great Depression, when protectionist trade policy exacerbated the downturn”. (Ibid). As argued by Mark Wynne, the financial crisis that began in August 2007 had a more direct impact on trade flows, over and above the effect it had through the decline in economic activity. Why? “One possibility is that stress in the financial system caused financial institutions to out back or trade finance to exporting firms. (p.8). Existing models of international trade do not assign an important role to access to trade finance as an important determinant of trade. According to Wynne, the evidence available suggests that access to trade finance is an important determinant of firm’s ability to export and that the declines in exports to the United States were greatest among firms in countries where access to finance was already limited and for firms that were most dependent on external finance, had the lowest collateralizable assets and had the least access to trade credit. (Ibid, p.13).

UTILIZATION OF BEHAVIORAL ECONOMICS TO MODEL INTERNATIONAL TRADE

As explained before, notwithstanding some exceptions, international trade occurs among firms and not national governments. Specifically, international trade occurs among internationally engaged firms, whether multinational or international companies. Whether MNCs or not, these entities have decision makers who, as real human beings, are boundedly (and not omnisciently) rational individuals who face very complex global environments. Being real, these decision makers do not possess identical capabilities to obtain information relevant to the benefits and difficulties of their decisions to engage in international trade. In various international trade models, no such differences exist. In fact, information processing skills of these decision makers-whether about what has been called psychic distance, the possibility/difficulty of trade finance, or about the possibility of gainful international trade – are non- homogenous, and the uncertainties they face are agent specific. Undoubtedly, in this uncertain environment, the decision-makers within those globally engaged organizations must make decisions whose difficulties – in terms of both psychic distance and trade finance – exceed their own competence. As a result, decision making for those individuals moves from one of risk to that of uncertainty. In other words, while the international environment faced by those decision makers is very complex, decision makers have limited capacity for facing this complexity. (See Hosseini 2003 and Hosseini 2006). But how should we model decision making for companies that engage in international trade in this complex environment? Let us limit ourselves to the decision-making process of companies that engage in international trade (never mind that many exporters do also import and engage in foreign investment). Then, assume that U represents the uncertainty associated with making a decision to export for companies whose decision- makers are influenced by psychic distance as well as the ease and difficulty of attaining trade finance. We can argue that U is s decreasing function of P, i.e. the perceptual abilities of knowing the ease-difficulty of obtaining trade finance and understanding the degree of psychic distance. We can also argue that U is an increasing function of the complexity of the global trade environment reflecting the ease-difficulty of trade finance and the degree of trade finance. Since the complexity of international trade environment

76 Journal of Applied Business and Economics vol. 15(2) 2013 increases with an increase in psychic distance and the difficulty of obtaining trade finance, we can argue that this complexity is a measure of psychic distance and the difficulty of obtaining trade finance, which we would designate as E. No doubt, E itself is a decreasing function of newly attained information about psychic distance (i.e. cultural, political economic) and the difficulty of trade finance, or N. Thus, we can write:

u= (P, E (N) => equation 1 where: ú (P) < 0 ú (E) > 0 É (N) < 0

New information (N) may either increase or decrease the risk-adjusted value of an exporting decision. Obviously, an increase in N decreases the complexity of the international trade decision, being able to help decision makers within firms to revise previously held expectations about the country which they want to export to, and the possibility of receiving trade finance. Further, the impact of this new information may be positive or negative. Positive new information can increase the size/volume of intended exports, while negative new information can lead to a reduction in its volume. Of course, we have to realize that international information gathering, or even information about the ease –difficulty of trade finance, should be viewed as subjective, since different firm decision maker would react to new information differently. In our model, the decision to export, and the amount to be exported, is a function of the level of uncertainty about exporting faced by the firms involved. The conditional probability that the firm engages in exporting when it should depends on this uncertainty we would term R (U). We would also let W(U) denote the conditional probability of making an export decision when it should not. Obviously, both R and W are functions of U, which we defined as the uncertainty associated with making a right export decision. We can also argue that:

Ŕ (U) < 0 Ẃ (U) > 0

Thus, as uncertainty (U) increases, R will decrease and W will increase, thus the ration of R/W will decrease. To proceed further, let us assume that: Q (E) is the probability that the firm’s export decision is correct, and 1 – Q (E) the probability that the firm’s export decision is incorrect (again, E being a measure of complexity in terms of psychic distance and trade finance). Let us also assume that, for the firm, if it exports when it should its success is shown by a positive profit (gain) rate of G (E), and if it exports when it should not it fails, as measured by a loss of L (E). If that is the case, then firms should know exporting should take place if the expected gain (i.e. success rate) exceeds expected loss (i.e. failure rate). Because we argue that:

Expected gain = G (E) = R (U). Q (E) and Expected loss = L (E) = L (E). [ - Q (E) ],

Then we can write (equation #2) as:

G (E)·R (U)·Q (E) > L (E) ·W (U) [ 1 – Q (E) ] => #2 Dividing both sides of equation (#2) by = G (E) Q (E)·W (E) We will have: G (E)·R(U)·Q(E) is greater than L (E)·W(U)·[1-Q (E)]

Journal of Applied Business and Economics vol. 15(2) 2013 77 G(E)·Q(E)·W(U) G(E)·Q(E)·W(U)

Since this is equal to U (P,E), and we can call the above equation R the reliability condition, or B (P,E). We can re-arrange equation #2 to get our #3 equation, thereby introducing the tolerance limit, T (E).

B(P, E) R[UCP,(E)] is greater than L(E)·[1-Q (E)] = T(E), or equation #3 W[UCP,(E)] G(E)·Q(E)

The left hand side of the inequality in equation #3 is the reliability ratio, which is the ratio of our conditional probabilities, in other words the probability of correctly exporting when the entry leads to profit, relative to the probability of exporting when that exporting decision leads to a loss. This ratio shows that an agent’s competence- complexity gap affects the relative probability of making an export decision compared to the probability of making a correct export decision. T (E) in that equation is the tolerance limit. In the context of exporting to foreign countries, T(E) should be different depending upon the risk-adjusted expected values. Obviously, as the risk-adjusted expected value of an export decision becomes negative (due to a large psychic different, or difficulty of obtaining trade finance), the exporting project becomes less desirable for the firm. T(E) of greater one represents inability to export due to a large psychic distance and difficulty to obtain trade finance, and T(E) of less one but positive is the opposite. At any time, the risk-adjusted expected value of an export project may be positive or negative depending upon the positive/negative values of G(E), L(E), and Q(E). In this model, the value of T(E) may deviate from the value of one which would explain represent a behavior change for the firm’s decision makers. The degree and speed of this change depends on the reliability ratio, which in turn depends on the conceptual competence to interpret new information, and the degree of T(E) divergence from one. It is possible that information about the country the firm wishes to export to, or about the possibility of trade finance, becomes difficult to obtain or understand, or mistakes are made by firm decision makers. If such things occur, actions by exporting firms become unreliable since their competency – gap would be lower. At least partly, this explains the fact that firms in advanced countries would be more willing to export to other industrialized countries. Perhaps this would also explain why such firms would be less willing and eager to export to countries in periods of political upheaval or economic crisis. This model, relying on the realism of behavioral economics, assumes that decision makers of firms engaging in international trade are non-homogeneous in terms of their perceptual abilities, or their abilities to obtain trade finance. In other words, for those managers.

P1 > P2 > P3…… > Pn

Since all have the same degree of access to information, and all can apply for sources of trade finance, we can argue that uncertainties would be the opposite, or:

U1 < U2 < U3… < Un

Recalling that R(U) is the probability that an international export is taking place when it should, W(U) would be the probability of it when that export should not/would not be made, and that R(U) is a decreasing function of U and W(U) an increasing function of that. As a result we can write:

R1 (U) > R2 > R3 (U)…Rn(U) and W1(U) < W2(U) < W3(U)… < Wn (U) As a result of the above, we can write: B1 (P1, E) > B2(P2, E) > B3 (P3, E)… Bn (Pn, E)

78 Journal of Applied Business and Economics vol. 15(2) 2013 On the basis of these, a firm’s exporting project becomes feasible if each B(P,E) exceeds its T(E). Thus, in the case that information is vague and confusing, it would cause a great deal of uncertainty since B(P,E) would be less than T (E). In other words, the exporting project should not be taken unless more positive information would emerge. As stated before, international trade takes place among firms and not countries, and that managers of different firms possess different abilities and access to information. Thus, realistically speaking, the reliability rate would exceed the tolerance limit for some firms, and not for others - even for the same trading countries and in terms of trade finance. Thus, for the firms that are able to export successfully, B(P, E) would exceed their T(E).

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