English for Economic Sciences
Adriana Vintean
Communication is essential to life and imperative if business is to prosper and survive in a competitive environment.
It can be:
Verbal - the written word
Oral - the spoken word
Visual - the illustration
Numerical - the written and interpreted number
Electronic - using a computer
Communication should be received and understood so we must ask ourselves not what we want but what the audience wants.
The term communication skills covers a number of defferent areas, including:
-speaking clearly, fluently, convincigly.
-understanding and responding to non verbal communication(body language).
-Producing effective written communications, including briefs and presentations.
In business life it' s important not only to be efficient and do your job but also to look and sound friendly, confident, sincere and helpful.
Poor communication is the cause of all breakdowns in business relationships.
When they try to communicate people go through different stages and the lack of care at any of them lead to confusion and wasted time and energy.
1.The need or desire to communicate with someone else- aiming.
2.The translation of internal thoughts and feelings into an external means of transmitting them as a coherent message- encoding.
3.The transmission of the message(spoken, pictorial, written, body language, tone of voice, timing)- transmitting.
4.The reception of the message(how and why people listen)-receiving
5.The translation of the message to internal thoughts and feelings on the part of the receiver-decoding.
6.The need or desire to respond to the message that has been sent(thinking, feeling, planning internally, setting objectives)-responding.
A successful communication is meant to beware that the meaning of the message is the responsibility of the sender first. Having decided what it is that you need to communicate and whom you are going to communicate with, you then need to consider the impact the information will have- will it alarm people, will it make them more efficient, irritable, more comfortable, resentful, dafer, happier, bored, more productive, better informed, more motivated, more loyal? The impact that your communication will have on the productivity of your organization has to be a primary concern mostly if you are the bearer of bad news or your message is concerned with a change that will affect the working life of others. Think about the questions people will need answers to, ask yourself what you would feel if you were to hear this for the first time, decide just what you want your audience to do after you have communicated with them, think about the actions and changes that your communication will cause.
Then, you have to make your message of interest to the receiver. The more you can personalise your communication to fit with the needs and interests of your audience, the better that information will be received and acted upon. We have to list the information that is to be sent and then prioritize the points into categories such as:
must know, important to know, helps understanding, gives examples, nice to know, interesting but not important; this is important when communication is verbal since it is linear and it moves the whole time; the listener is required to take part in and remember all that was said. After organizing our thoughts we put them into words and images.They are based on our internal dictionaries, assumptions, experiences, education, mood. Clarifying the meaning comes next as sometimes words alone are not enough to get the meaning when we deal with complicated concepts or spatial information.
We think at least three times faster than we speak. It is easy to mishear, ignore or miss a great deal of information. So, written communication is easier to focus on because we can return again to parts that we need to consider carefully.
What impression do you try to give to the people you deal with in business?
* pleasant, sincere, efficient, confident, calm, honest, skilful, intelligent, nice , polite.
* Unfriendly, shy, aggressive, sleepy, unclear, lazy, dishonest, clumsy, stupid, inefficient, nasty, unhelpful, off hand, rude.
Asking questions is something people have to do a lot in business.
Decide what the questions are that led to each of these answers :
1.Yes, thanks I had a very good flight.
2.I'd like to see Mr. Barry if he's in the office.
3.On my last visit I spoke to Mrs. Helen.
4.It was Mr. Weber who recommended this hotel to me.
5.I think I'd like to see round the factory after lunch.
6.No, my husband is traveling with me. I'm meeting him later
7.We'll probably be staying till Friday morning.
8.No, this is his first visit; he has never been here before.
a.Did you have a good flight?
b.Who would you like to see?
c.Who did you speak to last time you came?
d.Who recommended this particular hotel to you?
e.When would you like to see round the factory?
f.Are you traveling alone?
g.How long are you planning to stay?
h.Has he been here before?
Imagine you're having dinner with Mr. Johnson who is visiting your country for the first time.
Write down ten questions beginning like this:
* Are...?/Is...?
* Do...?/Does...?/ Did...?
* Have...?/Has...?
* Who..?/When...?/Where...?
* What...?/ Why...?
* How many...?/How much...?/How long...?
What do you consider difficult and/or enjoyable about talking to:
* Someone you've never met before?
* A superior or someone who could influence your future career?
* Someone who is considerably older than you?
* A foreigner?
* A member of the public?
* What experience did you have with a public person?
* What does the meaning of a message depend on?
* How do you respond to change?
Principal Comunication Media
Written Oral/Aural
Internal External
Memoranda
Notices
Bulletins
Agendas
Minutes
Reports
House-journals
Contracts
Handbooks Letters
Circulars
Invitations
Estimates
Quotations
Advertisements
Orders
Invoices
Statements
Export documents
Promotion literature
Press releases
Articles
Reports
Information
Booklets Face to face-encounters
Interviews
Briefing sessions
Seminars
Workshop
Meetings
Conferences
Telephone
Teleconferencing
Intercom
Public address system
Radio
The Principal Communication Media
Visual/Physical Telecommunication/
Technological
Charts
Diagrams
Graphs
Photographs
Slides
Films
Television
Video
Overhead projector Models
Conveyer belts
Messenger/
Courier services Telex
Tele text
Facsimile transmission
Electronic mail
Voice mail
Videoconferencing
View data
Wide area networks
Cellular radio/
Telephone
Cable television
Satellite transmission
MY EVERYDAY ACTIVITIES
I start work at the same time every day.
I wake up only when the alarm clock strikes.
I go to work by car/ underground/ I walk
I work overtime and have very short breaks.
I am never late at work. I am always in time.
I do not complain about my work.
I like my job and my boss.
I hate cigarettes and coffee.
I share my office with a smoker who is...my husband.
I get a lot of important calls.
I attend meetings and I talk with people.
I ask questions and I give answers.
I take decisions, I negotiate.
I reach agreements, I create a climate of co-operation or expectation.
I work with money. I know that it bewitches people.
People fret for it, swear for it, devise most ingenious ways to get it and to get rid of it.
I work in the banking system/accountancy/management/trade/
I operate with consumer/ market/ current/ overhead/ top/ bottom/ ceiling(maximal) flat(unic)/floor(minimal)/closing(la inchiderea bursei de valori)/fair(convenabil)/ force account rate(de regie)/knock out(derizoriu)/ upset(initial, de pornire))/ price
I operate in a Stock Exchange with securities: marketable(usor realizabile/quoted/unquoted
I operate with : bearer bond-(obligatiune la purtator)/irredeemable bond (neamortizabila)./registered bond-(nominativa)/junk bond-(riscanta, cu evaluare de credit scazut).
I operate with shares: preference/ ordinary/deferred/forteited/ in trust.
I do market research and I check the mercurial(fluctuanta)/ sluggish(activa)/ sagging(in scadere)/steady(stabila)market.
I direct the sales for future delivery(vanzare la termen)
I talk about costs: flat(uniform)overheads(indirect)sunk(investit)capital(de investitie).
I chair meetings and take the floor.
I order a cake as I like to eat sweets.
I go home late in the evening, very tired.
I have supper and I eat some fruit.
I listen to the news on TV.
I go to bed and I have nice dreams.
I relax on weekends: I go shopping, I watch TV, I go to picnic, I breathe fresh air, I chat with my friends, I rest in the countryside, I get away from the noisy and dusty town, I listen to music, I cook, I read the latest books, I meet my friends, I drive my car.
Are you in control of your life?
I am keen on my job, enthusiastic, bursting with energy, confident with myself. I love new challenges, I analyze problems methodically, I am an objective thinker, I am friendly, highly trained, well informed, generous, easy going, polite,
Sometimes I am boastful, uncertain, embarrassed, moody, annoyed, bored, lacking confidence, reluctant, incomprehensible
I often feel that I am at the mercy of outside forces beyond my control.
I often feel that life is passing me by.
When people praise my work I believe that usually they really mean it.
I have at least one habit that I can't break.
I think it's a waste of time planning ahead because something always turns up which makes me change my plans.
I often dream about work problems.
I have at least three important leisure interests or hobbies that have nothing to do with my work.
I often refuse my friend's invitations because I have too much work to do.
When I read newspapers my mind keeps wandering back to work problems.
I enjoy meeting new people.
I like to be successful in my job
I want to know as much as possible about customers.
I never believe only in luck.
I don't like outdated and inefficient things.
I admire smart people
I enjoy discussions and to hear other people's opinions.
I find it easy to choose rich colour combinations in clothes, furniture,(yellow-happiness, fulfillment, positive thoughts, creativity, orange-positive energy, well being, blue-infinite power, balance, wisdom, red-courage, determination, energy, ..
I make important decisions based on what looks best to me, on my feeling and intuition. I think of myself as someone who dresses sensibly, neatly, tidily.
I like to share attitudes and values with my partner.
I like to meet the highest demands and standards.
I consider signs important in life:nr.1.-creative power, unity, nr.2-balance,nr.3-the Trinity,nr.4-order, nr.5-the figure of man, nr. 6- universal harmony, nr.7-cosmic order, nr.8-the initiated one,nr.9- eternity...
What are your weaknesses ?
I am inexperienced, too enthusiastic. Not very confident in using the computers, shy, not a very good communicator.
Sometimes I have no direction in life, I feel like getting lost.
Do you agree or disagree?
1. whatever reason people have for living together, it is a private matter.
2. couples need support of other families, of society.
3. young passions die and interests change.
4. rooms reflect our personalities and colours too.
5. man is confronted with possibilities or alternatives on the basis of which he can project his life.
6. we are left with the freedom of choice as long as we consider experience never limited and never complete.
7. we will always search for temporary solutions, we will always move away from the values and authority of the older generations.
8. relationships will always remain incomplete even if with wonderful moments.
9. we create versions of reality out of our desires and when they clash with the external world they disappoint us.
10. we become complete when we assume the responsibility for our own lives.
11. if we fail to look into ourselves we remain fragments, unsatisfied, incomplete, empty.
12. never look into the past in order to find out how to live in the present but always make the effort to find a new direction in life.
13. some of us fill the gap in our life by the help of traditional values and yearn for the stability and security of marriage, others respond only emotionally being "prisoners" of impulses, following a logic of the soul.
14. if given a solution, we face reality and act6 creatively in terms of our own powers and we answer the most important questions in life.
15. sometimes we live out an illusion all our life and realize that the workings of fate are enigmatic. We get strength when we cooperate with it as we live in an universe of oppositions where the vertical has to return to the horizontal.
16. sometimes human suffering is far from remedy and we find the ordering of existence meaningless so that we come to doubt our own doubts.
17. sometimes we are too intellectualized and the intellect threatens and stifles the life of feelings and emotions.
18. the awareness of our divided nature has constantly unsettled us. Despite such a divided nature, we still manage to preserve our balance.
19. our attempts range from the ridiculous to the sublime to cross even if only in dreams, the boundaries of existence.
20. even if our illusions are swept away, we prefer life's restlessness.
The Interview
Fashions seem to change quite rapidly in interview techniques and the only rules that applicants should be aware of may be "expect the unexpected" and "be yourself".
In different countries, different trades and different grades, the salary that goes with a job may be only part of the package: perks like a company car or cheap housing loans, bonuses paid, company pension schemes, generous holidays, flexible working hours may contribute to the attractiveness of a job.
Everybody has to go through interviews to be offered a position. Recruiting a new member of your staff is likely to be the most expensive decision you will make as a manager. If you do it right you can make a fortune for your company. Most managers inherit a team of workers who know what they are supposed to do, who know something about your company, about the way your team works, about your customers, about the business processes within the department.
What happens when you bring an outsider in to this situation? Some of the possible outcomes if you do it wrong are:
-you and your staff spend ages helping the new team member to get started.
-Your team norms are threatened and possibly changed.
-You discover that the perfect qualifications on the new employee's C.V are no more than hype.
- You discover that the new employee is not fit for what you want.
So, the recruitment process has to take into consideration the following:
a) job advertisement
b) C.V
c) The interview
Both parties the interviewer and the interviewee have to communicate effectively: open questions, right answers, positive opinions.
A job appraisal interview is one of the major tasks of the leader of a team of people. It enables to: plan the future, look at individual performance, discuss and plan training and development needs, contribute to company career planning, salary planning and job progression, evaluate the efficiency of past targets and goals, establish priorities, identify, assess, solve problems, look at resourceful needs.
Job appraisal needs to be systematic if it is to be of any use. All effective managers have day to day or week to week contact with their team, they will also be running up dating sessions where they inform the team of corporate, market or local changes in working, policy or law and any changes that affect the workings of their teams. These are day to day tasks of management. The job appraisal interview is an opportunity for the team member and their manager to think about the future months in an organized manner. Before an appraisal they both have the opportunity to think in depth about what they have been doing and where this will lead in the future, where the success and shortfalls are, and what objectives they will set each other in the future.
Applying good communication practices to the appraisal process will ensure that career progression has the best chance of success from the point of view of both parties.
Interviews really aren't out to trap people. They evaluate people, they know how to assess your qualities.
Characteristics to have a successful interview :
* Be neat and well groomed.
* Be natural, friendly, relaxed but not sloppy or overly casual.
* Be interested in the work involved in the job.
* Have definite vocational goals.
* Articulate the goals you have in mind.
Attention to:
1.What to wear! Inappropriate clothing or being late can cost you the job.
2.What to bring to the interview! Select those items from your background that demonstrate what employers look for.
3.How to act. Sit straight, don't mumble, look at people when you talk, don't smoke.
Parts of an Interview
I. The Opening (2-5')
The interviewers will set you at ease. They will open with easy questions about your major interests or by telling you about the job of the company.
II. The Body (10- 20')
You should expect questions that give you the opportunity to show your strong points and of course to raise questions.
III. The Close (2- 5')
The interviewer will tell you what happens next.
Possible Interview Questions:
1.Tell me something about yourself.
2.Why do you want to work for us? -state your qualification -state things that separate you from other applicants
3.Did you have any accomplishments? -pick up one or two which you are proud of.
4.What is your class rank? What University did you graduate?
5.Where do you see yourself in 5 years?
6.What would you see as the ideal job for you?
7.What do you know about our company?
8.What are your interests outside work?
9.What are your strengths and weaknesses/ shortcomings ?
10.When did you last lose your temper?
11.What is the best idea you have had lately?
12.What is your worst fault and what is your best quality?
13.How long do you think you would stay with us if you were appointed?
14.What makes you think you'd enjoy working for us?
15.Why are people unlucky or unsuccessful in getting jobs?
16.If you were me what other questions would you ask?
Attention: -Don't focus on salary. -Draw the attention that you'll work hard with loyalty.
* Why are people unlucky or unsuccessful in getting jobs?
Imagine that a friend of yours is about to attend an interview. Write at least ten pieces of advice that you would give him. You have as suggestions:
. Wear smart, formal clothes
2. Don't smoke
3. Sit up straight
4. Arrive on time
* Find out about your partner's career.
Ask about:
-present job
-work experience
-education and training
-ambitions and prospects for the future
-its rewards and frustrations
* Discuss how the impression you may give especially to a foreign can be affected by:
a) Your expression ( smiling, blinking, frowning, looking down, looking straight in someone's eyes...)
b) The noises you make ( sighs, yawns, knocking loudly or softly at a door, clicking a ballpoint pen.... )
c) Body contact ( shaking hands, touching...)
d) Body language ( crossing your arms, sitting up straight )
e) Clothes and appearance ( hair, make up, suit, tie )
f) What you talk about ( politics, business, sport, family )
g) Your tone of voice (sounding cool, friendly, familiar, serious )
* Find out about your partner's career.
Ask about:
. Present - its rewards and frustrations
2. Work experience
3. Education and training
4. Ambitions and prospects for the future
* Employees are often given a "progress interview" some months into a new job, so that they get feedback on their performance so far. Participants on training courses often take part in similar mid-course interviews too. Make a list of ten questions that might be asked at such an interview in your firm. Here are some examples:
? What have been your most valuable experiences with us so far?
? Which parts of the course have been least valuable to you?
? What particular difficulties have you had?
? How will do you get on with the other members of the staff?
? Try this quiz with a partner.
1.Which is the best definition of good conversationalist?
a.Someone who always has plenty to say.
b.Someone who has plenty of amusing stories to tell.
c.Someone who will listen carefully to what you have to say.
d.None of them ( give your own definition. )
2. If someone just says "what?" after you've carefully explained something, do you ...
a.Go through the explanation again using different words?
b.Feel that you have been wasting your time?
c.Feel that you have not been believed?
d.None of these.
3. If someone always looks you straight in the eye this means that he is:
a.Honest
b.Rude
c.Friendly
d.Trying to frighten you
4. If someone shakes your hand very hard and long, it means:
a.He is very pleased to see you.
b.He is trying to show you that he is sincere.
c.He is waiting for you to say something
d.He is reliable and friendly.
5. If a man wearing jeans and no tie comes into your office, do you think he:
a.Isn't correctly dressed?
b.Can't be important?
c.Is quite normal?
d.Is someone who has come to fix the electricity or something?
6. If you are meeting an Arab client it is polite to:
a.Get straight down to business.
b.Wait until he raises the topic of business.
c.Stick to small talk for the first few minutes.
d.Ask him to close the door of his office to prevent interruptions.
7. If someone smiles while you're explaining something, this means he is:
a.Not sincere.
b.Happy.
c.Not listening.
d.Crazy.
Managing our Time
Are you a busy person?
Are you crowded by events?
Do you make your life manageable?
Well, time may be infinite, but each of us has a finite allocation: time is something you can't increase or decrease. As far as, no matter how clever you are, how wealthy, how industrious, you still get 24 hours every day. What you need to do is to carefully manage the time you have got putting it to the best use possible.
Before you can save time you have to spend some. You have to understand time management and make a little effort to do things like: plan, organize, review, rearrange, sort, think.
Can you invest time in time management?
Well, most of the words commonly used about time are money orientated: buying, losing, saving, spending, wasting time. Time becomes important because you can use it to make money but...no amount of money can buy you one extra second of time; time becomes more valuable the less of it we have: it is like most commodities.
Good time management can:
• give you more time to do what you want
• improve your availability
• improve your decision making
• improve your health
• improve your productivity, efficiency, effectiveness
• make you easier to live with
• make you easier to work with
• make you feel more relaxed
• minimize the risks you take
• reduce stress
Good time management is about setting limits for:
*availability (how willing you are to be disturbed, to make yourself available)
*duration (how long you spend doing things)
*importance (how you prioritize things)
*involvement (how much you do yourself as opposed to delegate to others)
*standards (how well you do things)
*urgency (how quickly you do things)
Why are interruptions urgent?( when the phone rings or on there is someone at the door)
Do you treat all work for a particular person as important?
Do you check how important something is when you receive work?
Do you limit your involvement in things?
If we aren't perfectionists what standards do we set?
Is it important to give priority to things that are non urgent?
Do you agree with the following statement? : "you need to spend your time on actually doing things, not being busy."
! So, you can spend time doing the right things, doing what you like doing, doing what you're good at, achieving things not just being busy.
! Then, setting goals is something that we must do because they increase our motivation, raise our self confidence, help us achieve more, improves our performance, increase our satisfaction, improve our concentration.
Which would you choose?
• creative (decorate your house, landscape your garden, write a book....)
• career ( become a manager, gain a pay rise, work part time...)
• educational (gain an extra qualification, learn a language, read more..)
• family (get married, spend more time with the family, visit your relatives more often...)
• financial (save at least 100$ every month, reduce mortgage payments, repay debts and credit cards...)
• mental (accept your faults, be more sociable, control your temper more, stop criticizing..)
• physical (cut down on junk food, lose weight, reduce tea and coffee, stop smoking...
• social ( have friends round once a month, read more, start a hobby, take a long weekend twice a year and go away..)
Discussion points:
1. Consider your personal goals and make a list of these. Do any of them conflict with your work goals? If so, which is the most important to you?
2. Are you aware of your own limits? Which are they?
3. Do you set unnecessary high standards, do you aim for perfection?
4. Where do you belong to: the optimist, the perfectionist, the rebel, the socialite(important persons) , the worrier? Do you agree with the following:
- being too optimistic is being unrealistic
- optimists are good starters of work but poor finishers.
- perfectionists often take so long to do something that its value is reduced; they set impossibly high standards and then set about achieving them.
- rebels set their own deadlines with no reference to others; relish(enjoy) crises and problems as they can overcome these to show how much in control they really are; they are good finishers but poor starters of work.
- socialites like to be involved with people; they like to talk, to gather information.
- the worriers never seem to develop confidence in their own ability; they may avoid certain types of work as they worry of not being able to do it.
The world would be a very simple place indeed if it were an easy matter to analyze what sort of person someone was, and to handle them accordingly. It would even be simpler if there were definite types of persons. But they aren't. In time management terms two types of people cause the majority of problems and they are at the two extremes: perfectionists and procrastinators. Both tend to achieve less in a longer time.
Perfectionism can be a good thing: society has long valued accuracy, attention to detail, low error rates. But it can actually interfere with your progress and work, to the overall detriment of your work. Trying to be perfect can stop you feeling satisfied and motivated.
Recognizing perfectionism:
• all or nothing thinking or black and white thinking. There is always one right answer if only you can find it.
• being afraid of disapproval
• being afraid to make mistakes
• being over sensitive to criticism and the opinions of others
• constantly looking for a mistake or slip up
• difficult personal relationships
• difficult keeping things in perspective
• equating failure with being worthless
• expecting too much of others
• feeling that what you achieve is never enough
• living life with a set of rules: a life full of "shoulds" and "mustn'ts"
• never feeling satisfied with anything you have done
• putting off completing work to improve it or get it just right
• valuing yourself based on what others think of you
Working with perfectionists:
• ask them to help you set your goals so they can see how others motivate themselves and think
• be approachable, so they encouraged to admit mistakes and not cover them up
• be careful of rewarding over achievement
• check that they are progressing in the right direction; stop them focusing on quality at the expense of getting the job done
• discuss your own mistakes openly and constructively
• encourage them to set goals based on past performance not their best hopes
• help them set goals and make sure they are realistic
• let them know what standard is required
• never laugh at them for lack of success or making mistakes
• openly discuss priorities
Procrastination (postponement) is like perfectionism- it's faulty thinking and feelings; you are being dishonest to yourself when you say lies such as "I'll do it after this cup of coffee" and you know that you won't.
Recognizing procrastination:
• accepting low standards
• being easily distracted
• dawdling
• getting side tracked
• ignoring things in the hope they will go away
• "just one minute' syndrome"
• low priority tasks get in the way of high priority ones
• putting things off until later
• underestimating the effort or time needed to achieve a task
• waiting until you are in the mood
Working with procrastinators:
• compliment and encourage them when they do make progress
• don't let them get distracted
• don't laugh at their putting things off
• help them break down large tasks into phases or sub tasks
• monitor their progress and let them know they are being monitored
• reward them for progress
• set deadlines
Discussion points:
1. Can we understand the causes of perfectionism?/ procrastination?
2. Do you impose your high standards on others?
3. Do perfectionists lose track of the deadlines?
4. Look carefully through the signs of perfectionism. How many can you see in yourself? How can you work on this situation? What about procrastination?
5. What is the impact of fearing success, failure, the unknown? Can it become a cause of procrastination?
6. What do lack of information, of motivation entail?
7. How can you work on your weaknesses?
Little perfectionism can work wonders. But it isn't normal thinking; it is faulty thinking. Beliefs and feelings are inaccurate; appropriate working is far more valuable than perfectionism to any company.
The Job I Like
People have always worked. So they have had different occupations along centuries.
All professions require much training, learning and responsibility.
To get a job it's not enough to be good, but you must convince others that you are good.
You have to manage your own work easily, to be flexible in any situations, to come up with new ideas to inspire confidence, to have well established priorities, to be a good team player.
More and more people have part time jobs such as: babysitter, waiter/ waitress, shop assistant, paper boy, taxi driver .Among the advantages of part time jobs there might be:
? -the sense of financial independence
? -self reliance
? -getting to know other people
? -stronger links to real life
There are jobs in all the fields of human activity:
Industry :
o Worker
o Foreman
o Technician
o Engineer
o Economist
o Mechanic
o Computer operator
Services
• Carpenter
• Potter
• House painter
• Blacksmith
• Glazier
• Locksmith
• Chimney sweeper
• Cooper
• Plumber
• Electrician
• Dustman
• Watchmaker
• Dressmaker / tailor
• Shoemaker
• Cobbler
• Hatter
• Receptionist
• Milliner
• Furrier
• Seamstress
• Barber
• Hairdresser
• Dyer
• Dry cleaner
• Waiter/ waitress
• Cook
• Typewriter
• Accountant
• Clerk
• Designer
Law
? Judge
? Prosecutor
? Lawyer/ solicitor
? Notary
? Clerk of the court
Education and culture
? Writer
? Printer
? Publisher
? Bookseller
? Bookbinder
? Journalist
? Producer
? Playwright
? Stage manager
? Actor/ actress
? Painter
? Librarian
? Singer
? Dancer
? Musician
? Composer
? Conductor
? Sculptor
? Teacher
? Philosopher
? Linguist
? Critic
? Priest
? Cameraman
Commerce
? Shop assistant
? Butcher
? Baker
? Greengrocer
? Salesman
? Grocer
? Confectioner/ pastry cook
Transport and telecommunication
? Driver
? Sailor
? Railway man
? Airman
? Postman
? Phone operator
? Telegraph operator
? Air hostess
Construction
? Architect
? Planer
? Bricklayer
? House painter
Agriculture and forestry
o Farmer
o Forester
o Agronomist
o Woodcutter
o Winegrower
o Fisherman
Health
• Physician
• Surgeon
• Oculist
• Dentist
• Chemist
• Nurse
Other jobs
? Policeman
? Fireman
? Officer
? Soldier
? Custom officer
I. Answer the following questions:
1. Who are those making and repairing things?
2. Advantages and disadvantages of the teaching profession?
3. What does the medical profession require?
4. What do computer operators do?
5. Whom does the profession of arms include?
6. What could the ideal job be?
7. What qualities would somebody need for the following careers: police officer, politician, journalist?
8. Explain what a part time job means?
9. What are the qualities that business people look for when they want to employ someone?
10. What will you look for in your future career?
II. Find out the correct definition for:
a. Accountant
b. Civil engineer
c. Computer operator
d. Babysitter
e. Stevedore
f. Economist
1. An engineer involved in construction
2.An expert in economics
3.A person qualified to keep a company' accounts
4.A person who works in the docks loading and unloading goods
5.A person who translates information into a form computers can understand
6.A person paid to look after a baby
III. What careers are the following qualities needed for?
Determination Curiosity Skill
Patience Shrewdness Tenacity
Inventiveness Ability Courage
Faith Tolerance Perceptiveness
Self-denial Physical appearance Modesty
IV. Match the following columns containing interest jobs
1. scientific a. plumber
2. artistic b. nurse
3. practical c. accountant
4. welfare d. academician
5. computational e. novelist
V. What are the things you should do or shouldn't do if you want to get a job?
2) Find out as much as you can about your future job.
3) Sit down immediately when you enter the room.
4) Be careful about the clothes you wear.
5) Make sure where the interview is since you should always be on time.
6) Stress poor aspects of yourself.
7) Have a light meal before you go to the interview.
8) Have a drink; so you will pluck up courage.
9) Bring your school certificates or letters of introduction.
0) Smoke if you like.
1) Criticize your last boss.
VI. Describe your ideal boss:
• Strong/ weak personality
• Very ambitious
• Easily adapting
• Good organizer
• Modest
• Funny
• Well informed
• Efficient
What do you think of the following situations?
1. You don't like your boss.
2. You think your boss is rubbish.
3. The boss is picking on you personally.
4. Your boss is prejudiced against you.
5. Your boss seems to think you're permanently on call.
6. Your boss is having a tough time and is taking it out on you.
7. Your boss takes credit for your ideas.
8. Your boss blames you for their mistakes.
VII. How important are each of the following to you in providing you with job satisfaction?
? Challenge
? Meeting people through work
? Security
? The respect of colleagues
? Working conditions
? Status in your organization
? Learning something new
? Personal freedom
? Exercising power
? Helping other people
? Being promoted
? Making money
VIII. Advertisements for jobs vary considerably in style. There are advantages and disadvantages in using the dynamic style.
Imagine that you are interested in applying for a job. And you have come across the following advertisement. Read the advert and write two more.
Sdk International
Has an immediate career opportunity in your city:
SALESMAN
Candidates should have excellent verbal communication; skills in both English and Romanian, strong personality and creativity and age should be under 30.
Please respond in English with your CV and Letter of Application to Sdk International Romania CP 129 OP 16 Bucharest
Read the advert and write two more.
IX. Write a Letter of Application having the following as model:
Dear Sir,
With reference to your advertisement in the Adevarul of October 23 I'd like to apply for the job
I' m 26 years old and I have graduated a course in Economics and Law.
Last summer I acquired some professional experience working in the accountancy department of an office automation equipment company.
I am fluent in English, German and French.
I am not married and I can work on weekends too.
I enclose a CV and hoping that I will suit your requirements I look foreword to hearing from you.
Sincerely
Adrian Voicu
X. A CV is essential if you are applying for a new job or for promotion; it usually accompanies a letter of application.
Name
Address
Telephone
Date of Birth
Age
Nationality
Status
Education:
School
College
University
Results obtained
Post school qualifications
Post graduate qualifications
Languages
Experience/ achievements
Interests
Published works
References
How Can you Manage Difficult People?
At work and in our leisure time we are often confronted by difficult people and awkward situations and they seem to come at us from every angle. How can we cope? People do not change easily.
What is a difficult person? In general they are people who demonstrate bad behavior, who don't care how their behavior affects others and who even use it to their advantage.
Being difficult is effective because it works but in the short term. Long term relationships need a greater complexity of behavior. Difficult people hope that due to their behavior we will either start to give priority to their wishes or that you will leave them alone.
Difficult people are not restricted to the workplace. Working relationships have few emotional ties and are more detached whereas within the home environment lurks a complex web of history and emotions.
When you deal with difficult people effective listening is very important; you must be able to tune in to what he/she is trying to tell you. A good listening means: to hear the message- genuinely listen to what is being said; to interpret the message- to take in all aspects of body language, tone of voice and interpret their significance; to evaluate the message; to respond to it.
It is not always the people that are difficult but sometimes it is the situation. Working relationships and environments bring together a whole host of situations for which you cannot always prepare. At some point in your career you will have to deal with difficult situations. They come up at the workplace. Difficult colleagues create added pressure.
Then, conflict can hardly be avoided. You also have to cope with difficult managers and with difficult staffs.
Difficult people and awkward situations are everywhere; therefore, running away is not really an option unless you want to live a hermit for the remainder of your days. So, a far better strategy is to learn to deal with such situations; this does not mean being weak or let everyone take advantage of you; it means having some firm strategies for dealing with people and situations.
Advantages:
-the ability to work with all people
-being known as a person who can get things done
-being seen as flexible and someone who can "deliver' whether that be projects or products.
Disadvantages:
- being restricted as to whom you can work with
- being seen as weak and ineffectual and being given a wide berth(mostly in times of promotion)
- being thought difficult yourself owing to your inability to work effectively with others.
Answer the following:
1. Where do you encounter difficult people most?
2. How can you achieve a responsible and effective working relationship?
3. Are difficult people at work fixed in your life?
4. Do you find that life will become easier each time you deal with a difficult situation?
5. Who are the people at the top?
6. Is it still possible to bully people into doing what they want?
7. What kind of people are the negativists?
8. How important is body language?
9. Do teams need to celebrate success?
10. How can you win people's respect and your own peace of mind?
11. How important is the environment when you deal with difficult people?
12. How important is timing in tackling a situation?
Action Points
1. Think of three things that you could do now to make you feel more confident about your ability to tackle the next difficult person or situation which comes along.
2. Make a list of all the people you have difficult working relationships with, then write one thing you like about them beside each name. Try at some point in future to complement them on that one thing- it will build bridges for the future.
3. Reflect on the last time you were criticized by a colleague. How would you handle that if the same thing happens again tomorrow? Are there lessons you have learnt?
4. Think of three people who have displayed difficult behavior in the last month. What did their difficult behavior have in common?
5. Have you ever seen anyone or been involved yourself in a bullying situation at work? What could you have done to help or done differently?
The Media
It is impossible to imagine a modern society functioning without the media which remains a powerful means of spreading news and information.
We want to get informed and the T.V., the press, the radio have turned out to be great transformers of minds or society.
•Answer the following questions.
I. Which of the media provides most of your:
a.) International information.
b.) National information.
c.) Local information
d.) Entertainment
II. If you had to rely on only one of the media, which would you choose ? Why?
III. You've heard about a local radio program in which ordinary people are interviewed about their lives and opinions. Each week there is a different theme e.g..
Fear "my most frightening experience"
Achievements "the proudest moment of my life"
Disasters "the worst holiday of my life"
Leisure "my hobby is so important to me"
Add possible themes for the next programs.
Do you classify the news when you listen to or watch it?
Do you prefer listening or watching the news?
IV. List the negative effects of T.V.
V. Mention some of your favourite T.V programs on T.V
You may refer to:
-documentaries
-soap operas
-bulletins
-topics
-broadcast
-commercials
•Answer the following questions:
1. Is T.V. a great transformer of minds or society?
2. Do you remember much from a T.V. documentary?
3. Can you name some ideal subjects?
4. Do you think that a night's viewing is wonderfully forgettable?
5. Is T.V. harmful to children?
6. What effect does quantity of viewing have on people?
7. What is the most interesting documentary you have seen?
8. What do soap operas have all in common?
9. Are the news always interesting?
10. What topics do you prefer?
11. What happens when you watch a boring film?
12. Can you name some commercials that you liked most?
13. Do you watch politics?
14. Are you better informed after watching T.V.?
15. Do you consider that some subjects are out of place/
The Press
The newspaper remains a powerful means of spreading news and information.
The purpose of the press is to publish news and give information on politics, finance, economics, arts, theatre, science.
Apart from the ideological difference, there is also one in the way they are designed.
We read newspapers, magazines, revues, journals.
There are daily newspapers, weekly, monthly newspapers quality and popular newspapers.
The newspaper:
-instructs
-informs
-reports
-caters
-entertains.
A newspaper article is based on:
1. a discussion
2. a description
3. a narrative or a combination of more than one of these.
The backbone of an article is:
a) headline/ heading opening
b) paragraphing
c) quoting
d) ending
Journalists aim at covering five W's and an H( who, what,when,where, why,how) about the event.
Newspaper columns express opinions. Writers contributing to them are famous and influential and they adopt their own style. They say that a column can be appreciated after reading it in order to understand the attitudes of its author.
Popular headlines frequently use slang and punning references to an article's content while quality newspapers tend to provide more information in their headlines. Both types of newspaper use common jargon words to save space.
Look at the headlines and chose the correct answer:
Day the jailbirds came out in sympathy
1. prisoners
a) were extremely co-operative
b) planned an escape from jail
c) supported a strike
d) were released from jail
Lazy' doc gets a rap
2. The doctor has been
a) Criticized
b) Sued
c) Fined
d) Dismissed
Shoplift slur on Doris, 72
3. An accusation of shoplifting has:
a) Made an elderly woman furious
b) Made an elderly woman confused
c) Damaged her reputation
d) Damaged her health
•Answer the following questions:
-Are you a great reader of periodical press?
-What sort of articles can a newspaper carry?
-What kind of newspapers do you know?
• Supply the suitable words:
A person -who sends news, articles, reports to a newspaper
- who looks through the manuscript of an article, corrects it, suggests, changes and prepares it for printing.
-sets up type for printing
-who buys a newspaper, a magazine regularly
-who is engaged in publishing, editing or working for a newspaper.
But:
Whatever the T.V./ video industry might now say, television will never have the impact on civilization that the written word has had.
The book - this little hinged thing - is cheap, portable, unbreakable, can be stored indefinitely, can be written and manufactured by relatively unprivileged individuals or groups, dozens of different ones can be going at the same time, in the same room without a sound.
Advertising
Advertising is the greatest art form of the 20th century. It may be described as a science of arresting human intelligence long enough to get money from it. It stimulates debate and sometimes controversy. It has a powerful effect on the human consciousness as it is around us on television, radio, cinemas, newspapers and magazines. The way we dress, talk and behave sends a message to other people. It is about manipulating public opinion and getting a message across to an audience so that they will behave in a particular way.
The advertising industry has been in existence since the end of the 17th century when newssheets carried printed advertisements for products and information. Merchants returning from voyages overseas needed to generate markets for the products they imported and so they had to advertise. By the end of the 19th century, advertising was big business. Advertisements dominated the newspapers, posters were commonplace and spawned a whole art form. But the new communication technology gave the industry its biggest boost. Modern advertising exploits every medium of communication. We tend to think of advertisements in terms of the mainstream media but we also have posters, billboards, point of sale displays, direct selling and cold calling by phone and fax, the internet which taps into worldwide audiences.
If you work in advertising , you will for sure be part of an influential band of people who can change public attitudes and behaviour.
The heart of this industry lies in the advertising agencies. The large ones are multinationals with in such far flung places as Beijing and Buenos Aires. If you work in a small agency, you may be expected to do everything, including account management, client liaison, concept development, creative work. In a larger one, job roles will be more structured. You will have a specific role and a greater chance of more formal career development. Advertising agencies vary in the services they offer. The most familiar names are full service agencies but there are also other companies that specialize in media services or focus on particular areas of advertising, such as recruitment or business to business advertising.
Business need to advertise so that we should learn of the existence of different products.
Advertising is aimed at conveying information to potential customers and clients.
Advertising is used to persuade the public to buy.
At the lowest level people need food, shelter, warmth and sex. Then, people begin to think about personal possessions and finally we move on to egocentricity.
The ultimate need is for fulfillment. This would come when we have all that the advertisers say we so desperately need. For most of us it seems that that day will never come!
Sometimes advertisements are misleading. Advertisers shouldn't make untrue statements about their products but they so often do it. They create a demand which would not otherwise exist.
Advertising goes far beyond T.V. and hoardings, newspapers and magazines, they enrich our lives.
• Answer the following questions:
? What are the arguments for and against modern advertising methods? Are there any controls which you think should be imposed on advertisers?
? Glamour and humour are two of the appeals which ads try to make for us. What other appeals do they make?
? In what other ways, apart from advertising are we persuaded to buy one product rather than another?
? How do national newspapers benefit from advertising?
? How can window dressing be seen as forms of advertising?
Arguments for advertising
? It tells consumers about the products that are available, allowing them to make a wider choice.
? It encourages competition between firms.
? By creating a wider market for products it makes large scale production and sales possible.
? Media would be more expensive without it.
Arguments against
? It is expensive.
? It can be wasteful, sometimes involving the same firm advertising virtually identical products against each other. (eg. washing powder )
? It can be misleading.
? It can exert control over media.
? It can put pressure upon people to buy products that they don't really need or can't afford.
Advertising media
? National newspapers
? Regional newspapers
? Consumer magazines
? Business and Professional Directories
? Press production costs
? Poster and Transport
? Cinema
? T.V, Radio
* Banners on Internet sites
Television commercials
? The most effective medium for reaching large numbers of people.
? They have to be brief.
But:
? They cannot be very informative and display images rather than information.
? They are selective - it is hard to reach a particular group of people except for certain programs.
Radio
-advertising is cheap and can be effective in reaching certain types of people: old people and housewives.
National press
?- it is expensive too but if has a large geographical selectivity and allows detailed information to be given.
Magazines and trade press
It is a way of reaching a specialized group of customers.
There are magazines for almost any interest and for any type of product.
Posters and hoardings
-Effective if good locations can be found.
Sales promotions
-They include free gifts, competitions, give away samples, special offers.
Sponsorship
-Of the arts, public works, sport can be very effective in putting a product or company name before the public.
Packaging and display
-In shops; they maintain existing sales but also encourage first time buyers.
?Here are some advertisements.
a. "when you can't say good bye!"
b. "from here to eternity"
c. "you know the name. It's the face you may not recognize"
Enlarge on them.
•Make an advertisement for:
a. a shampoo
b. a drink
c. a book
d. a restaurant
e. a sofa
? Write some adverts that promise:
? you'll feel happier
? you'll enjoy life more
? you'll have a nice holiday
? you'll be rich
? you'll be famous
? Make an advert as the one below:
Friendly, humourous boy 20, not very good looking but funny, seeks nice girl to go swimming, dancing, walking.
? Complete the following sentences using your own words:
? Advertising can help a business to .....................
? A good advertising agency will ........................
? Although newspapers and magazines ..................
? One of the weaknesses of human beings is that ......
? It is essential that the packing of a product should be .........
? This is the information about a job advertisement:
Asian Monetary Institute
Computer Programmer in the Statistics Division
The successful candidate will have
? A University degree in economics or statistics
? Work experience in banking and financial accounts
? Fluent English and Mandarin
Applicants should send a C.V., a recent photo and references from previous employers to the Asian Monetary Institute P.O. Box 6707
• Answer the following
1. What is Hello: a magazine or a newspaper?
2. Which country in the world spends the most on advertising: U.S.A or Japan?
3. Why is William Caxton famous: he produced the first printed advertisement in England or in U.S.A. ?
4. How did the earliest advertising take place?
5. Who invented paper?
6. How do we promote ourselves?
7. When did TV advertising come to Britain?
8. What is advertising industry entitled to do?
9. What is the difference between small and large advertising agencies?
10. What does modern advertising exploit?
11. What do advertising campaigns bring?
12. What is business to business advertising?
13. What does concept development refer to?
14. How important is timing in advertising?
15. Which are the advantages and disadvantages of advertisements on the internet?
Make an advertisement for:
1. Your Town and the Surroundings.
2. A Museum
3. A Car.
4. A Hypermarket
5. A Magazine
Enlarge upon the following:
" More than a watch. A dream that has come true!"
" It is not just a broken vase. It is the silence you feel when your shoppings are being protected with the credit card."
" They are the snapshots of a challenge, they are always with us!"
Meetings
Managers spend a lot of time in meetings.
In fact they would argue "too much time" a meeting = the gathering of a group of people for a controlled discussion with a specific purpose.
1. People should call a meeting
a) When decisions require judging rather than calculation or expertise.
b) When pooling ideas improves the chances of good decisions.
c) If 'acceptance' of the decision is an important consideration for members.
d) To discuss multi-faced problems requiring different skills or specialists.
2. Essential elements of a meeting:
a) A purpose
- problem solving
- idea gathering
- training
b) An agenda
c) Members
-the chairman - presides the meeting.
-the secretary
-the other participants
d) A result (most resolutions are voted by a mere show of hands. For important decisions, the so called "constitutional majority" is necessary, amounting to two- thirds of the assembly.
e) A report, the minutes
Every meeting has an agenda. Whoever controls the agenda controls the meeting. If the agenda is not made public, the meeting may be hijacked by private agendas: the result will be confusion, frustration and failure. A written agenda allows everyone to focus on what they are to do: before, during and after the meeting. It acts as a plan of the meeting to aid preparation, an objective control of the meeting's progress, a measure of the meeting's success. The responsibility for setting the agenda is the Chair's. The agenda should follow a natural shape: the most difficult items will be placed in the middle third of the meeting, when the group's physical and mental alertness are at their peak. The easiest items can be put at the end. The agenda should also reflect the thinking process that we wish to follow as problem solving, evaluation of information and conflict resolution will need different approaches.
An agenda contains the following:
- title of meeting, date, time, venue, apologies for absence, minutes of previous meetings, matters arising from the previous meeting, other items to be discussed and decided, reports from subcommittees, contributions from guest speakers, any other business, date, time and venue of next meeting.
Minutes are considered: a reminder of what happened at the meeting, a basis for discussion of matters arising at the next meeting, a guide for non attendees, a permanent record. Taking minutes involves two skills: listening and note taking. In a society that communicates through visual images, listening has become a highly complex skill. Most people will be thinking and speaking at the same time and sometimes they will all be talking at once. Only a small proportion of the words we use carries the information we wish to communicate. Most people surround their thoughts with words which express feelings, attitudes to the listeners or their relationship to the group.
You cannot listen and take notes at the same time; your primary task is to understand what is going on: most of your time in a meeting should be spent listening. You should take notes only intermittently. The trick is to be able to note down only keywords but you have to be attentive to record information properly.
The minutes have to be written as soon as possible after the meeting and they should follow the agenda exactly.
Opening a meeting
• Good morning ladies and gentlemen
• If we are all here
-shall we start
-make a start
-let's start
-I think we should start
• First of all I'd like to introduce
let me introduce
two colleagues from our Munich office
Would you like to say a few words about yourselves?
•Right, thank you.
•Have you all got a copy of the agenda?
•If everyone has got a copy of the agenda, let me first explain the purpose of the meeting.
•The purpose / aim / target of the meeting is to ...
•Now; let's look at the agenda in detail.
•As you can there are 5 main points / items.
•I suggested that we take them in the following order.
•As we have a lot to get through this morning, can we agree on ground rules?
•I suggest the following ......
Moving to the first point
Handing over to another person
Bringing people in ( encouraging hesitant speakers ) "would you like to add anything?"
Stopping people talking
? One at a time please!
? We can't speak at once. John first, then Mary.
? Would you mind addressing your remarks to the chair?
? Could we have some other opinions?
? I think that's clear now. We've all got the point. Shall we move on?
If you didn't hear you can say:
• I'm sorry. Would you mind repeating?
If you didn't understand you can say:
• I'm sorry. I don't quite follow you. Could you go over that again?
If you feel the speaker is being vague or imprecise you can say:
• What exactly do you mean by?
Preventing irrelevance
•I'm afraid that's outside the scope of this meeting.
• We lose sight of the main point.
• Keep to the point.
• I think we'd better leave that subject for another meeting.
Keeping on eye on the time
• We're running short of time.
• There's not much time left
• Could you please be brief?
Moving to the next point
• Let's move on to the next point!
• Would like to introduce the next point?
• Well, I think that covers everything on that point.
Let's move on!.
Controlling decision-making
• I'd like to propose that...
• I'd like to propose the following amendment.
• Can we take a vote on that proposal?
• All those in favour. Right?
• All those against. Right?
• Well then we agree / with some reservations.
• Well then we agree / unanimously.
• Well it seems that we are broadly in agreement that...
Indicating follow up tasks.
• Do you think you could...?
• How about preparing some figures for the next meetings?
Closing
• I'd like to thank Mr. X & Y for coming over from Paris
Participating in a Meeting
1.Getting the chair's attention.
• I'd like to comment on that.
• May I have the floor for a moment?
2. Asking for and giving opinions.
• I'm convinced that / sure / positive.
• I strongly believe that ...
• I have absolutely no doubt.
• I definitely think that ....
• I really do think that ...
• To my mind ...
• As I see it ...
• From my point of view ...
• Am I right in thinking that ...
• Would I be right ...
• Don't you think that ...
• Are you absolutely sure / convinced / that ...
Sample sentences
• In my opinion we shouldn't rush into a long term agreement before considering the implications.
• I tend to think that the loss of key personnel has damaged their confidence.
• Do you think that national advertising is the right way to launch our products?
3. Agreeing and disagreeing
• I totally / agree with you / accept fully.
• I'm in total agreement.
• I'm in favour of that.
• Up to a point.
• To a certain extend.
• You may / could / be right but ...
• That may be so, but ...
• I can't / agree / accept.
• I don't /agree / accept.
• I can't go along with ...
Sample sentences:
• I have talked to the foremen and they completely agree with the idea to set up a quality circle.
• We are in agreement over the payment terms.
• I agree with Peter to a certain extend but I still feel that we are exposing ourselves to unnecessary risks.
• I'm afraid we can't agree to the terms in your latest offer. Please reconsider them and get back to us.
• A productivity bonus for the workers? I totally disagree with that type of incentive.
4. Advising and suggesting
• Shall we get started?
• Why don't we move to the next point?
• Let's postpone this till...
• I suggest we close the meeting.
• We should meet again next ...
• Why don't you present it at the next meeting?
• How about ...
• I would recommend ...
• It's advisable to ...
• He suggested that we analyze the threats and opportunities.
Sample sentences
• I don't think we've got enough for all the points in the agreements.
• Why don't we discuss point 4 at the next meeting?
• First you should do an audit of your present operations!
• The consultant suggested that we should focus on the threats to our business.
5. Requesting information and action.
• Can / could you tell me ...
• Will / would ...
• I'd like to ...
• Do you happen to know ...
• I wonder if you could tell me ...
16. Write a complete report having the following as a model.
Report
Meeting held on 15 October 2000.
Location: Danavian Insurance Company, Stockholm
Present: Ulf Edberg (Treasurer, Denavian) self
Agenda: Letter of Credit Facility.
Client is not yet sure about company requirements for 2000.
Expressed worry, however, over the increase in our commissions and estimates that this will cost Denavian three times as much as before.
Client pointed out that the counter value of SEK 800 million is deposited with us. Currently pays 0.24% for outstanding volume of standby letters of credit but changes will mean paying 0.75% flat on this amount. Requested that we look into the possibility of setting up a trust found with Denavian's securities. Volume of letters of credit likely to fall quite heavily because of increased charges. I promised to investigate the possibilities of setting up a trust fund and to contact the client early next month with our outline proposals.
What do you think about the following:
1. "Training and experience go hand in hand if we want to reach a high level of responsibility in our career."
2. "Managers spend too much of their time in meetings and they may be sometimes too confident".
3. "Don't learn from books but from practice and make things happen"!
4. "Team work and the know how offers you stability".
5. " Everybody has to be aware that competition makes us tougher and more resourceful."
Market
Originally it was a physical place where buyers and sellers gathered to exchange goods and services.
To an economist, a market describes all the buyers and sellers who transact over some goods or services.
A market is:
-the set of all actual and potential buyers of a product
-the set of buyers and an industry in the set of sellers.
1) Potential market - the set of consumers who profess some level of interest in a particular product or service.
2) Available market - the set of customers who have interest, income and access to a particular product or service.
3) Served market - the part of the qualified available market the company decide to pursue. The company may decide to concentrate its marketing and distribution efforts on Central and Eastern Europe.
4) Penetrated market - the set of consumers who have already bought the goods.
If a company is not satisfied with current sales it can consider a number of actions. It can try to attract a larger percentage of buyers from its served market.
It can expand to other available markets.
It can lower its price to expand the size of the available market.
It can try to expand the potential market by increasing its advertising.
Marketing
It is a creative management function which promotes business and employment by assessing needs of the end user of products or services, initiates research and development and produces products or services which can be profitably provided to service market requirements. It coordinates the resources of production and distribution of goods and services, determines and directs the nature and scale of the total effort required to sell profitably the maximum production to the ultimate user.
This is the process of:
-identifying
-maximizing
-satisfying consumer demand for a company's products.
Marketing a product involves:
-anticipating changes in demand
-promotion of the product
-ensuring that its quality, availability and price meet the
needs of the market
-providing after sales service.
Marketing can be split into four components:
1.research
2.strategy.
3.planning.
4.implementation.
Marketing and selling influence and control almost every part of a company's activities.
Marketing is customer rather than product focused. That means understanding how everything about your product or service impinges on the customer. It is not just the product itself that counts, but the way in which it is presented, delivered, repaired, replaced. Marketing touches on many areas of product management; the marketing department will be involved from the very beginning of a product's life in determining its image, deciding when, where and how it should be launched and monitoring its success in the marketplace.
Market research is based on the idea that if you find the customers' needs and wants and then use the information to provide a package that meets these, then you will be no doubt successful. There are two main types of research: desk (local library) and field research (phone research, written questionnaires, street interviewing, face to face interview, product tests, consumer panels, focus groups).
Marketing offers a range of career opportunities at different levels for people who are interested in making things sell. In a large organization, the marketing function will work in tandem with other functions, such as buying, logistics, distribution, retailing. If this is the chosen field, then you will be working at the heart of your company and will gain valuable experience.
Marketing staff may work on re-branding a product if it starts to loose popularity or launching the product into new markets overseas.
All kinds of products and services are actively marketed these days, even public services and monopolies.
Think of eight products ( goods and services ) that are produced or provided in your city or region and answer the following questions:
• What competition does each product face?
• What is the image of each product?
• What is the image of the company that produces it?
?Fill in the gaps using the words from the list:
profitable,. price, promotion, need, image, design, place, product, creative process, satisfy.
1. What is marketing? Marketing is the ..........satisfying customer needs......
2.What is 'the marketing mix'? It consist of 'the four P's': providing the customer with the right P .... at the right P ....... presented in the most attractive way ( P.....) and available in the easiest way ( P......).
3. What is a product? It is something customers buy to...... a ........ they feel they have. The ....... and the ...... of the product are as important as it's specification.
• How strongly or weakly is each of the products marketed?
• Where is each product advertised?
e.g.
a. A brand of beer or soft drink.
b. A grocery product.
c. An industrial product.
d. A service
e. A place of entertainment
f. A public service
g. An educational service
h. A financial service
• What sort of questions are most useful in a sales meeting?
• What answer is each of these questions likely to provide/
• Which of the questions are likely to give more useful information?
Give your own examples.
#In marketing a product we should:
• analyze statistics
• conduct market research
• devise a questionnaire
• carry out a market survey
• consider the strengths and weaknesses
• devise a marketing strategy
•draft an advertisement
? Comment on the advertisements
•Iceland as nature intended
•Sweden refreshing
•Malawi the warm heart of Africa
# Make a list of five or more regions or countries that are in competition with yours.
Design a questionnaire to find out about people's attitudes to your region and to its competitors.
The people you ask should rate each destination for its qualities on a scale 1 to 10:
Good value for money
Good entertainment
Friendliness
Culture
Easy to get to
Health and sport
Hospitality
Beautiful scenery
Peace and quiet
Uniqueness
Ask them to describe each place in one sentence like this:
"When I think of Sweden I think of cold winds and a flat landscape"
#The promotion of a product involves considering it as a "total product"; its brand name, presentation, labeling, packaging, instructions, reliability, after sales service.
Promoting a product involves developing a "Unique Selling Proposition" ( USP ): the features and benefits which make it unlike any of the competing products.
There are 4 stages in promoting a product (AIDA):
a) Attract the Attention of potential customers.
b) Arouse Interest in the product.
c) Create a Desire for its benefits.
d) Encourage customers to take good Action.
# Did you know that:
1) The world's largest advertising agency is British Saatchi& Saatchi.
2) The world's greatest consumers of coffee are the Swedes. (8 kg per person per year).
3) The world's largest employer is Indian National Railways with 2 million employees.
4) 99% of all business is Japan and Switzerland employ an average of 15 people.
5) The world's biggest manufactures of motor vehicles is Japan.
6) Over $1 billion a year is spent on advertising in the USA and the rest of the world is over $1.5 billion.
7) The world's largest airport is Jeddah (by area) or Chicago (by number of passengers)
8) Most Japanese companies pay professional trouble- makers not to cause trouble at their shareholders' meetings otherwise the meeting is sure to be disrupted.
9) The airport that handles the second largest number of international passengers in the world is Gatwick. Number one is Heathrow.
10) The average person over 15 smokes, 1,750 cigarettes annually.
11) The world's number one exporting country is Germany.
12) The world's biggest restaurant chain McDonald's serves about 15 million hamburgers a day at its 9000 restaurants.
13) The world's largest food company is Nestle.
14) The world's greatest and busiest port is Rotterdam.
15) The world's greatest beer drinkers are the Germans.
# how would you deal with Mr. Call. as - he keeps raising objections to your products: he say they are too expensive, that he's worried about your after sales service, that your new technology may not be reliable, that your design may not appeal to his customers.
# What would you do if you worked in marketing for "Dentallo".
Dentallo is a medium size firm marketing toothpaste and toothbrushes. Your Dazzle toothpaste and Protect toothbrushes are market leaders in the domestic market, but due to heavy competition from multinational companies with big advertising budgets you are no longer able to reach your export sales targets. Market research shows that a large proportion of consumers aboard find your product image is old fashioned and dull though your prices are lower than the competition.
Travelling
People travel abroad on business or for pleasure by road, by air and by sea.
They travel at their own expense or at the firms' expense, they arrange accommodation, they make travel arrangements, they even find out the "romance" of travel.
Travel is a solitary enterprise: to see, to examine, to assess.
Travelling on your own can be very lonely so even if we crave for a little risk, some danger, an experience we should have companions.
• What are the advantages / disadvantages / of travelling:
-alone
-with a companion
-in a group with a guide?
• Can travel broaden the mind? How?
• Advantages and disadvantages of travelling on business.
• Speak about your experiences and feelings about:
-staying in a hotel
-driving a car abroad
-traveling by train
-visiting new places
-leaving out of a suitcase
-eating in restaurants abroad
-weekends away from home
-waiting for a delayed flight
• Which are enjoyable, exciting?
• Which are stressful, annoying, depressing?
• What difference does it make if you're on holiday and not traveling on business.
• Do you agree or disagree?
-take hand luggage not large suitcases.
-it's essential to organize everything before you travel.
-you should take a walkman and plenty of reading matter.
-learn as much as you can about the customs of the people.
-it's important to arrive a day earlier to give yourself time to adjust and acclimatize.
-be careful about local food and drink.
-don't get involved in a political discussion.
-treat everyone you meet with respect.
-"never forget that you're a foreigner"
Add some more pieces of advice.
• How many of these tips for travelers are worth following?
-never get to the airport too early in case the plane is late.
-always take a good long book to read on a journey.
-always try to get some sleep on the plane.
-never take more than one suitcase on a journey.
-always try to do some work on the plane.
-never drink alcohol on a plane.
-you can avoid losing any important document by keeping it in your hand luggage.
-you can save money on a hotel accommodation by getting rooms at a discount through your travel agent.
-you can avoid delays by taking carry on luggage onto a plane.
-always have some water with you.
• You may depend on a travel agent or your firm's travel department to make your travel arrangements but there may be times when you want to change an itinerary for a visitor or yourself.
Some phrases you might need to use:
? I want to fly to Miami on the 10 of the next month, returning on the 20.
? I'd like to reserve a seat on Flight number ...
? I'd like to change my reservation on Flight no..
? I need to get to the airport / railway station / as quickly as possible.
? One coach class / round trip / one way to Huston.
? One first class / club class / tourist class return / single.
? Is it too late to check in for flight nr. E009?
? Which platform / track / gate does the 13: 40 to London leave from?
? Can you tell me what time flight nr. ... is due to arrive / depart/ ?
• Who would you speak to in each case to get the information you require? What would you say?
-You have heard that flight BZ 431 is delayed.
-You want a rail ticket to Manchester.
-You want a plane ticket to Paris.
-You are in hurry to get to the airport.
-You have arrived at the airport three hours before your flight.
-You have three minutes before your train leaves.
-You want to make sure of a hotel room in Madrid before your flight departs.
• Do you know:
-where a visitor could go on a free day or at the weekend?
-when the museums are open?
-how a visitor can get tickets for a show?
-which restaurant to go?
-where a visitor can buy local specialities to take home?
• Imagine you'll welcome two people from the other side of the world who haven't left their own country before. They're coming to work with you for a few months.
Make a list of customs and habits that will seem strange to them and which will be different from their country. What will you explain them about:
-eating
-public transport
-shopping
-work
-entertainments
-sports
Accommodation
• Where can you find accommodation:
-in comfortable chalets/villas/?
-private houses / bungalows /?
-motels/
-holiday camps?
• What kind of hotel do you prefer to stay in on a business trip?
• What facilities do you know? Chose those you are interested in:
-buffet style breakfast
-fitness centre /gym/
-jacuzzi &sauna
-secretarial service
-video movies /T.V. /
-restaurant serving local specialities
-cocktail lounge
-free car parking
-photocopying
-self service cafeteria
-24 hour coffee shop
-room service
-swimming pool
-lifeguard
-golf course
-beach
Travel and hotels have always been closely related.
We place hotels in four groups:
? Commercial hotels providing services mainly for transients. Most of them traveling on business.
? Resort hotels located in vacation areas providing recreational facilities of their own.
? Conventions hotels which service conventions meetings usually held yearly of business or professional groups.
? Resident hotels where people can rent accommodations on a seasonal basis or even permanently.
Each hotel has got:
-a large lounge furnished with settees and chairs.
-a lobby with the reception desk.
-a service bureau.
-information desk.
-foreign exchange desk.
-waiting room with new stands.
-post office desk.
-souvenirs shop.
-lifts.
-restaurants
-bars.
-modern convenience.
• The hotel staff include:
-manager
-assistant manager
-night auditor
-cashier
-desk clerk
-reception clerk
-bellboy
-porter
-doorkeeper
-chambermaid
-houseman
-cook
-waiter /waitress
-storekeeper
-wine steward
-bartender
• What sort of rooms can you book in a hotel.
-single
-double
-suites
-rooms with bath /shower
-room looking out to ...
• What modern convenience can you have in a hotel?
-central heating
-laundry service
-air conditioning
-disco
• Name some of the do's and don'ts of the hotels. Start with:
-when going out you should not forget to leave the keys at the desk.
-you must pay the bill before leaving the hotel.
-rooms must be vacant by 12 am on the day of departure.
-you are requested not to disturb other people's rest.
-complaints should be made to Reception or to the manager.
• Describe a hotel that you liked most.
Travelling by Train
Railways today still carry the bulk of passenger and goods traffic.
It is one of the cheapest ways of transporting freight over long distances.
The railway station is provided with:
? A waiting room
? An inquire office
? Parcels office (heavy luggage is registered and labeled)
? Left luggage office
? Book stalls
? Post office
? Telephone booth
? Booking office
? Catering facilities ( restaurant, snack bar, coffee room, tea room..)
? Time table
? Shop
The passengers hurry along the platforms getting on or off the train; the porters carry the luggage to the train or push it on their trucks to the luggage van.
The luggage van is placed behind the engine, then the mail van and the passenger carriages with smoking and non smoking compartments, a dining car.
The passengers' compartments have numbered seats.
At intervals a guard or a special inspector checks the travelers' tickets.
The train arrivals and departures are posted up in time, the passengers being invited to the trains by loudspeaker.
• What kind of trains can passengers get on?
Express trains
Fast trains
Slow trains
Through trains
Commuting trains
• What luggage do you usually have about you?
Light luggage
Heavy luggage
A suit case
A truck
Hand luggage
• Under what circumstances do you book?
A single, one way ticket
A return, round trip ticket
A platform ticket
A season ticket
• I wonder whether you have watched the rush in a railway station.
People looking up members in the Telephone Directory.
People consulting the time table.
People booking in advance.
People getting on and off the trains.
Porters seeing to the passengers' luggage.
The incoming and outgoing trains.
Trains pulling out the station and picking up speed.
• Find the definition for each of the words:
a. railway
b. railroad
c. railhead
d. bulk
e. station
f. bulky 1. U.S. system using trains to carry
2. end of a railway line
3. B.E. system using trains to carry passengers & goods
4. large and awkward
5. large quantity of goods
6. place where trains stop
• Describe your last journey by train using the following vocabulary:
First class sleeper
Through train
Booking office
Luggage rack
Smoking carriage
Return ticket
Entrance gate platform
Ticket collector
Breath talking landscape
Unique landscapes To travel light
To run on time
To change times
To delay
To enjoy
To put out / off the lights
To have a change
Travelling by Air
It is most comfortable and speediest of all means of transport.
Airlines are constantly improving their services.
They are concerned about improving check in facilities hiring well trained deck-in personnel providing excellent in flight services such as: cabin services, seat comfort, in flight entertainment, good catering.
It is advisable to book tickets in advance. You can book :
A first class (P) seat
A Business class (C)
An Economy class (Y)
Before boarding the plane the passengers must have their tickets and passports checked, their luggage inspected, weighed and tag attached to it.
The passengers can avail themselves of the various services offered by the airport:
? the exchange office
? the duty free shop
? the book stall
? the restaurants
They will be waiting for the announcer calling the flight.
The stewardess will take the passengers to the concrete runway where the plane is ready to take off.
• What sort of classes and tickets can you book on any flight?
First class (P)
Business (C)
Economy (Y)
Single -one way
Return -round trip
Direct -point to point
Open dated return
Dated ticket
• Which are the airport formalities?
Flying ticket checking
Luggage weighing
Customs control formalities
Passport control
Security check
• Why are these necessary when the plane takes off?
Fasten your seat belt
Stop smoking
Listen to the instructions given by the air hostess
• What are these for?
The information desk
The currency exchange office
The public address system
Telephone booth
• Can you explain?
Aircraft
Aircrash
To board a plane
To book a ticket
Check in facilities
Catering To hit an air pocket
Liable to duty
Non stop flight
Point to point flight
Runway
• Find the definition for the words and expressions:
1) A direct flight
2) Catering
3) Load factor
4) Open dated ticket
5) Check in facilities
6) Break even point
7) Return ticket
8) Long haul
9) Yield a) a point where sales cover cost but do not make a profit
b) one way flight
c) round trip ticket
d) amount of weighed factor
e) long distance
f) to book a ticket leaving the date of the return open.
g) supplying food ready to eat
h) profit
i) places where passengers give in their tickets for a flight
• You want to fly from Bucharest to New York.
Book a flight.
Write down a short dialogue.
? Why do people prefer to travel by air?
? What might a travel by plane depend on?
? What aspects are the airlines all over the world concerned about?
The Customs System
Customs clearance consists in the following operations of the means of conveyance to customs units and production of the accompanying documents.
- customs inspection of the means of conveyance and of the merchandise carried.
- the checking of customs declarations.
The customs Tariffs are applied when clearing the goods through the customs - then customs duties are being charged in conformity with the guide to the law of Import Customs Tariffs.
The guide enters the goods under several columns:
? tariff heading and subheading
? description of the goods
? rate of duty
Customs bodies should check whether the merchandise is in accordance with the customs declaration and transport documents.
Customs duties are charged on the customs value of the goods. If the goods fall under customs restrictions they are liable to duties, if they don't exceed the free tax quota they are un dutiable.
Natural persons may bring in the country personal effects which are duty free.
The Customs Regulations prohibits the introduction into the country of: arms, narcotics, toxic substances, radio transmitters and receivers, documents and printed matter under law restriction.
It is prohibited to take out of the country securities, goods that belong to the national cultural patrimony.
Any traveler who has items coming under customs restrictions should declare them either orally or in writing on a special form.
• What should the officer do in case of contraventions?
-fine you
-confiscate your objects.
-charge a penalty for dutiable goods, for deliberate concealment of prohibited goods.
• How can your passport be?
-in order
-needs the entry / transit visa
-needs no visa
-has expired
• Chose the correct definitions:
a. customs
b. to go through the customs
c. customs clearance
d. customs formalities
e. customs officers
f. customs tariffs
g. customs union
1. agreement between several countries that goods can travel between them paying duty.
2. the government department that organize the collection of taxes or imports.
3. to pass through the area of an airport (port where customs officials examine goods).
4. documents given by customs to show that customs duty has been paid and the goods can be moved.
5. declaration of goods and examination of them by the customs.
6. people working for the customs.
7. list of duties to be paid on imported goods.
• Make up a dialogue using the following vocabulary:
I came from ...
I'll spend a few days as a tourist
Your passport is in regular order
I have no cash
Liable on duty
Personal effects
No charge on
On condition
Prohibited goods
We are through with the customs
Clearance
Restrictions
To register
Visa
Money
All values in the economic system are measured in terms of money.
Our goods and services are sold for money and money is in turn exchanged for other goods and services.
Coins are adequate for small transactions, while paper notes are used for general business.
We also have a wider sense of the word "money" covering anything which is used as a means of exchange.
Originally, a valuable metal (gold, silver, cooper) served as a constant store of value; even today, the American dollar is "backed" by the store of gold which the US government maintains.
As gold has been universally regarded as a valuable metal, national currencies were many years judged in terms of "gold standard"
Today national currencies are considered to be as strong as the national economies which support them.
Valuable metal has been replaced by paper notes. They are issued by governments and authorized banks and are know as "legal tender".
Cheques and money orders perform the function of substitute money and are known as "instruments of credit"
Credit is offered when creditors believe that they have a good chance of obtaining legal tender.
If a man's assets are known to be considerable then his credit will be good. If his assets are in doubt then it may be difficult for him to obtain large sums of credit.
The value of money is basically its value as a medium of exchange or its "purchasing power" which is dependent on supply and demand.
The demand for money is reckonable as the quantity needed to effect business transactions.
An increase in business requires an increase in the amount of money coming into general circulation.
But the demand for money is related not only to the quantity of business but to the rapidity with which the business is done. The supply of money is the actual amount in notes and coins available for business purposes. If too much money is available, its value decreases and this condition is known as "inflation."
The unit of English coinage is the pound sterling which is worth 100 new pennies.
The symbol £ is always placed before the figures.
The abbreviation of "p" is written after the corresponding figures.
The Bank of England issues banknotes for £1, £5, £10, £50 and £100. there are three bronze coins 1/2 (half penny), the one and two new penny, two copper- nickel coins: the five and ten new penny. Then there is the 50p. coin.
# The unit currency in U.S.A:
dollar - a paper bill or a silver coin.
- banknotes of $ 1, 2, 5, 10, 20, 50, 100, 500, 1000
- coins 1¢ 5¢ (nickel), 10¢ (dime), 25¢ (quarter), 50¢ (half dollar) are made of silver.
# How can you ask for a price?
• How much is it?
• How much does it come to?
• How much do I owe you?
• How much do you charge?
• It's very expensive...
• It's rather cheap...
• I'm short of money, can I buy cheaper?
# Say whether these statements are true (T) or false (F)
• The U.S. dollar is a constant store of value.
• Instruments of credit are accepted because they can be converted easily into substitute money.
• The purchasing power of money depends upon supply and demands.
• The demand for money is related to the rapidity with which business is done.
• You can earn interest on a current account.
• Banks lend money to depositors who need capital.
• The main profits of a bank come from lending money at a fixed rate of interest.
• Money is described as "liquid" because it is compared to flowing water.
Everyone borrows money. And when you do this you improve your lifestyle. It may be a risk but it also promises great rewards. Where do you borrow money from? Banks are considered to be profit making machines. They come in all shapes and sizes and they help you.
Lending money becomes one of the main functions of a bank. It is the interest earned from banks that brings in most of the revenue to pay the expenses, including staff salaries of the bank and give a sufficient surplus to pay shareholders a dividend and retain funds in reserves accounts for the expansion of the bank. Before any loan is granted, the following questions must be answered by the customer:
- how much is required?
- the purpose of the loan
- length of time the advance is requested
- the source of repayment
We have the following sources of funds for the Romanian banks:
- bank deposits(Short term, long term)
- borrowed funds
- own funds(own capital, supplementary capital)
The funds that are put out on loans belong to customers. It is their money that is put at risk, so if a bank is making bad or unprofitable loans, this will be reflected in the deposits.
Types of credit or loans:
1.Country loans.(in order to achieve national, political, social and economic goals)
2.Corporate lending.( such as loans for:
- working capital and fixed assets
- overdrafts
- term loans
- syndicated loans
- revolving credit
.
Types of credits:
We can have:
1. Revocable credits( may be cancelled or amended at any time without prior notice being given to the beneficiary)
2. Irrevocable credits(can be cancelled with the agreement of all parties)
3. Sight credits(allow for payment to be made as soon as documents are presented)
4. Deferred credits(it allows for payment at a future date without calling for a Bill of Exchange).
5. Transferable credit( it can be transferred by the original beneficiary to one or more second beneficiaries).
6. Red clause credits(incorporate a special concession to the beneficiary allowing the advising bank to advance a percentage of the total credit amount before presentation of the shipping documents).
7. Revolving credit(the amount can be renewed or reinstated without specific amendments to the credit being needed).
8. Stand by credits(acts as a guarantee by the issuing bank to the overseas beneficiary against defaults by its applicant customer).
The main principles of granting credits are:
- the banking prudence
- the creditworthiness of the borrowers
- the credits granted should be profitable both for the bank and for the borrowers
- the credits have a destination precise and mandatory which cannot be changed by the borrowers.
- credits are granted under guarantees that are written in the credit contract.
- The bank shall reserve the right to verify its customers.
Forms of Payment:
1. Cash( small amounts can be sent in note form very easily, impractical and expensive if in large amounts).
2. Cheque(remittance is quick and simple, exchange risks unless issued on appropriate currency account, delay in receipt of proceeds by beneficiary where bank insists on collection)
3. Banker's Draft( issue process is straight forward; available in major currencies, expensive to purchase, involves lengthy formalities including giving an indemnity to the bank)
4. International Money Order(cheap, issue process is quick, but appropriate for smaller amounts up to GBP 1000 or USD 2,500..)
5. International Payment Order(no limit of amount, documents can be attached, payment is inter- bank, therefore secure, not appropriate for urgent transfers)
6. Telegraphic Transfer(quick, no limit on amount, an expensive method)
7. Giro Cheque(inexpensive, but can be lost or stolen, remittance is quick and simple)
8. Giro Transfer(simple and quick, number of countries limited)
9. Postal Order(exchange risk for the recipient, can be lost or stolen, number of countries limited).
How ca you define a bank risk?
It is that risk that the bank is being confronted with in its current operations. Banks are subject to all the risks that their customers face. The most significant is the the credit one that arises from lending to individuals, companies, banks, governments.
The main types of risks involved in the banking activity are:
1. The Financial Risks
2. Delivery Risks
3. Environmental Risks
Financial risks:
- Credit risk
- Interest rate risk
- Liquidity risk
- Foreign exchange risk
- Capital risk
Delivery risks:
- operational risk
- technological risk
- new product risk
- strategic risk
Environmental risks:
- defalcation
- economic
- competitive
- regulatory
Some British authors divide the main risks into :
1. product market risks
2. capital market risks
Product Market Risk
- credit risk
- strategy risk
- bank risk
- operating risk
- merchandise risk
- human risk
- legal risk
- product risk
Capital Market Risk
- interest rate risk
- liquidity risk
- currency risk
- discount risk
- basic risk
We may also have:
• The fraud risk
• The country risk
• The market risk
Electronic Banking Services
Electronic banking- essentially automated payment by computer - will increase in importance and volume. The main forms of electronic banking services are:
Telephone Banking
Such a service represents a competitive area and it may be either voice-activated (i.e. the computer is expected to react to customer's voice and comply with his or her instructions accordingly), or electronically activated ( the client speaks over the microphone of their telephone and dials certain numbers meaning a certain transaction). The telephone banking can offer transfers of funds, payments of regular bills, applications for loans and overdrafts etc.
Bankers Automated Clearing System
This system is especially used for funds transfers between the participating members and essentially operates standing orders, direct debits, payment of wages, salaries, rentals, trade debts, etc. Bankers Automated Clearing is supplied with a magnetic tape containing the details of the accounts to be debited or credited. It sorts them into bank orders and, then, it provides each paying bank with the relevant details, a printout being also
Electronic and Internet -Based Payments
Internet banking is a banking product, which follows the older solutions like e banking. E-banking represents a solution which is technologically obsolete, supposing at the client level of that service a phone line and a computer dedicated for such an operation, able to fulfill technical needs quested by the bank and to run (execute) a software program necessary for lie optimal communication with the client's bank. In that way, the person who will handle the e-banking application have to work only from that computer which it is not very good for someone with a dynamical job and with many physical places of work even in different localities or countries.
Despite e banking, the I-banking (Internet-banking) supposes the usage of a computer from wide world on which is installed a browser and an Internet connection. The performances of such a solution are far away better also for the bank and for the end user (the client).
The costs are calculated to a number of 100 banks from the United States of America which are using all the channels, but the costs are represented at a world wide level because they are common to all the banks that promote the electronic pazments.
World tendencies
63 % from the great banks are offering Internet banking services and 59 % are offering electronic banking services. Not all Internet banking institutions are charging the services, but most of those, which do, are starting to use a monthly subscription for the base services . 61 % from the firsts 150-th banks of the United States of America are offering on-line banking services, 15 % don't have included in their strategies for the future the offer of on-line banking service and 19 % already announced their intention to provide such services by the end of 2001.
In May 2000, Forrester Research estimated that by the end of the year 2003 there will exist over 20 million of home users in the United States of America which will use the I-banking services, that means around 30 % of the profits obtained from retail.
At the end of 2000, the specialists from Data monitor estimated that at the end of the year 2005, around 20% of the world population would be connected at the Internet.
Regarding Europe, since March 19, 2001 the British group Vodafone has announced that the first transaction pilot project that will use the digital signature using the mobile phone will start in April 2001 together with the Radio Communications Agency. That announcement was made at a short period of time after the British Government announced that it intended to allow all physical persons to pay their taxes throw an electronic environment, using digital signatures.
On July 19, 2001, the cut-off time until which all the member state of the European Union had to implement the Directive regarding digital signature expired. The ending of that period will lead inevitably to a new beginning in the development of electronic transactions field and in the e-business area.
As a consequence of that, the banks renounced at their territorially development and instead they are concentrating on the new products which are based on new technologies and the Internet development. So, the banks are reorienting their investment politics to new technologies. That supposes the reconsideration of the concept of territorial network of a bank, which is about to become an informational network. At the end, the new technologies allow the banks to be closer to their clients and in the same time to provide them more comfort and a depersonalization of the services due to the elimination of the classical physical direct relation between the account officer and the bank's customer.
SWIFT
These initials stand for the Society for Worldwide Interbank Financial Telecommunication, which is an international organization whose members consist of several hundred of the largest international banks. The society, which was created under Belgian Law and located in Brussels, was formed to accelerate the transfer of funds and other messages between the member banks. .
The system works by means of a telecommunication link between the computer systems of the banks, which allows the rapid transmission of messages. The system is used to execute telegraphic transfers previously sent by cable or telegraph and may also be used for international payment orders/airmail transfers at the discretion of the bank, making for a much faster execution of a customer's instructions. When instructions are transmitted in this way the bank is said to be sending a SWIFT message and for telegraphic transfers the phrase used is urgent SWIFT message.
Lexical Index
Advertising
Advert - anunt în ziar
Advertisement - anunt, reclama, publicitate
Advertisement canvasser - prospector de publicitate
Advertisement column - rubrica anunturi
Advertisement department - serviciu de publicitate
Advertisement manager - director de publicitate
Advertisement office - birou de primire a anunturilor
Advertising agent - agent de publicitate
Advertising appeal - atractie publicitara
Advertising contest - concurs de reclame
Advertising directory - anuar de publicitate
Advertising expenditure - cheltuieli de publicitate
Advertising rates - tarif de publicitate
Advertising schedule - calendar al anunturilor
Drawback - neajuns
Folder - pliant, dosar
Hoarding.- plancarda
Misleading - înselator
Poster - afis
Target customer - client tinta
To advertise - a face reclama
To boost - a populariza prin reclama
Want ads - anunt la rubrica cereri de serviciu
Mass media
Blurb - prezentare, reclama.
Broadsheets - ziar popular
Cover - coperta.
Coverage - relatare.
Feature - rubrica fixa.
Headline - titlu.
Headlines - rezumatul stirilor principale.
Item - articol.
Jacket - supra coperta.
Layout - aranjarea materialului pentru o carte.
News caster - crainic.
News hawk - reporter.
News release - comunicat autorizat.
News sheet - gazeta de format redus.
News stand - chiosc de ziare.
Newsbill - afis de ziar.
Newsbutcher - vânzator ambulant.
Newsreel - jurnal de actualitati.
Oblituary - anunt mortuar.
Peak viewing time - ora de maxima audienta
Press clipping - taietura din ziar.
Press release - comunicat de presa.
Printing works - tipografie.
Radio schedule - programul emisiunulor.
Rumour - zvon.
Script - scenariu
Sequel - continuare
Sets - decor
Skim - a atinge usor.
Snap shot - instantaneu
Soap opera - telenovela
Stunt artist - cascador
Tabloids - presa de scandal.
The picture flickers - imaginea pâlpâie
The picture is blurred - imaginea este estompata.
The picture is distorted - imaginea este deformata.
The picture washing out - imaginea se sterge.
Time signal - ora exacta.
To bribe - a mitui
To broadcast - a transmite
To browse through - a rasfoi
To cover news - a relata, a comenta.
To hint - a face aluzie.
To issue - a edita..
To re-edit - a reface
To release - a lansa
Market
Base rate - curs de referinta
Blue chips stock - actiuni sigure
Bond - obligatiune,garantie
Bond market - piata hartiilor de valoare
Brand image - imagine de marca
Brand leader - cap de serie
Brisk - piata activa
Canvasser - prospector de piata
Deferred shares - actiuni esalonate
Demand - cerere
Demand rate - curs la vedere
Futures - piata livrarilor la termen
Hardening of the futures - redresarea pietei
Home demand - cerere interna
Home market - piata interna
Margin - marja
Margin in cash - acont în numerar
Margin of profit - marja de beneficii
Market overt - piata publica
Market share - cota pietei
Market swing - tendinta pietei
Market value - valoarea comerciala
Prices levelled off - preturile au atins un nivel constant
Prices picked up - preturile s-au redresat
Prices rocketed - preturile au crescut vertiginos
Rate of exchange - curs de referinta
Rate of interest -.rata dobanzii
Rate of return - rata de recuperare
Revenue - venit al statului
Sales plummetted - vantarile s-au prabusit...
Sales topped - vanzarile au depasit...
Securities - garantii,titluri
Security - valoare,titlu
Settlement day - zi de referinta
Soft market - piata în scadere
Steady demand - cerere permanenta
Steady market - piata stabila
Stock account - cont de capital
Stock adventure - speculare de actiuni
Stock holder - actionar
Stock on hand - stocuri nevândute
Supply - oferta
Terms of supply - conditiile livrarii
To dabble in the stocks - a juca la bursa
To take stocks - a cumpara actiuni
Uncertain market - piata nesigura
Underwriter - garant
Venture capital - capital de risc
Yield - venit al unei investitii
Travelling
Accommodation - gazduire.
Amenity - farmec,placere.
Appeal - atractie.
Appropriate - adecvat.
Available - accesibil.
Booking - rezervare.
Clerk - functionar.
Chargeable call - convorbire taxata
Commercial hotels- hoteluri pentru oameni de afaceri
Continental breakfast - mic dejun usor
Convenience - confort.
Courses - feluri de mâncare
Discount price - pret redus
Discount - bonificatie
Half fare ticket - bilet cu pret redus
Height - înaltime
Joint destination - combinarea a doua destinatii.
Junction - încrucisare de drumuri
Lobby - culoar, hol mic.
Lounge - hol.
Maid - camerista.
Promotional fares - preturi promotionale
Registration card - registru de hotel
Resort hotels - hoteluri în statiuni.
Roundabout - ocol.
Season ticket - abonament
Settee - canapea.
Shallow water - apa putin adânca
Silversmith - argintar
Soft drinks - bauturi slabe
Sparkling landscapes - peisaje stralucitoare.
Spicy - condimentat
Straight ahead - drept înainte
Tender - oferta.
Ticket nipper - compostor
Ticket window - ghiseu de bilete
Tip - bacsis
To accommodate - a gazdui.
To add - a adauga
To cater - a se îngriji de nevoile cuiva
To chill - a racii
To chop - a taia
To dip - a înmuia
To disturb - a deranja.
To go sight seeing - a vizita orasul.
To melt - a topi
To offer facilities - a oferii conditii.
To outline - a contura
To peel - a descoji
To pour - a turna
To provide with - a furniza
To put up at a hotel - a se opri la hotel
To season - a condimenta
To shake - a agita
To sprinkle - a stropi
To whisk - a bate ouale
Undercooked - crud
Vacant - liber.
Well sitted - comod.
Width - largime
To put through - a face legatura
Money
Account - cont
Account book - registru de conturi
Assets- active
Bank return - venitul bancii
Bill of exchange /draft - cambie
Board of trade returns - statistica comerciala
Bounds - obligatiuni
Bullion - lingou
Cash account - cont în casa
Cash assets - capital în numerar
Cash deposits - varsaminte în numerar
Cash flow - fluxul numerarului
Cash in hand - numerar disponibil
Cheque to bearer - cec la purtator
Cheque to order - cec la ordin
Currency depreciation - devalorizare monetara
Current account - cont curent
Debenture bounds - obligatiune cu dobânda fixa
Deferred payments - plati întârziate
Deposit account - cont de depozit
Earnings - venituri
Expenses - cheltuieli
Figure - cifra
Financial backing - sprijin financiar
Financial futures - contracte pe termen
Gamble - joc de noroc
Gross return - beneficiu brut
Hard currency - valuta forte
Interest - dobânda
Legal tender currency - moneda legala
Let down - declin
Money chest - casa de fier, seif
Money in cash - bani lichizi
Money market - piata monetara
Money on deposit - bani depusi
Money pressure - lipsa de bani
Overdraft- sold debitor
Pay in ship - borderou de varsamânt
Payee - beneficiar
Return - venit, beneficiu, rambursare
Revenue - venit mare, câstig
Revenue assets - capital circulant
Revenue office - administratie financiara
Saving bonds - titluri de economii
Savings - economii
Tax return - declaratie de impozit
Tenor - scadenta unei obligatiuni
To earn - a câstiga
To get into dept - a avea datorii
To grant a loan - a acorda un împrumut
To open an account - a deschide un cont
To owe - a datora
To save money - a economisi bani
To settle an account - a lichida un cont
BUSINESS and BUSINESSES
Business is a long term, highly repetitious activity, frequently requiring people to do the same thing today, tomorrow, the next day.
Many of today's well known businesses were started by one or two people and the ownership of those businesses was very simple. It was during the 19th century that businesses wanted to expand and increase the number of owners. To do this they needed to sell shares. To encourage people to buy shares, governments around the world passed laws which gave people limited liability. During the 20th century many people bought shares in sucessful businesses for the following reasons:
- to have a share in the profit made by the business.
- the hope that a profitable business would attract more and more people to buy shares and this will make the price rise so that shares could be sold at a profit.
The simplest form of business ownership is the sole trader. Here, one person owns the business, takes all the decisions and risks his own money. People enjoy to be self employed and they are happy to have complete control of their own business. But there is no one to share the responsibilities involved in decision making and raising finance is a problem. Sole traders finance their business through a bank loan and the bank will charge a high rate of interest. A bank will ensure that it can get the money back, if the loan is not repaid, by requiring security on the loan. Sole traders are liable for any debts they have, even if they are not the trader's fault. A trader may do a job for a larger business; it may be worth 20 000$ but it will not be paid until the job is complete. The sole trader must spend 9 000 $ on equipment, but when the job is complete the larger business closes down and the 20 000$ are not paid; still, the sole trader has to cover the 9 000 already spent as he has unlimited liability.
Sometimes, a pair of a small group of people will get together to run a business. This is called a partnership. Partnerships face unlimited liability as sole traders do.
Partners may put some money into the partnership in return for a share of the profits but take no part in the running of the partnership, do not work for it and have "no say" in any decisions.Under these circumstances, it is only the money that has been invested that is liable to be used in order to apy off any debts. This is a silent partner and he has only limited liability.
The technical name for both private and public limited companies is joint stock company. It means that the stock in a company is owned jointly by several people.
Some business activity is carried on by the government and this forms the public sector.
Profit maximisation may not be the only aim of a busines; in public companies there is a separation of ownership and control, so that directors and managers may run a company in their own interests.
Business is the production,buying, and selling of goods and services. A business, company or firm is an organization that sells goods or services. A business may be referred to formally as a concern. Then, it may be referred to approvingly as an enterprise in order to emphasize its adventurous, risk taking qualities and business in general may be referred to in the same way, in combinations such as free enterprise and private enterprise.
A business requires tremendous effort to get it going and once going, it requires minimum effort to keep it going. The role of business is to stay in business, providing wages, goods and services into the community and meeting the profit needs of the business and the key stakeholders in the business. The source of funding and capital is considered to be the main difference between the stakeholders and the shareholders. In the stakeholder model, funding is being supplied through bank loans. This means that they will ask for managerial consideration and response from those running the company.
In the shareholder model, stockholders advance capital to managers who act as their agents in pre-authorized ways. Shareholdes buy shares to maximise the return on their investment; the responsibility of the manager in a firm is to engage in activities designed to increase the profits, that is to engage in open and free competition. To create shareholder wealth, the management needs to outperform the expectations shareholders had when they made their investment decisions. In the shareholder model of corporate governance, the focus is on institutional agents monitoring corporate agents in order to enhance the investment prospects of investors. In the stakeholder model, the premise is that a company is more likely to perform well and the shareholders are more likely to benefit, if opportunities are created for the various groups holding an interest in the company to enter into binding relationship. The emphasis in the stakeholder model is the way enterprises are governed while in shareholder model the emphasis is on the way enterprises are managed. The shareholder based entity is more responsive to changes in market conditions.
Both approaches take account of the issues of board checks and balances, abuse of authority and power, the role of boards, director rewards and participation in setting standards for accounting, safety, employee relations and risk management.
In today"s business world we have to take into consideration the two models. The shareholder model encourages a top down, command and control leadership approach whereas in the stakeholder model a team based, shared decision making, servant leadership approach is more likely.
Stakeholder based governance refers to how the organization makes cost effective decisions in terms of wealth creation but with consideration of stakeholders' rights. Corporations have multiple responsibilities and need to balance competing conditions, such as long and short term notion of gain, profit and sustainability, cash and accounting concepts of value, democracy and authority, power and accountability. This model is more common in continental Europe and Japan.
The micro approach to corporate governance refers to shareholders. This is concerned with maximizing wealth creation for shareholders. Control is linked here to profitability, an Anglo American model.
Then business may be referred to as commerce, commercial distinguishing the business sphere from other areas such as government or arts or from non money making activities.
Large companies are being referred to as corporations. Corporate is used to describe things relating to a corporation or to corporations. Large companies operationg in many countries are multinationals. Big business can refer to large business organizations or to any business activity that makes a lot of money. Small companies are referred to as small businesses or small firms.
When a private company is bought by the state and brought into the public sector in a sell off, it is privatized. The first to be sold in a privatization programme are often the companies responsible for the public supply of electricity, water and gas: the utilities.
If a company A owns shares or equity in company B, then A holds a stake, holding or shareholding in B. If A owns less than half the shares in B, then it has a minority stake in B. If A owns more than half the shares in B, it has a majority stake or controlling stake in B. If you have shares in a company you are a shareholder.
A holding or holding company is the one that holds stakes in one or more subsidiaries. If it owns all the shares in a subsidiary, then the subsidiary is a wholly owned one. A holding company"s relationship to its subsidiaries is that of parent company and the subsidiaries" relationship to each other is that of sister companies. A holding and its subsidiaries form a group. A conglomerate is a group containing a lot of different companies in different businesses.
Company A may be attempting to gain control of company B in a takeover bid, maybe by increasing its holding or stake in company B if it already owns shares in B. Company B makes or launches a bid against company A, the takeover target. If company B does not want to be taken ober, the bid is hostile. There are other ways of saying that one company is taking over another one and it means that the company is acquiring another or making an acquisition.
In a leveraged buyout or LBO, a company is acquired by a group of investors, often financed by heavy borrowing. The debt is then paid out of the target company"s operating revenues or by selling its assets. The borrowing involved inLBOs is often high risk debt called junk bonds. LBOs financed by junk were frequent in the 1980s and after an absence following the excesses of that period, they are now coming up again.
Two or more companies may decide to work together by setting up a joint venture or alliance in which each holds a stake. When two companies combine voluntarily, they merge in a merger.
The social role of any business is linked to what we call as serving the future: sufficient profits to satisfy the business and the stakeholders meet today's profits needs. But as the expectations increase society has to invest in ideas and technology that expands the economic base and the wealth of the society. An essential requirement is that each and every business strives to achieve profits over and above immediate business needs and the stakeholders' needs. Without this "surplus profit" there can be no venture capital. Without venture capital, economic growth will struggle to match population growth and the growth in social expectations.
Any business requires true professionalism- the courage to care about people, clients, career.
True professionalism means the pursuit of excellence. If you value something, then you must monitor your performance in that area, acept nothing less than excellence and actively work to learn what to do differently every time you fall short of excellence. Firms must provide help and counsel to those who are encountering difficulties in living uo to their standards, in order to help them get back on track. Once professionals have confirmed their core values, they need to design systems which provide consequences for noncompliance. By leaving each individual professional to decide for himself what level to achieve in key value areas, firms say that the company as a society has no standards that must be adhered to. Excellence in such areas become a matter of personal professional choice. Professionals must live by the slogan " you are allowed to fail, you are not allowed to give up trying."
The oposite of the word professional is not unprofessional, but rather technician. These may be highly skilled, but they aren't professionals until they demonstrate characteristics such as:taking pride in their work, showing a personal commitment to quality, reaching out for responsibility,getting involved, looking for ways to make things easier for those they serve, listening to the needs of those they serve, being team players, honest, trustworthy, loyal, open to constructive critiques.
Professionalism is an attitude not a set of competences. A true professional is a technician who cares. And if finding people with technical skill is usually easy, finding people who are filled with energy, drive, enthusiasm personal commitment to excellence is hard. Because real professionalism has little to do with which business you are in, what role within that business you perform, how many degrees you have. It implies a pride in work, a commitment to quality, a dedication to the interests of the client, a sincere desire to help.
Traditional definitions of professionalism are filled with references to status, educational attainments, noble calling. Now, we refer to attitude and character. So, firms should hire people for attitude and train for skill. Being a professional asks for treating people as professionals that is invest in them. Then professional success requires more than talent, it asks for initiative, involvement, enthusiasm, commitment.Being good at business development involves nothing more than a sincere interest in clients and their problems and a willingness to go out and spend the time being helpful to them.
Success in business life means not only good professionalism but effective functioning of the firms, positive outlooks.
The Secrets of Achieving More with Less
Some things are likely to be considered more important than others. You can achieve more with less effort, time and resources. We think that there is an inbuilt imbalance between causes and results, inputs and outputs, effort and rewards. But each individual can be more effective and happier, each profit seeking corporation can become very much more profitable, each non profit organization can also deliver more useful outputs, every government can ensure that its citizens benefit much more from its existence. For everyone and every institution it is possible to obtain much more that is of value and avoid what has negative value, with less input of effort, expense or investment. At the heart of this progress there is a process of substitution. Resources that have weak effects in any particular use are not being used sparingly. Those which have powerful effects are being used as much as possible. Every resource is ideally used where it has the greatest value. Wherever possible, weak resources are developed so that they can mimic the behaviour of the stronger resources. Business and markets have used this process for many years.
And so we call for a well known principle namely "the 80/20Principle" which tells us that a minority of causes, inputs, efforts lead to a majority of the results, outputs or rewards and that our daily lives can be improved by using this principle. A new way to use this principle is the 80/20 thinking, that is about any issue that is important to you and asks you to make a judgement on whether the principle is working. This is the daily life , non quantitative putting into practice of the principle. It is used to change behaviour and to focus on the most important 20 per cent. It works when it multiplies effectiveness. Action resulting should lead us to get much more from much less. When using this principle we do not assume that its results are good or bad or that the powerful forces we observe are necessarily good. We decide whether they are good and either determine to give the minority of powerful forces a further shove in the right direction or to work out how to frustrate their operation.
By putting it into practice, this principle implies that we should do the following:
- celebrate exceptional productivity, rather than raise average efforts.
- look for the short cut, rather than run the full course
- exercise control over our lives with the least possible effort
- be selective
- strive for excellence in few things, rather than good performance in many
- delegate or outsource as much as possible in our daily lives and be encouraged rather than penalized by tax systems to do this
- choose our careers and employers with extraordinary care
- only do the thing we are best at doing and enjoy most
- look beneath the normal texture of life to uncover ironies and oddities
- in every important sphere work out where 20 per cent of effort can lead to 80 per cent of returns
- calm down, work less and target a limited number of very valuable goals where the 80/20 principle will work for us, rather than pursuing every available opportunity
- make the most of those few "lucky streaks" in our life where we are at our creative peak and the stars line up to guarantee success.
The 80/20 Principle applied to business has one key theme- to generate the most money with the least expenditure of assets and effort.
The classical economists of the XIXth and XXth century developed a theory of economic equilibrium and of the firm that has dominated thinking ever since. The theory states that under perfect competition firms do not make excess returns, and profitability is either zero or the normal cost of capital, the latter usually being defined by a modest interest charge. Then the theory of the firm goes like this: in any market, some suppliers will be better than others at satisfying customer needs. They will obtain the highest price achievements and the highest market shares.
More than this, the objective of 80/20 thinking is to generate action which will make sharp improvements in your life and that of the others. Thinking escapes from the linear logic trap by appealing to experience, introspection and imagination. If we are unhappy we do not worry about the proximate cause. We think about the times we have been happy, we do not look for causes of failure, we imagine and then create the circumstances that will make us both happy and productive.
What do you think about the following insights for our personal life:
> 80 per cent of achievement and happiness takes place in 20 per cent of our time.
> Our life can be affected by a few events and a few decisions. The decisions are often taken by default rather than conscious choice; we let life happen to us rather than shape it; we can improve it by admitting the turning points and by making the decisions that will make us happy and productive.
> There are always a few key inputs to what happens and they are often not the obvious ones; if the key causes can be identified and isolated we can very often exert more influence on them that we think possible.
> Everyone can achieve something significant. The key is not the effort but to find the right thing to achieve. You are no doubt more productive at some things than at others but one have to dilute the effectiveness of this by doing too many others where our skill is nowhere near as great.
> There are always winners and losers and always more of the latter. You can be a winner by choosing the right competition, the right team and the right methods to win.
> Most of our failures are in races for which others enter us. Most of our success comes from races we ourselves want to enter. We fail to win most races because we enter too many of the wrong ones: their ones, not our ones.
> Few people take objectives really seriously. They put average effort into too many things, rather than superior thought and effort into a few important things. People who achieve the most are selective as well as determined.
> Most people spend most of their time on activities that are of low value to themselves and others. The 80/20 thinker escapes this trap and can achieve much more of the few higher value objectives without noticeable more effort.
> An important decision is the choice of allies. Almost nothing can be achieved without allies; but most people do not choose them carefully. Some of us have too many and do not use them properly. 80/20 thinkers choose a few allies carefully and build the alliances carefully to achieve their specific objectives.
> Money used rightly can be a source of opportunity to shift towards a better lifestyle.
> Few people spend enough time and thought cultivating their own happiness. They seek indirect goals(money, promotion), that may be difficult to attain and will prove to be extremely inefficient sources of happiness. Happiness not spent today does not lead to happiness tomorrow. It will atrophy if not exercised. The 80/20 thinkers know what generates their happiness and pursue it consciously, cheerfully and intelligently, using happiness today to build and multiply happiness tomorrow.
> The logic of professional success leads to ever greater professional demands. To succeed you must aim for the top. To get there, you must turn yourself into a business. To obtain maximum leverage, you must employ a large number of people. To maximize the value of your business, you must use other people's money and exploit capital leverage- to become even larger and more profitable.
> If you decide which shares to buy it is good to specialize in an area in which you consider yourself an expert. Possibilities are almost endless; you could specialize in shares of the industry in which you work or of your hobby, your local area or anything else you are interested in. if you like shopping you might decide to specialize in the shares of retailers. Then, if you notice a new chain springing up, where new store seem to be full of keen shoppers, you might want to invest in those shares.
> The key to making a career out of an enthusiasm is knowledge. You must know more about an area than anybody else does; then work out a way to market it, to create a set of loyal customers. It is not enough to know a lot about a little. You have to know more than anybody else, at least about something. You should not stop improving your expertise until you are sure you know more, and are better in your niche than anybody else. Then, reinforce your lead by constant practice and do not expect to become a leader unless you really are more knowledgeable than anyone else.
Many years ago, Aristotle said that the goal of all human activity should be happiness. It seems that we haven't listened too much to him. Perhaps he should have told us how to be happy. So, he could have started by analyzing the causes of happiness and unhappiness. Happiness is profoundly existential. Past happiness may be remembered or future happiness planned, but the pleasure it gives can only be experienced in the "now". One of the 80/20 hypothesis would be that 80 per cent of happiness occurs in 20 per cent of our time. It is interesting that those who are happy with most of their lives are more likely to be happier overall; those whose happiness is concentrated in short bursts are likely to be less happy with life overall.
Are there some ways to be happier?
> Identify the times when you are happiest and expand them as much as possible.
> Identify the times when you are at least happy and reduce them as much as possible.
Or :
-spend more time on the type of activities that are very effective at making you happy and less time on other activities.
- start by cutting off the spots of unhappiness, the things that tend to make you actively unhappy.
The best way to start being happier is to stop being unhappy. You have more control over this by avoiding situations where experience suggests you are likely to become unhappy.
- for such activities that are ineffective at making you happy it is good to think systematically of ways that you could enjoy more.
- by cultivating habits of optimism we can have a happier life as optimism is an ingredient for both success and happiness.
- we must sometimes change the way we think about events; we can train ourselves to break the self reinforcing pattern of depression by simple steps such as seeking out company, changing our physical setting or forcing ourselves to exercise.
- we can change the way we think about ourselves; we can make ourselves happy or unhappy by the way we decide to feel. We must make the choice that we want to be happy. We owe it to ourselves and to other people too. A positive self image is very important, a sense of self worth can and should be cultivated; you know that you can do it: give up guilt, forget about your weaknesses, focus and build on your strengths, remember all the good things you have done, all the small and big achievements.
- we tell ourselves stories about us. We have to do this and we will increase the sum of human happiness by starting with ourselves and radiating out to others.
- we can make ourselves happier by changing events we encounter and that make us depressed or miserable.
- we can become happier by changing the people we see most( the amount of time spend with them has to be changed).
Dialogue
Richard , the reporter: Good morning Mr. Osborne, thank you for being so kind to me and give me some answers.
Mr. Osborne: I am available for only 20 minutes because I am meeting the Company executive.
Richard: Would you be so kind and tell me if there are secrets for successful businessmen because people wonder how you managed to become in such a short time a well known businessman.
Mr. Osborne: Well, first you have to be open minded and explore ideas, to aim for the top. You must turn yourself into a business. You must use other people's money and exploit capital leverage.
Richard: Do you think that professionals have to be very close to you?
Mr. Osborne: You need them to get excellence and then money will come, no doubt.
Richard: Why is strategy important?
Mr. Osborne: If you arrive at a useful business strategy you can be successful and raise profit.
Richard: Where are you making the most money?
Mr. Osborne: I am attentive to long term investments when the stock market is low, I build my investments on expertise, I consider the merits of the emerging markets, I run my gains...
Richard: What is the key to understanding and driving up profitability?
Mr. Osborne: Competitive segments as parts of our business where we face different competitors or competitive dynamics.
Richard: What does business require?
Mr. Osborne: Decisions tacking and analysis. Since 1950 business has been blessed by management scientists and analytical managers incubated in business schools, accounting firms and consultancies who can bring analysis to bear on any issue.
Richard: Can you work less, earn and enjoy more?
Mr. Osborne: Yes, your thinking has to be strategic, you have to be ambitious and trust your own values.
Richard: Are you happy? If so, what makes you be happy?
Mr. Osborne: I have found two ways to be happy: first to identify the times when you are happiest and expand them as much as possible, and to identify the times when you are least happy and reduce them as much as possible.
Richard: Thank you for your time given and I wish you a prosperous life.
Enlarge upon the following:
1. Happiness is a duty. We should choose to be happy. We should work at happiness. And in doing so, we should help those closest to us, and even those who just stumble across us, to share our happiness.
2. Time is the benign link between the past, present and future. Time keeps coming round, bringing with it the opportunity to learn, to deepen a few valued relationships, to produce a better product or outcome and to add more value to life. We do not exist just in the present, we spring from the past and have a treasure trove of past associations, and our future is immanent in the present.
3. One good rule for being successful is: "realize that knowledge is power".
Do you agree or disagree:
1.An essential ingredient of a happy day is mental stimulation, as well as a spiritual and artistic one.
2. Lack of control is the root cause of much unease and uncertainty.
3. Objectives that are too easy will lead us to be complacent, accepting mediocre performance. Those which are too tough lead us to self fulfilling, self perceptions of failure.
4. Life's unplanned contribution should be incorporated into our own plan so that it can proceed to an even higher level.
5. People with low self esteem and self confidence are a nightmare to live with, however much mutual love abounds.
6. Most of the satisfaction you draw from all of your friends will be focused in your relationship with a small number of close friends.
7. A short cut to lasting happiness is to evolve the lifestyle you and your partner want and this requires of course a harmonious balance between your work life, home life and social life.
8. The impact of the quality revolution on customer satisfaction and value, and on the competitive positions of individual firms is truly great.
9. The information revolution has a long way to run.
10. Cause and effect, input and output operate in a non linear way. You do not usually get back what you put in; you may sometimes get very much less and sometimes get very much more.
11. The real world comprises a mass of influences where cause and effect are blurred, where complex feedback loops distort inputs, where equilibrium is fleeting, where there are patterns of repeated but irregular performance, where firms never compete head to head and prosper by differentiation, where a few favoured souls are able to corner the market for high returns.
This principle can help people get a great deal more out of their lives, to raise their effectiveness and happiness, to boost profits and what leads to profits. It is a practical tool for making a more sensible world. Business leaders who observe the principle at work and see that 20 per cent of products or revenues are producing 80 per cent of profits and that 80 per cent are contributing only 20 per cent of profits- do not shrug their shoulders. Sensible and profit maximizing entrepreneurs do something to correct the imbalance; they make the really productive 20 per cent of activities a larger proportion, they use the 80/20 principle in the pursuit of progress to improve on reality as progress relies on finding a better way to do everything.
Now we do not prefer life to be quiet, stable or unaccountable. Now the competition is very tough, and so we strive for solutions and for efficiency in all domains. Any good business asks for
- good and trustful professionals
- developing personal career strategies
- caring for the genuine clients
- cost reduction and service improvement
- good marketing strategy
- the right management
- the valuable negotiation stages
- the appropriate funding
- finding the best solutions in order to increase profit
- sticking to the rule of the few: the search for the high product quality
- using technology at its best
- a good fitting into the world
- courage in entering a business, faith in progress, in the great leaps forward, in mankind's efforts to improve life.
- creativity and determination
More than these all, I do think that we have to ponder over the following:
" God plays dice with the universe. But they're loaded dice. And the main objective is to find out by what rules that were loaded and how we can use them for our own ends"!
Discussion points:
1. How can development in business life be carried out?
2. Is life different for a businessman?
3. What do businesses operate with?
4. How important are trust and confidentiality?
5. What do we expect from a professional?
Enlarge upon the following:
1. It is better to make the wrong decision than to make no decision at all!
2. Support any of your views regarding true professionalism with examples from your own experience.
3. Everybody begins at the bottom!
4. Tackling challenges in business life is not easy at all!
5. There will always be a time for healing....
Additional Vocabulary
To set up in a business- a se lansa în afaceri
Bid- oferta
Bidder- licitant
Bond- obligatiune
Business forecast- prognoza economica
Business data processing- informatica de gestiune
Business assets- active comerciale
Business environment- mediu de afaceri
Business expenditure- cheltuieli de reprezentare
Business outlook- prespective economice
Business manager- director comercial
Corporation earnings- veniturile societatilor pe actiuni
Corporation income tax- impozit asupra veniturilor corporatiilor
Corporation sole- corporatie individuala
Corporate acquisition- achizitie de firma
Corporate banking- servicii bancare pentru firme
Corporate body- persoana juridica
Corporate bond- obligatiune emisa de o societate
Corporate equity- capital social/ fonduri proprii
Corporate securities- titluri de societate
Corporate venturing- furnizare de capital de investitie de catre o companie altei companii
Equity- capital al actionarilor într-o companie
Equity shares- capital investit în actiuni cu drepturi asupra profitului
To hold- a cuprinde,a retine,a tine sub control,a organiza, a mentine, a se aplica.
Holder- detinator, purtator, proprietar, concesionar
Junk bonds- obligatiuni riscante
Joint venture- societate mixta
Interest- dobânda
Leverage-putere, influenta, randament,raport dintre creante si capital, indice de îndatorare, mijloc de majorare a profitului.
Leveraged buyout- preluare asistata, pe credit.
Leveraged management buyout- cumparare de câtre salariati
Liability- responsabilitate, raspundere
Security- titlu de valoare
Security market- bursa de valori
Sole trader- comerciant pe cont propriu
Take over- preluare
To merge- a fuziona
Trader- speculator la bursa de valori, comerciant
Merchandise- marfa
Merchant- comerciant
Willingness- bunavointa
Willing- dispus, binevoitor
THE COMPANY
A company is a very special form of business. It is owned by the shareholders but has a separate legal existence from the people who own it. The shareholders elect a board of directors to run the company on their behalf. If the company has 2- 50 shareholders it is a private one. The liability is limited to the money that the shareholders have used to buy shares. If the shares are traded on the stock exchange we have a public limited company. Members of the public can buy these shares by going through a stockbroker or bank.
In business we must create for ourselves a set of attitudes and values that balance the conflicting factors, enabling us to act effectively with integrity, dignity, understanding. So we'll have better relationships with our partners and our life becomes richer. Emotional containment ensures then that the business values are not undermined by other values from our society, such as we perhaps learned early in life.
We then have to know that there is no social health without economic wealth; the role of business is to stay in business, providing wages, goods and services into the community and meeting the profit needs of the business and the key stakeholders in the business.
The business does not operate in a vacuum; there are competitors, there is a level of economic activity, there is rapidly changing technology.
The visions we have for our businesses are what makes them and us really successful. Setting goals and objectives will help us achieve our vision. The key to success and happiness in life is to create a positive vision, to remain true to one's own spirit, to have the energy of challenge.
But running a business is never easy. It's a ride through a range of hazards and difficulties but one thing is sure: life will rarely, if ever, be dull. If you do not enjoy running your business, you can't expect to do it well.
Some ways to make a business successful are the following:
1. Ideas- bad or good- are important as the lifeblood of business and vital to its long term success. Ideas are vital to develop new or existing products or services or even to take the first step into a new business.
2. Choosing professional advisers is essential and they can make or break your business.
3. Finding and keeping clients must form an integral part of your planning if you want to grow your business.
4. Research your target companies does take time, but it's well spent. If knowledge is power, then researching a company can give you a much better understanding of what they do and help you to prepare a successful bid.
5. Brand your business and you'll be set apart and enable you to introduce a wider range of products and services more easily.
6. Team up with another business to enhance yours and be competitive on the market.
7. Consider a project based working which has many advantages for the employer and employee. This means working for just one or two employers at any time.
8. Be creative, have an open mind philosophy and a "I can do" attitude. Any business can benefit from using it creatively.
9. Focus on creating a win/win situation.
10. Use your time wisely, as it is not elastic and it will not magically expand to accommodate all we have to do.
11. Keep your employees happy and remember that a happy workforce is a productive one and will contribute to the performance and profits of your business.
12. Make powerful presentations by a good planning and preparation. Exhibitions can be invaluable marketing exercises for any business.
13. Event management is important: organizing gatherings, conferences, seminars, training courses.
14. Networking for success is a way to meet new people, exchange information and get new business.
15. Master the media and you may get rewards by being attentive to the interviews.
16. The success of a business will depend on how well you sell products and services. How do you persuade people to buy the product? The more work you put into planning and developing your sales strategy, the easier it will be to close and develop a loyal customer base.
17. Lasting customer relationships are very important as profitable business starts and ends with the customer. So it's worth giving them the attention they deserve.
18.Ensure that success will come from a website but be careful to a sound strategy. E-commerce revolution is on its way and the staff has to be well trained in this respect.
19. Maintain a positive flow of money in your business by realistic forecasting which will only be of benefit if it is checked and reconciled on a regular basis.
20. Enter into partnership agreement and make sure that your partner can contribute to the business and will strengthen it.
In business life time is important to be taken into consideration as it is our most precious resource. We have to maintain a balance, we have to give ourselves time and opportunity to do things right; we do not get a second chance with time, so we must do our best to make every minute purposeful and enjoyable. Then our goals are set as we want them to be and we can reward ourselves for gains.
A business is a coordinated effort to achieve certain ends summarized in the profit and loss. Joining a business means embracing some part of that at least. The assumption is that everyone wants to be successful and for this within a company it is important to:
* consolidate the aims of the team, the team spirit.
* understand the team' effort to strive for achievements.
* focus on creating a team climate.
* understand the energy of challenge.
* be aware on one's responsibility.
Desire or will is the very essence of success. Without this intensity the actions of success have a hollowness, the hallmark of "but I tried".
Successful business asks for good leadership and this is not some mystical act performed by the few and only able to be performed by them through some luck of upbringing or genetics that made them natural leaders. We can become better leaders than we are; to achieve this means that we need to do the right things at the right time more often than we usually do and we also need to examine ourselves. We also need to have a clear idea of what to do in order to gain the best possible result from others. The actions identified must be the appropriate actions in what is broadly called "western society"(North America, U.K., Europe, Australia, New Zealand).
Leadership is to be taken into account whenever we have in view any business; there are some steps to be followed:
1. The agreement to success for every team member. Everyone wants to be successful as far as goals are clear and business processes are far from being clumsy. Everyone has positive and negative thoughts in their minds most of the time. We know how easy it is for the negative thoughts: the company is not good, the boss is bad...We represent the positive assertively in our mind- "work is rewarding". But we select our thoughts and they influence us. If a person has negative thoughts about the job and the company, work performance is suffering. The negative impact can make the team output less than it should otherwise be. But we are responsible for our own thoughts, so what a manager can do is to point out the consequences. It is clear that when the team becomes focused, gets people organized, celebrates success, then bad attitudes disappear.
Defining success entails the idea of challenge which energizes people.
The team leaders and managers must live as exemplary models of how they expect others in their team to act. Each management team member is expected to be an " inspiring player." The team effort has to be understood properly. The team spirit must be a consequence of doing other things well. Coordinating the effort is to be achieved by the profit profile with each team member being accountable for some number on the profile and this will define success for a team. People have seen now the standards required.
Identifying the behaviours of success. As the goals have been agreed, the steps to be followed are to make clear what actions were most likely to bring about the goals.
In the goal-action principle, the idea of action becomes clear now, we have those behaviours that will best fulfill the goal, derived from the goal and belonging to it. It is important to find the balance between two things in conflict as a crucial act of insight and creativity for the manager and the team. If the issue is finding sales tactics, then the problem is one of creativity for the team to brainstorm possible tactics and then select one or several that best achieves the balance of the required result.
Provide monitoring and feedback on progress and performance. The main concern among the teams was to provide useful guidance on what should be changed to improve the results. Better reports were being sought, better information.
Celebrate success, large and small. Teams celebrate success as people have risen to the challenge. Team results were evident. The progressive build up of life satisfaction was something that occurred beneath the daily flux and it should increase each year. It was seen as related to goals and work had the potential to be a major component.
Teams will remain the core of the business. Before demanding better performance one have to be sure that this can be achieved. So, for every goal there are tasks that must be acted out if the goal is to be achieved. Everyone succeeds if the team succeeds. It is important to recognize individual performance, but from within the framework of the team.
A management team should be a team, not a collection of individuals with personal accountability. This means that every team member understands that they can win only if the team wins and the team wins by achieving the targeted operating profit. Within that, each person has his or her role and tasks within this role. If people can fully perform their own jobs and have the mental, emotional and physical energy to assist others, and if the others accept and appreciate the assistance, then those people should be encouraged and celebrated within the team.
A management team operates within the framework and policy prescribed by the strategic plan and is accountable for creating sales revenue and converting it into operating profit.
To develop a manager means to develop the person. That is, to improve business management or business leadership is not merely an act of adding some skills or some knowledge to the person; knowledge alone is not power; only if it is backed by the ability and willingness of how, the judgement of when to use that knowledge is power.
Intellectual honesty is an important quality that must be taken into consideration. That means being truthful with yourself and not only. We have wishes and dreams, sensitivities about ourselves; so often we do not want to think poorly of ourselves; it is easier and more comfortable to find reasons beyond us for the unfortunate things that happen or for results that should have been . Such emotional forces can and do push us to think in certain ways. Then, intellectual honesty comes to help us: a process of conceiving the factors accurately as a scientist might, without the comfort of the excuses. It allows us to avoid giving up too early and this is one of the hallmarks of all champions.
There are some situations we meet within a company:
There are all kinds of reasons for wanting to be your own boss. Some people like the idea of there being no one in authority over them, telling them what to do, saying their work is not up to standard, turning down their ideas, or insisting on methods that seem pointless. Others are attracted by the thought of deciding their own hours, or days, of work.
Running your own business gives you the status of being self-employed, perhaps also of being a company director. There is the general feeling of independence, and that your income - and perhaps even your way of life - is in your own hands. Some are attracted to the idea of starting a small enterprise and making it grow, much as a gardener tends his plot and makes a number of plants come to maturity, each in turn creating further growth.
If you are your own boss, say some people, work is so much more pleasant. You can get someone else to do the less interesting jobs and you are not bogged down in annoying details. Work becomes easier, too, because you can get someone else to do the more difficult tasks.
Many others want to set up a little business of their own to occupy their spare time, and as a pleasant way of earning extra money from work they like doing.
These are just a few of the reasons commonly given. Some have good sense behind them; others are based on completely false ideas. Most contain some element of truth which gets magnified out of all proportion, and seized upon without it being borne in mind that there are other points to consider as well.
As with so much else in life, running an enterprise of your own entails disadvantages as well as advantages. It is surprising how rarely people stop to consider in real detail just what the drawbacks are, yet this is an essential first step for anyone thinking about whether it is even practicable for him to be his own boss.
An important reason why there is such glamour about being in charge of your own business is that when you are working for someone else, many of the petty irritations of life, as well as the chore of often having to get down to work that you do not feel like doing at that particular time, become associated with being an employee. There is a feeling that, if only you were your own boss, life would immediately become infinitely pleasurable and free from irksome detail.
This is almost entirely misleading. Many of the little annoyances probably have nothing to do with being an employee: being interrupted when you have at last immersed yourself in some disagreeable task, missing the bus when you are in a hurry, feeling tired or in other ways not really up to working hard at the moment, and so on.
These occur just as much when you are your own master. In fact, they tend to happen much more often, while at the same time, their effects can be far more upsetting.
There are very real drawbacks to running your own business, though for the right kind of person, immeasurable benefits also.
A company has two ways of delivering value to clients: either the clients obtain just the accumulated wisdom and talents of the specific professionals who are servicing their work, or the clients can get this, "plus" all the relevant accumulated wisdom, experience, tools, methodologies of the rest of the firm. What does it mean for a company to have value above and beyond the talents of individual professionals? What can a firm do that will help a professional to be more successful than he or she would be at a halfway decent competitor? Maybe:
- provide professionals with the benefit of shared skills and experiences within the practice group.
- facilitate access to the skills of others in different disciplines.
- establish procedures to produce well trained junior professionals.
- achieve a high level of cross selling and access to clients of other professionals.
- provide superior support staff and systems.
- instill a system of supportive challenging, coaching to bring out the best in each professional.
- create an emotionally supportive friendly environment.
- provide for diversification of personal risk.
- establish a powerful brand name that makes marketing easier.
Interesting but more and more in our concern the firm, the company has to be viewed in future. The strategic challenge for professional firms is not to forecast the future, but to ensure that the firm is effective at adapting to already observable market changes. Most professional firms are resistant to change.
Old ways of doing business suffer from inertia and few firms are either willing or able to implement significant changes in the way they manage their affairs. Major trends are being identified and big schemes are announced as responding to them. But a professional firm is not completely at the mercy of unknowable fates. You can make things happen if you want to. Why plan in an unpredictable world? Because you can make sure that the way you run your affairs makes you more adaptable and adaptive.
Through a combination of planning and reexamination of current management practices, firms can become better at listening to the environment and picking up its change signals early. They can also become better at ensuring that they have numerous experiments going on to test new ideas and approaches. Firms should be testing what the market will and will not respond to.
They must avoid complacency, be adaptive by constantly asking:" is there a better way to do what we do?"
Firms are very good at figuring out what they want their people to do differently. They are not so good at figuring out management systems to get them to do it. So, planning means managing in new and different ways. Many companies miss a central truth: if you haven't changed your measures and rewards, you haven't changed your strategy.
A firm has to be better than the competition in the following ways:
- Aggressive listening to the market.- good tactics: focus groups, feedback survey, client panels, formal market research..
- Using market intelligence: each practice is actively gathering market intelligence and is devising new things to do for clients.
- Raising the level of innovation- the management's job is to stimulate experiments and encourage innovation.
- Sharing new knowledge- firms must become good at sharing the results of their experiments.
- Pressure for personal growth through professional performance counseling and practice leadership.
- Management behaviour- management must be perceived as leaders of a changed effort; stimulating new ideas, willingness to provide seed capital for those who wish to try new things.
- Measuring success not only by the volume of work performance but by the type of work it brings in.
What do you think about the following:
1. Visionary companies share a common subset of correct core values
2. Visionary companies require great charismatic visionary leaders.
3. The most successful companies exist first and foremost to maximize profits.
4. Visionary companies are great places to work for everyone.
5. Highly successful companies make their best moves by brilliant and complex strategic planning.
6. Companies should outside CEOs to stimulate fundamental change.
7. The most successful companies focus on beating competition.
8. The only constant is change.
9. Flexibility means drafting several possible scenarios for the future.
10. Companies employed bottom up planning.
Enlarge upon:
1. The Firm of the Future is so Close to us!
2. How Can You Manage Your Clients" Projects?
3. When does a Professional Company Merger Make Sense?
4. What Should a Firm Be Tolerant about?
5. How will the Adaptive Firm measure its success?
Dialogue
Mr. Norman General Manager of a large company is meeting Mr. Cleary a reporter who wants to be informed about the success of the B&Y Company.
Mr.Cleary: Good morning Mr. Norman and thank you for the time you have allowed to me.
Mr.Norman: It is my pleasure and I do not mind sparing some minutes with you!
Mr. Cleary: I would like to write a few lines about your company in the "Capitalul" magazine.
Mr. Norman: Our business has increased and as you may be acquainted with, we have deemed it advisable to open more branches in the country.
Mr.Cleary: What kind of investment would you care for?
Mr. Norman: We deal with textiles. We enlarged our business by getting new partners and we expect higher dividends. The quality of our products has been maintained at a high level. So, wool prices are excellent and the revenue too. If we refer to the profit and loss account, an increase of more than 20% is to be taken into consideration.
Mr.Cleary: How did you manage that?
Mr. Norman: By working with a well trained team, by finding good partners, by having a stroke of luck, by keeping with the new market trends.
Mr. Cleary: I do have some questions if you don't mind. Such as:
- How quickly can one hope to climb the promotion ladder to partner level?
- What are salaries based on as your career progresses?
- How long do most people stay in your company?
- How successful is the company?
- Are you enthusiastic about the development of the company?
- Do you spend money on staff training?
- Where do you intend to expand the sales?
- What persons do you work with?
Mr. Norman:
The best are being promoted to partners; unless you make partner by the age of 35, you will basically never make it.
Salaries reflect the assessment of the employees.
Over a ten year period, less than 40% of those hired are to be retained by the company.
- The shareholders are content as the loss is small.
- Yes, as far as the turnover has increased and we have subsidiaries all over the world.
- There are full and part time courses, most of them being paid by our company.
- In Eastern Europe.
- Those experienced on the sales side, with first class technical knowledge, young, full of energy and new ideas; those who know what competition means.
Additional Vocabulary:
chartered company- companie înfiintata pe baza unei Carte Regale
joint stock c.- societate pe actiuni
unlimited c.- societate cu raspundere nelimitata
limited c.- societate cu raspundere limitata
parent c.- societate mama
wholly owned c.- societate în propietate integrala
unincorporated c.- societate neînregistrata
winding up of a c.- încetarea activitatii unei societati
greenfield c.- societate la început de drum
bogus company- societate fictica
close c.- societate închisa
dormant c.- societate inactiva
company funds - capital al firmei
company identity- imagine de marca
to stay afloat- a se mentine pe linia de plutire
shareholder-actionar
shares- actiuni, titluri de valoare
preference shares- actiuni privisegiate
deferred shares- actiuni cu plata dividendului dupa satisfacerea celorlalte
outstanding shares- actiuni în circusatie
share capital- capital social, în actiuni
share market- bursa de actiuni
share prices- curs
share index- indice
share split- divizare a actiunilor
to share the profit- a împarti profitul
to share one's views- a împartasi parerile cuiva
to share one's experience- a împartasi experienta
to assess-a evalua
assessment- evaluare
assessed- evaluat
turnover- cifra de afaceri
loss-pierdere, deficit
to run at a loss- a lucra în pierdere
loss ratio- rata pierderilor
relocation- mutare
core business- activitate de baza
break up- lichidare
liable- responsabil de
Dealing with a Customer
When dealing with a customer you may encounter some situations:
You have an angry customer because you messed up
The first step in dealing with any angry customer, whatever the reason, is to listen while they get their anger out of their system. Sympathize with the problem with phrases such as, 'How frustrating for you,' or '1 can see how infuriating that must: be'.
Once they have expressed their feelings, and realized that you are listening and sympathetic, they will calm down. At this point it is wise, as well as honest, to hold your hands up and admit your mistake by saying something like. I'm terribly sorry. 1 should have put the order through manually and I clean forgot. I do apologize, especially after it's caused you so much trouble'. This will take the wind out of their sails, not least because so few people actually admit lo their mistakes.
So long as you offer to put things right: in any reasonable way that suits the customer, they are likely to end up feeling very satisfied. Not only have you resolved the problem, you've also been honest with them. It should reassure them that you're a good organization to do business with: everyone makes the occasional mistake, and at least you admit to it and put it right magnanimously.
Some people will advise you never to admit blame when dealing with customers in case they sue you. It may be wise to take legal advice if your mistake has cost them thousands, but in most cases they're not going to sue. If you've cost them just a few pounds, what's the problem? You ought to pay up, so there should be no question of suing. From a legal point of view, refusing to admit blame may sometimes be wise. From an ethical and customer relations standpoint, it is always better to admit your mistakes.
You have an angry customer because one of your team messed up.
Handle this exactly as you would if it was you that had messed up. You are responsible for your team, and you should carry the can. The customer doesn't need to know which individual in your team messed up; it's enough to know that it's your team. Don't ever try to pass the buck when speaking to a customer, tempting though it may seem to say, 'I'm afraid a junior member of my department made a mistake'.
You will obviously need to talk to the team member in question privately. However, you need to separate the mistake from the customer's reaction to it. If the customer overreacted wildly to a minor error of judgement or an understandable mistake, don't make a big deal of it with your team member just because the customer made a big deal of it with you. If you're angry and upset by your exchange with the customer, wait until you've calmed down before tackling the person who made the mistake.
You can't deliver on a promise to a customer
The important thing is to limit the damage, and there are two key ways to do this:
1. The most important thing is to give your customer as much notice as you possibly can. The later you tell them, the deeper the hole you land them in. Plenty of warning gives them time to find a contingency without it becoming a major issue. If you're not sure whether you can deliver but it's looking increasingly dodgy, you'll need to explain the situation before you know for certain whether you'll have to let them down. Then they can choose whether to take the risk or whether to find an alternative.
2. When you tell them, apologize profusely and let them know that you recognize how inconvenient it is for them. Then offer them whatever you can to make up for it. This might mean telling them you can deliver part of what they want, or they can have everything they want but later than they hoped or to a lower standard. Or you might say, 'I can't do this, but I can find you someone who can'.
A major customer threatens to go elsewhere unless you make concessions you can't afford
They say that they'll go to your manager/the top of your organization/the press. The answer is in the question here. If you really can't afford the concessions, you can't afford the customer and you're better off letting them go. Before you do, however, make sure that there really aren't any other concessions chat would suit you both. If you can't drop your prices low enough, maybe they can pay in installments or on other very good terms. If you can't deliver soon enough, perhaps you could deliver part of the order.
If there is no meeting ground, make sure you part on friendly terms. Don't tell them they'll regret changing supplier. That way, they may well come back to you. If they were bluffing to get you to make concessions, or if their new supplier lets them down, you want them to feel they can come back to you easily.
A disgruntled customer threatens to report you
They say that they'll go to your manager/top of your organization/the press. Let them. Presumably you've done nothing wrong, so you have nothing to worry about. Arguing with them will make it worse, and look as if you're running scared. If you say to them, 'If you feel you want to take it further, that's up to you,' it's more likely to deter them. After all, they were threatening in order to get a response from you. The tactic clearly hasn't worked so they may well abandon it.
If the customer threatens to go to someone internally, from your immediate boss to the MD, forewarn the manager concerned. They won't be too pleased if they get a call from a customer and look a fool because they don't have any of the facts. So brief them fully.
If by any chance you are at fault, you're still better off 'fessing up. It is better for your boss to hear it from you first than from an angry customer.
A customer is wrong
Sometimes a customer accuses you of doing something that you really haven't done. In fact, maybe their subsequent problems have arisen because they failed to give you their full address, or sign the cheque. So what do you do when they complain? Is the customer really always right?
You need to listen to their complaint, and sympathize with their problem just as yon would if the complaint were justified. You can still say, 'How frustrating!' or I can see that must have put you in a difficult position,' without admitting blame.
Tactfully explain what has caused the problem, but don't make them feel stupid or they could get defensive. Avoid words and phrases such as 'fault' or 'you should have . . Give them an excuse for their mistake. For example, 'Our delivery terms are 28 days unless you specify express delivery. I know how easy it can be to overlook that sort of thing, especially when you're in a hurry.'
Let them feel their point is valid, without accepting blame. Say for example, 'Maybe we should print our delivery terms on the order form as well as on the terms and conditions. I'll suggest that to the department concerned.'
Don't offer refunds or replace items just to calm a customer down, in case it implies that you were at fault. This might be an unwise precedent. However, if you really want to do something, describe it as a gesture of appreciation for bringing their problem to your attention.
You know one of your customers is lying to you
You get them occasionally, customers who frequently claim, for example, that the goods arrived faulty or damaged when you know for a fact that they didn't. Whatever you do, don't bother arguing. You've got two options:
1. give the customer the benefit of the doubt
2. stop supplying them and ask them to go elsewhere.
You've already got a dishonest customer. If you argue with them, you'll have an angry, dishonest customer - and that's worse. They may spread rumours or damaging gossip about your organization. So don't fall out with them.
The other trap to avoid is changing your systems in order to try and combat their dishonesty. You could inconvenience all your honest customers, and make your own lives more complicated, just for the sake of a customer who doesn't deserve that kind of effort. So if you don't want to put up with it, just drop the customer.
An important customer demands more of your time than you can spare
If you have a very talkative customer who engages you in long-winded conversations, you need to find a way to get the information you need from them and then terminate the conversation without upsetting them. You can't keep interrupting them without sounding rude, so you need to interrupt yourself.
It may sound strange, but it makes sense really. You need to get a word in, but to do it by joining their conversation rather than deflecting it. Once you're in, then you can change the subject, like this: 'I quite agree, the traffic's getting silly on the North Circular these days. By the way, when do you need these delivered by?'
There's another kind of demanding customer, too: the one who's on the phone 10 times a day with endless minor queries. You can't avoid this customer altogether, and you'll offend them if you try. You just need to get them to be less of a nuisance:
If someone's calling several times a day, tell them the first time they call that you're very busy at the moment and you want to wait until you can give them your full attention. Ask if you can call back at the end of the day. They can save all their questions until you ring back, and you have only one call all day, at a time of your choosing.
Put your voicemail on or have someone field your calls. You do have to talk to this customer sometimes, however, so don't wind them up by taking ages to call back. Once they learn they can trust you to call back the same day - albeit at the end of the day - they'll start to feel happier about leaving messages.
If the customer is on email, ask them to email you instead of calling. Explain that you prefer to have everything in writing so you can be sure you have all the details, and you don't forget to follow anything up. Now you can deal with the queries at a time that suits you. You may have to speak to them occasionally but, again, you can choose the time.
A good and previously reliable supplier lets you down badly.
In the short term, you need to find another supplier. The question is whether in the long term you should change to a new supplier or whether you should give this one another chance. In the end it's your decision, but here are some considerations to lake into account:
-Why did they let you down? Is it something they should have foreseen and avoided? Or was it the kind of freak problem that no one could have anticipated?
- How did they let you down? Did they give you as much warning as possible that trouble was brewing? Did they sound suitably concerned at letting you down? Did they do anything to try to mitigate the damage?
- Have they ever let you down before? Have there been other minor incidents, or is this the first problem in years?
- Why were you using them in the first place? What is it that makes them better than other suppliers?
- Could you find another supplier as good as them in all the essentials -price, quality, reliability, service and so on? Shop around and see what else is available.
By the time you've thought through all these questions, you should be in a position to decide whether to stick with this supplier or not. And there's one other thing you can do- monitor the service and quality you get from whichever supplier you use as a replacement (assuming you find another supplier for this order). This should give you an idea of whether it's worth moving your contract.
You have a PR crisis on your hands
Everyone loves a drama - except perhaps the people caught up in it. Inevitably, then, many crises will attract the attention of the press. They gather like hyenas around the kill, each hungry to get first bite at the story. And not only do you have to deal with the crisis itself but you also have to cope with the press, who will be ready at any moment to turn on you if you make a wrong move.
The press can be either a blessing or a curse in a crisis, and the balance can lie in how you handle them. Of course, sometimes the press are on your side from the start. If your buildings have been damaged by severe weather, or a lorry has careered off the road straight through your shop window, you have the sympathy of the media from the outset.
But the press always want someone to blame, and all too often they will pick on you. If you're making redundancies, if you've polluted the river that runs past the factory or if an accident has been caused by faulty equipment then they'll be sniffing round for evidence to pin the blame on you.
So what can you do? The good news is that there is a wealth of advice, derived from the experience of thousands of organizations over many years. There are ways to handle the press (and other media) that will at least minimize the damage and, at best, turn their attitude around to one of support for your case. So below are the key rules for handling a PR crisis.
Tell the press what's going on right from the start. The more information you give them, the less they will need to dig die dirt to get a decent story. Don't wait until you've solved the crisis - keep them posted from the moment they turn tip asking questions.
It's no good keeping the press informed if you don't also keep your own people posted. Otherwise disgruntled staff, who are being kept in the dark, may well decide to pass on to the press their own outdated or misunderstood version of the facts.
Honesty can actually be a disarmingly smart policy. Many years ago, the BBC accidentally double booked two key political figures to give one of the prestigious Reith lectures. One had to be cancelled, of course, and the press were full of how and why he had been snubbed. The Director General of the BBC adopted a simple but ingenious approach when questioned by the press. He just said: 'It was a cock up, OK?' He was open, honest and wrong-footed the press completely. We all have cock tips from time to time, and the press understand that as well as anyone.
There are three rules to remember to keep things simple. First: the press don't know your organisation or your industry as well as you do, and they want to print a clear, simple story (or their readers. So don't confuse them with unnecessary details, jargon or background information they don't want. Just keep your message uncluttered. If they ask for more, give it to them if you can. But don't volunteer it.
The second rule of keeping your story simple is to make sure you have only one spokesperson if you possibly can. Otherwise there is a danger that they may contradict each other. One single point of communication means one single, consistent voice.
And the third rule is: never speculate. This simply adds to the confusion. Speculation may be reported as fact - it often is. So if you're asked to guess at the cause of the chemical leak, how many redundancies there are likely to be or when the building will be operational again, politely decline to comment. Or just say, I don't know'.
So, the three rules of keeping it simple are:
1.don't give more information than you need to
2.have a single, consistent message delivered by a single spokesperson
3.never speculate.
Then, get your priorities right
You will horrify readers, listeners or viewers if you start to talk about the financial cost of this disaster when people have been killed or injured.
Be aware how things look to other people
Be aware of what the public perception of your crisis handling will be. It's not enough to be right - you have to be seen to be right. Suppose a press story breaks reporting that many supermarket eggs are infected with salmonella, and there is a slight risk of serious illness. You are an egg producer. If you react by insisting that there is no danger at all, people will just think, 'They would say that, wouldn't, they?'
There may indeed be no danger - or there may be. It doesn't matter. What matters is that people will think you are trying to cover up the facts for your own ends; that you're prepared to lie to people about their health rather than lose profits. So consider how your version of events, which people will consider potentially very biased, will look. It is better to say that you are very concerned about the health scare over eggs - you have no evidence that there is any risk at all, but you're taking action to find out the facts as fast as possible. Support any research - maybe donate funds to it - and invite inspectors to check out your operation. Say you would welcome official guidelines on how your organization can remove any risk, and generally be seen to be taking the action the public, wants, not just paying lip service to it.
Never 'no comment'
What do you think when you hear an interviewee say 'no comment', or when a report says that 'the company declined to comment'? You think they're guilty, don't you? You reckon they've got something to hide. That's what everyone thinks. And it's what they'll think about you, if you say 'no comment'. So don't. If there's nothing you can tell them, it's better to say, Tin afraid I don't have any more information at the moment'.
Be positive
If you seem worried or down beat in interviews, people will assume you're in trouble. If you come across as angry they will take a dislike to you. People will read a great deal into your attitude, so make sure it is always friendly and positive, especially when you're talking to the broadcast media. If people have suffered, it doesn't do to look too cheerful about it, of course. But you can still be open and courteous. Make sure you show sympathy for any victims of the disaster, whether or not you accept responsibility.
Be friendly
The press are only doing their job. If you want them on your side, you need to accept this and not hold grudges against them the phone and the cafeteria and give them a warm room. Treat them politely and with respect and be as helpful as you can.
Get your friends on your side
If the press are against you, recruit people outside the company who will speak on your behalf. Satisfied customers, trade association contacts, suppliers, ex-employees . . . anyone who the press will be interested to talk to and whom you can rely on to back you up. They will assure the press that your safety standards are exemplary, that you're a great company to work for, that you are known for your reliability or whatever it is you need said. Outsiders always have more credibility than insiders.
Go the extra mile
If you've made a mistake, or are believed to have made a mistake, do everything you can to put it right. Even if people blame you for the crisis itself don't give anyone an excuse to complain about your response to it. Do even more than you have to give people extra time off, replace their damaged property without quibble and better than it was before, pay to clean up the river and fund a new wildlife reserve along its banks. Show that you're sorry you messed up, but you genuinely want to make everything better.
You may remember a few years ago a cross channel ferry ran aground on a sandbank. Due to the vagaries of the tide it was a day or so before they could float it off again. Meantime everyone was stuck on board. But the ferry company and the crew leapt into action as soon as the disaster struck. They kept everyone informed, refunded the cost of the tickets, gave away all the free food and drink they could and generally bent over backwards to make up for the discomfort and inconvenience.
When the ferry finally docked, the press were waiting to interview the passengers as they disembarked. But much to their disappointment , they couldn't find a single passenger who had a bad word to say about the ferry operator. They all insisted, 'It was just bad luck, and they looked after us beautifully.
Remember, you don't have to deal with very many crises , but the press deal with them for a living. They are bound to be smarter than you at it, so don't try to fool them - they'll make you look the fool. Just play it straight, honest and open.
Topics for discussion:
2. How can you discover the way the client defines quality?
3. Can you guarantee your clients" satisfaction?
4. How important is listening when you deal with difficult clients?
5. Which is the key talent in good selling?
6. Who decides value?
Enlarge upon the following:
* "Do good work and the clients will come"!
* "Professionals are supposed to care about their clients, aren't they"?
* "Quality must be negotiated continually."
* "New business will be won only to the extent that the client believes the professional cares and is trying to help."
* "Continuous investment must be made in getting better and better"!
Dialogue
Mr. Slide aims at success in business. He is a middle aged, talkative merchant, a retailer and wholesaler too. He has got a large warehouse and a wide range of products. The storage is done in a new, modern building. How important quality is for him might be guessed in the following discussion:
Mr. Daube, the customer: Good morning to you my friend!
Mr. Slide: How are you? I haven't seen you for a month!
Mr. Daube: Well, I was away in France. Now I am back and I do have plenty of products to buy for my store. I would like good quality as you have inured me so far. I need to buy coffee, tea, cigarettes, butter, juice, mineral water, olives, sweets, dairy products, fresh vegetables. I don't want them to be damaged, so please be careful with the packaging. They may be easily spoiled by dampness.
Mr.Slide: They are all well packed, you need not worry. And the quality is the expected one as far as I will always be concerned in stocking only the best goods. I hate to deal in cheap lines. As far as the vegetables are being concerned, I would like to recommend you the ones I brought from Craiova.
Mr. Daube: Are they ripe enough?
Mr. Slide: You will be pleased I do promise you!
Mr. Daube: Now, what about the payment? How would you prefer?
Mr.Slide: As you wish. Cash or by check. If you have a purchase in excess of 5 mil.lei the store grants a 10% discount and 2% additional rebate for cash payment.
Mr. Daube: You are very kind.
Mr. Slide: The prices have gone up lately due to the inflation and to the alignment of the most important products to the European prices(gas, energy.) So that I had no choice but to cope with them. Cigarettes and coffee are a luxury and still most of us cannot live without them. But they are worth buying as the quality is the best one.
Mr. Daube: Maybe more smokers will give up in future or will care more about their health.... And we'll drink less coffee and try to be less stresses and nervous...
Mr.Slide: You see, even if this rise in wholesale prices entails an immediate increase in the retail ones, the consumers are not alarmed. Then retailers will have to change their price labels again and the profits in the luxury trade may not be the ones we wish. Maybe some people living on a present day salary or fixed income will have to do without a luxury that they could have still afforded some months ago. The retail trade can be duller in this respect. Anyway, let's not be so pessimistic because things may change unexpectedly.
Mr. Daube: I trust your products and I will remain your faithful client!
Additional Vocabulary:
to grant- a acorda
storage- depozitare
subsidized price- pret subventionat
brand name- marca de fabrica
to book an order- a înregistra o comanda
sale- vânzare
sale by sample- vânzare cu mostra
sale for future delivery- v. la termen
sale on hire purchase- v. cu plata în rate
sales outlet-punct de desfacere
sales quota- cota de vanzari
sales records- evidenta vânzarilor
sales department- serviciul commercial
overstock- depasire a stocului
price advance- majorare
price alignment- aliniere
price collapse- cadere
price cut- reducere
price gap- decalaj
price maintenance- mentinere
price shading- reducere mica
price freeze- înghetare
price ceiling- plafon de preturi
blanket price- pret global
bid price- pret oferit
bottom price- pretul cel mai scazut
ceiling price- pretul maxim
flat price- pret unic
floor price- pret minimal
peg price- stabilizare
purchase price- pret de cumparare
sell price- pret de vânzare
invoice- factura
delivery- livrare
middleman- intermediary
convenience stores- magazine locale
out of stock- lipseste din stoc
sole selling rights- drepturi de vânzare exclusivista
world market price- pret de pe piata mondiala
store layout- configuratia magazinului
Negotiations
Negotiation is not a science nor is it a branch of technology. It is a life skill. We start to negotiate when we are very young and as we grow older we build up patterns of behaviour that reflect what we feel "works for us". And this will be based partly upon the kind of personality we may have inherited and partly upon the kind of personality we have lived and grown up.
Negotiation in business is no doubt about facts, costs, profits, logical decision making but also about people, their emotions(joy, surprise, fear, doubt, anger, sorrow) , goals and the kind of human beings they are. An understanding of people's motivation and how their personalities can affect their behaviour can be vital in discovering how you can do business with them better and better.
To negotiate effectively one must communicate as such. The message has to be conveyed, received, understood, accepted in order to entail the right actions or responses. The process of transmission is very important - not all negotiations are conducted face to face but there are other choices too: letters, the fax, the electronic mail, the phone. Still there might be some problems such as: they may get missed or misunderstood.
To many personnel managers, negotiation implies collective bargaining. To a sales executive, it will be thought of in terms of making a commercial deal. Quantity surveyors, purchasing managers and lawyers all have their own specialist interpretations of what, in essence, is a process common to all managerial work. In reality, all managers negotiate, if not with outside parties then with each other.
The procedures and language of formal negotiation vary with the type of negotiation involved. A set-piece pay bargaining session has its own system and jargon that differ from those of a meeting of solicitors to settle a claim for libel damages. Yet the underlying principles and much of the psychology of the process are the same for all forms of negotiation.
It is also easy for managers to overlook the fact that much of their informal daily activity is, in effect, negotiation. All managers spend a large proportion of their time trying to influence and persuade other managers over whom they have no executive authority. Consider two examples:
A personnel manager attempts to 'sell' the need for a more systematic form of employee consultation to a reluctant office manager. The company has a general policy of support for employee involvement practices, but has not laid down any specific system or procedure. Neither the extent to which the personnel manager can use the general policy to require the office manager's cooperation, nor the right of the office manager to reject the personnel manager's suggestions is clearly defined. The outcome will be influenced by their possibly differing perceptions of the formal position, and by the powers of argument or persuasion of the personnel manager.
A sales executive tries to persuade the production manager to change a manufacturing schedule to fit in a small order for a special customer. The production manager has full authority to decide production schedules against a weekly output plan set by top management. Officially, the sales manager should make a request through the sales director for an urgent variation to this plan but because the order is only a small one, he approaches the production manager informally and must, therefore, rely on persuasion.
Negotiating skills are, therefore, a very important element in the effective manager's portfolio of personal competencies.
Recognizing when negotiation is occurring is the first step towards acquiring the necessary skills, and this is aided by an understanding of the basic principles involved.
Negotiation is a process, not a single skill. A range of skills are involved in handling this process effectively, but to identify the skills relevant to any negotiating episode, it is important to recognize which elements or principles of negotiation are involved. There are seven principles common to all forms of negotiation:
• Negotiation involves two or more parties who need or think they need each other's involvement in achieving some desired outcome. There must be some common interest, either in the subject matter of the negotiation or in the negotiating context that puts or keeps the parties in contact.
• Although sharing a degree of interest, the parties start with different opinions or objectives, and these differences initially prevent the achievement of an outcome.
• At least initially, the parties consider that negotiation is a more satisfactory way of trying to resolve their differences than alternatives such as coercion or arbitration.
• Each party considers that there is some possibility of persuading the other to modify their original position. It is not essential - though it is usually highly desirable for each party to be willing to compromise. But negotiation can begin when parties have an initial intention of maintaining their opening positions, but each has some hope of persuading the other to change.
* Similarly even when their ideal outcomes prove unattainable, both parties retain hope of an acceptable final agreement.
* Each party has some influence or power - real or assumed -over the other's ability to act. If one party is entirely powerless, there may he no point in the other party committing itself to a negotiating process. The matter can be settled unilaterally by the party with the untrammeled power to act. This power or influence may, however, be indirect and bear on issues other than those that are the direct subject of negotiation.
* The negotiating process itself is one of interaction between people in most cases by direct, verbal interchange. Even when the negotiation is being conducted through correspondence, there is an essential underlying human element. The progress of all types of negotiation is strongly influenced by emotion and attitudes, not just by the facts or logic of each party's arguments.
Negotiation is a process of interaction by which two or more parties who consider they need to be jointly involved in an outcome, but who initially have different objectives, seek by the use of argument and persuasion to resolve their differences in order to achieve a mutually acceptable solution.
It will probably be readily accepted that this definition is relevant to formal negotiations such as pay bargaining or the settlement of a legal claim for damages. Trade unions and employers or the solicitors representing two parties to litigation obviously accept that they need jointly to evolve a mutually satisfactory outcome, starting from differing positions. Each party knows that the other has some power to influence the outcome. A trade union might apply the sanction of industrial action: an employer might reduce the labor force: the claimant's solicitors might stop negotiating and take the case to court: the respondent has some defense if this occurs.
In the second of these examples, the sales executive has no direct power to require the production manager to alter production schedules: the production manager can just say no -- so where does negotiation come in? A willingness at least to consider the request and thereby become involved in a discussion about a possible jointly satisfactory outcome - will stem from several aspects of common interest, or from a recognition of more subtle forms of power.
The sales executive wants the production schedules altered, the production manager does not, but both managers, it is to be hoped, share an interest in the success of the business. To disappoint an important customer may be of more immediate concern to the sales executive than to the production manager, but a good production manager will pay heed to the importance of good customer service. Similarly, the sales executive will recognize the costs and perhaps delays to other orders that a change in the production schedule might give rise to. So a common interest in the good of the business enables both to see something in the other's point of view, and thus encourages a dialogue, rather than the simple exercise of formal authority.
It may be that the sales executive (or the customer on whose behalf the request is being made) is known by the production manager to be highly regarded by the managing director. It might thus be unwise, in terms of company politics, for the production manager to run the risk of being considered unhelpful.
Both managers also know that they have to continue to work together. Without anything being said, both will probably be influenced by knowing that this long-term working relationship could be adversely affected by mishandling the particular incident. The production manager may have the right to say no in other words, not to negotiate but will wonder whether this would cause avoidable friction. There may also be the thought that by agreeing some concession, an obligation may be created that might be capitalized on at some future date.
In the other example, considerations of a similar kind might also lead to the office manager's being willing to discuss the personnel manager's advice. Both have an interest in the smooth running of the company and in compliance with the company policy: the personnel manager may be known to have top management backing: the managers have to go on working together, and therefore the office manager will have to consider the implications of rejecting the personnel manager's advice if employee relations are then seen to deteriorate.
Some key points to have in mind:
All managers negotiate - with each other, as well as with customers, suppliers, trade unions, and other outside parties.
Negotiation is about achieving a mutually acceptable outcome to a situation in which the parties involved initially have differing aims.
Negotiations are affected by the emotions and attitudes of the negotiators - not just by the logic of the arguments they use.
Consultation needs to be distinguished from negotiation. In negotiation, the parties accept that joint agreement is necessary; in consultation, one party reserves the right to act unilaterally.
Negotiators need to identify a top line objective - the best achievable outcome - and a bottom line - the lowest, still acceptable outcome.
Over optimism about the probable outcome is often linked to a failure to consider the bottom line. Top and bottom lines may each consist of several alternative permutations of the issues under negotiation. Possible outcomes need to be considered from the other party's viewpoint as well as one's own. It is important to retain credibility by restricting statements about 'final offers' or sticking-points to genuine bottom lines.
If possible, one objective should be to help the other party to feel satisfied with the outcome; but an aggressive or damaging claim has to be resisted with vigour.
In planning and conducting negotiations, positive attention should be paid to the duration of bargaining sessions, formal presentations, and individual contributions to the discussion.
A continuous session should rarely exceed two hours, a formal presentation 15 to 20 minutes, and an informal contribution two to three minutes.
Adjournments coincident with refreshments should be used to break a lengthy negotiation into two-hour segments. Adjournments should be used as powerful aids to negotiation by:
providing time to consider progress or new proposals
within the team and avoid snap decisions - bringing unconstructive or personalized arguments to an end
providing an opportunity for informal, exploratory talks between individual members of the two parties.
The purpose of negotiation is to reach agreement, not to score points in argument.
Effective negotiators are good listeners: they ask questions more often than they make statements. Humor, or good-natured banter, can be used to reduce tension and help create a bond between the two parties. It is important to look for verbal and non-verbal clues or signals of the other party's changes of mood or approach. There should be a concentration on issues or outcomes of common interest, rather than on the original differences.
The closer a negotiation is to agreement; the more sensitively the discussion should be handled. Periodic, jointly agreed summaries of progress can secure a phased agreement and prevent reversion to earlier argument. Proposals may initially be put as hypothetical suggestions. This makes it easier for both parties to avoid the pressure of immediate acceptance or withdrawal.
There is a positive advantage in making it easy for the other side to move, rather than challenging them on a win/lose basis. Proposals are best sold on their advantages to the other party, not to one's own.
Fear of losing personal or corporate face can severely inhibit progress.
Compromise should be seen as constructive, not weakness. In assessing the benefits of an agreement, consideration should be given to factors beyond the context of the immediate negotiation - such as the creation of useful precedents, and the quality of long-term relationships.
The final offer and agreement needs to be timed to coincide with a period of constructive discussion - and not be done during a combative phase.
It is important to achieve credibility for any statement about an offer's being final - the tone and style of such a statement may be as important as its substance. Devices can be used to break a deadlock in reaching agreement - such as promises of future negotiations on a related topic, or making the introduction of a new conditions subject to later review.
Before finalizing an agreement, check that all aspects have been agreed, particularly dates for implementation, review or completion; and definitions of terms. Ensure full understanding of what has been agreed through final summaries and by producing written confirmation. Unresolved issues should not be 'fudged' by producing vague or ambiguous forms of words in order to achieve apparent agreement.
An agreement is not successful until it has been effectively implemented.
It is often helpful to include an implementation program as an integral part of a negotiated agreement. An implementation program defines what has to be done, when, and by whom.
For some agreements, implementation may be best effected by a joint team.
Those affected by, or required to apply, an agreement (though not themselves involved in the actual negotiation) need adequate information and explanation. Such action should be based on defining who needs to know what, how, and by whom this information should be given, by what methods, and to what time-scales.
Face-to-face discussions are not the only form of negotiation: effective use can also be made of correspondence and the telephone.
An opening letter can help to set the parameters and style of later negotiation.
Dealing with all or part of a negotiation by correspondence may well save time, avoid an emotional confrontation, provide a record of the negotiation, and enable carefully drafted and complex proposals to be produced. Some negotiators are less resistant to proposals when discussing them on the telephone.
Telephone discussions may be used to settle minor or simple negotiating points extremely quickly.
Negotiations cannot be conducted through the media, but the media can be used to influence the attitudes of those concerned, as well as - where appropriate - public understanding and support.
The common characteristics of media communications of all kinds are accuracy, clarity, and reasonableness. Press advertisements offer full control over what is said, but their status as advertisements may reduce their credibility. Press releases provide initial control over content, but it cannot be guaranteed that they will be reproduced fully, or at all.
Press releases need to be written in the style of the media to which they are issued.
Journalists may be assisted or persuaded to write news stories. These may carry more public credibility than company statements, but incur the risk of error or distortion.
Radio or TV interviews should be seen as opportunities to put across a message in clear, simple terms, regardless of the precise questions asked.
• Commercial negotiations often differ from other forms of bargaining in that the two parties have no working relationship outside the issues under negotiation.
• Internal market negotiations should focus on the joint responsibility of purchaser and provider for the survival and success of the organization they both work for.
• The most common feature of commercial negotiations is buying and selling - often to produce a contractually binding agreement.
• In buying and selling, the balance of power frequently lies with the buyer who can choose to deal with an alternative source of supply.
• Consequently, business literature and training programmes concentrate far more on developing selling skills than on the expertise involved in buying.
• Sales techniques include the avoidance of direct competition by emphasizing the unique qualities of the goods or services being sold, an emphasis on the benefits of a deal to the buyer, and encouraging the buyer to make an immediate decision.
• General bargaining principles include an emphasis on careful planning, the trading of concessions, and the avoidance of impasse.
• Because most commercial agreements constitute legally enforceable contracts, it is important that they should be in writing, unambiguous, and founded on a basis of accurate information.
• Legal remedies for breach of contract include injunctions to enforce performance and also compensation for financial damages.
Although some people are better natural negotiators than others, negotiating skills can be acquired or improved by practice, coaching and training.
There are three main elements involved in improving one's negotiating abilities - knowledge, skills and attitudes. Effective negotiation demands a knowledge of the principles of the negotiating process, the context of the particular negotiation, and its detailed subject matter. The main types of skill involved are analytical, interactive and communicative.
Different approaches are needed to deal effectively with different types of difficult negotiations.
Negotiations are strongly influenced by underlying attitudes to the process itself, to the issues and personalities involved in the particular case, and by one's own self-perception and personal needs for recognition and achievement.
Planning to improve one's negotiating skills should be an element in most personnel professionals' personal development plans.
Dialogue
Mr. Nagel is the owner of a beautiful estate located 20 km far from Sibiu.
Alex Feeny came from the USA two months ago and now he is looking for a place to settle with his family. He met Mr. Nagel at a meeting last week. Mr. Nagel owns several estates and this one is worth buying. But he wants to deal directly with the person willing to become owner.
A. Feeny: Good morning Mr. Nagel how are you today?
Mr. Nagel: I am very tired as I have been looking for some agencies to help me with the sale. It costs a lot, so I do want to deal with the client and not through a middleman.
A. Feeny: I agree and I would like to talk with you about this. Have you thought of a price?
Mr.Nagel: Well, the estate is worth around 570 000$ but the price may be negotiable.
A. Feeny: It is a bit too expensive for me. Even if I am a businessman, I do think I cannot afford the price unless you drop it.
Mr Nagel: Prices here have skyrocketed lately and they are not leveling off.
A. Feeny: I can only pay 550 000 $ cash. If you agree then I can give you the money tomorrow.
Mr. Nagel: I agree only if you take into consideration the terms regarding the insurance of the house. You have to pay the installments in advance as I had already done this so far.
A.Feeny: I agree. I think we have to meet a notary and sign the papers.
Mr.Nagel: Therefore, we can see him at 9 tomorrow morning. I will bring all the papers and as far as you are concerned do not forget to have the money with you!
A. Feendy: I will. Thank you very much. You are a very nice person. My family is going to be very grateful to you as they enjoy this gorgeous land.
Additional Vocabulary:
to negotiate a loan- a negocia un împrumut
ongoing negotiations- tratative în desfasurare
negotiations in progress- tratative în desfasurare
joint- comun
joint bargaining- negocieri commune
joint owner- copropietar
joint management- conducere colectiva
outcome- rezultat, consecinta
to settle- a stabili, a solutiona, a reglementa
to claim- a pretinde, a cere, a revendica
to score- a înregistra, a nota, a marca, a obtine, a realiza
scheme- plan, aranjament, combinatie
damage- dauna, prejudiciu
to adjourn- a amâna, a suspenda
adjournment- amânare, suspendare, întrerupere
to adjust- a adapta, a ajusta, a corecta, a aranja, a pune în ordine, a aplana
adjustment- ajustare, potrivire, corectare, adaptare, aplanare, acoperire.
to involve- a implica, a antrena
involvement- implicare,participare
to enforce- a aplica, a pune în vigoare
enforceable- aplicabil
enforceability- aplicabilitate
enforcement- aplicare a unei legi
to bind- a lega, a încheia, a impune, a oblige, a se lega, a se oblige
binding- legatura
concession- concesie, recunoastere
to incur- a contracta, a asuma, a suporta, a suferi
to induce- a convinge, a determina la, a impinge la, a hotarî la
guaranteed- garantat
guarantee- garantie, siguranta
Topics for discussion:
1.How can you be successful in a negotiation?
2.Can you be persuasive with a client? In what way?
3.Are there secrets in communication?
4.How can you be inventive in negotiating a product?
5.What mistakes do you have to avoid?
Enlarge upon:
1.There is no failure, but results and only results!
2.There is no long lasting success without sacrifices...
3.There are of three kind of people: those who make things happen, those who look at things to happen, those who do not understand what is happening.
4.Keep close with those who win and avoid those who lose!
5.Never negotiate without being afraid, but never be afraid to negotiate!
Meetings
Meetings have to be an efficient tool to assist us in getting decisions, information and action. We discuss, decide, decree, demolish. Sometimes they can take over our life. Some are efficient, others are not and for some of us they have even become a way of life. The objective of a meeting should never be to have a meeting. They are a means to an end, never an end.
If handled well, meetings can be invaluable tools for getting things agreed or discussed. Enjoyable meetings that are productive and help to get the job done are an ideal that becomes possible with a little effort. An unsuccessful meeting may do more harm than one which never takes place. So, the success is judged by the actions that result from it. And this is linked to running the meeting as the responsibility of the whole group not only the chairman.
There are many reasons to call a meeting:
briefing people
exchanging and evaluate information
negotiating a deal
making decisions
taking things through
solving a conflict
establishing a plan
We hold or attend meetings which serve a number of purposes. People have to be sure why the meeting is being held. Not only does the meeting need to achieve business but also people have to be satisfied that this has been done. Meetings are at the very heart of management. More and more time is spent in attending them. They can be inspiring, energizing and fun.
Sometimes meetings fail because of:
interruptions such as noisy rooms, mobile phones, messages, people arriving late.
lack of focus: irrelevant discussions
objective not achieved: decisions are not taken, people say they need more time.
politics motives are being brought in: confronting discussions
poor preparation: research has not been done properly.
poor chairing
poor environment: people crammed into a room, tables covered with tea and coffee cups and room for the papers.
poor timing: people arriving late, meetings starting and ending late.
right people absent: people with necessary input or information are not invited or not available.
unnecessary meetings: you need a quick decision
wrong people present: they can ruin a meeting.
What is important to know in a meeting:
* to clarify the purpose of the meeting
* to have meetings only if they are necessary
* to invite people who need to give approval, have the required expertise or information, have the creativity or intelligence to help the group generate ideas, will carry out decisions made, will support your issue, will be directly affected by the outcome.
* to send out a background information
* to create an agenda in order to give the start time of the meeting and location, list participants expected to attend, list issues, give the order in which they will be dealt with.
* to anticipate and prevent problems: problem people, hot topics, alliances and politics, support.
* the agenda can do half of your work before the meeting even starts: assessing items, standard items, have an order for the items, time each item, write the agenda.
* to chair the meeting carefully and well balanced: bring in quiet people, be open about input, stimulate a debate or discussion, listen actively, control discussions, gain agreement and approval by bringing discussions to an end, by letting people know it is time to make decisions or to agree, summarize different viewpoints, discourage interruptions, ask for a decision or consensus, make sure the quiet people speak up, take a vote if necessary.
* to satisfy the participants as well as the agenda.
* to consider that a compromise could achieve both completion of business as well as satisfying the participants.
* to be a good communicator by: making people feel good and value them and their opinion, getting them involved in the meeting, by showing you understand the way someone feels.
* to handle challenges by focusing on the issue not the behaviour or opinion of others, bring in others on your side, do not lose temper, give in and then raise the matter with a higher authority or at another time.
* to announce a finishing time, to limit the number of items on the agenda to the time allowed.
* to allocate a task owner to each item who will control the conversation and take responsibility for any decision.
* to summarize within items, at the end of them and at the end of the meeting.
Types of Meetings
Team Meetings
Consultancy and client meetings
Negotiations
I. Team briefing develops the team meeting into a management information system. The objective is to ensure that every employee knows and understands what they and the others in the organization do and why. Team leaders and their teams get together regularly to talk about issues relevant to them and their work. There are some benefits to team briefing such as:
* it reinforces management
* it increases commitment
* it prevents misunderstandings
* it helps to facilitate change
* it improves upward communication
II. Whenever you meet a client to present a proposal, however uncommercial the situation, something is being sold. So, the meeting will fail if the client's requirements are not defined adequately beforehand. Part of our job may be to help the client to clarify what he wants. So preparation becomes essential, a pre- meeting is useful to define the problem and agree the client's requirements as clearly as possible. First stage thinking has to be used to clarify what the client wants, before suggesting solutions. The following guidelines have to be used:
* create agreement with the client.
* identify the client's need.
* present your solution.
* explain the proposal in detail
* anticipate any objections you know the client has.
* restate the proposal by summarizing, discussing.
* keep discussion separate from your presentation.
III. Doing deals is a fundamental way to achieve goals; but it is a means not an end. A successful negotiation closes with everybody satisfied, the negotiator is delighted when the meeting creates genuine agreement. Once you recognized a meeting as a forum for negotiation we have established as adversarial situation. As a result, scoring over the opposition becomes an important strategy. The negotiation becomes an exercise in game playing: secrecy, bullying, hood-winking. So, this tacit agreement entails stress, wastes time and catastrophe may follow, new problems may arrive, commitment will suffer, promises will be broken, reputations will be bruised.
The responsibility will be to seek agreement: a specific plan of action to which all parties can commit themselves.
How to hold better meetings
Conflict
Conflict is undoubtedly one of the most common sources of anxiety in meetings. Many meetings seem to collapse into argument, hostility and ritual recrimination almost as a matter of course. Do not regard conflict as inevitable or desirable. You are not powerless in the face of emotional hostility; but, in order to handle it well, you need to distance yourself from it.
Begin by trying to locate the source of the problem. Sometimes this is obvious: insecurity at a time of great change, stress, a new set of working relationships or pressure from public exposure. On other occasions, it may seem to bubble up from nowhere, starting with something small and escalating quickly as it takes hold of the group. Conflict thrives on confusion and doubt. Some group members may seek to manipulate it for their own ends or use it to justify their cynicism about all matters managerial. As conflict grows through a group, it becomes more emotional, generalized and unfocused. Looking for a target, it can find the Chair, turning the meeting into an all-purpose 'grouse session'.
Hostility often results from a sense of powerlessness. It is the feeling of being at the mercy of forces outside our control that is so disabling. This is why anger often centres on what has happened in the past, and in particular on what 'they' have done: senior management, other teams, department heads ,rogue operators' who have bucked the system, engineers or
sales staff who are never in the office, customers, suppliers, competitors. Be prepared. If you are facing conflict or group
resistance, you must give yourself a single overriding objective: to empower the group to do something practical. Only by focusing their thoughts on the future, and on what they can do
will you transform people's energy from conflict into purposeful activity. Arm yourself with a few guiding principles.
- Make the objective of the meeting clear at the outset. Write it up on a flip chart and be ready to refer back to it frequently.
Challenge people to explain the relevance of their remarks to the meeting's objectives.
- Remember that your task is to control the conversation.
Resist being drawn into the emotional maelstrom, however hard that may be.
- Slow the conversation down. Do not mirror the tone, pitch or speed of others' speech.
- Do not interrupt or cut people off in mid-sentence.
- Listen to the points people are making and display them openly on the flip chart.
- Do not be tempted to argue, or to contradict opinions or generalizations: about what 'they' do, or what 'always' happens. A good response to such remarks would be: 'In what circumstances?
- Turn complaints into objectives by asking people to restate them as 'how to' statements. Write these up on the flip chart and display them.
- Stop people from talking about others who are not at the meeting. Insist that 'they' are not here and we are, and that only we can address our objectives.
-Focus on solutions, not problems.
-Be a broken record! Repeat your questions to the group, over and over - 'What are we trying to do? What can we do about it? How does this relate to our objectives?'
Be specific. People should know what contribution they are being asked to make, and how their contribution will contribute to wider objectives. Being explicit about goals and targets is the only way to achieve this. If you genuinely consult - asking for suggestions, inviting people to participate in finding solutions -a great deal of resistance will melt away.
Focus on action. Draw the group's attention away from what others have done or are doing, towards what we will do in the future. You will have to be sensitive about this. Demonstrating that you understand people's grievances can be useful in winning them over to your own ideas; and in rooting out areas for improvement. However, there will come a point in a 'grouse session' when you should start asking, insistently but quietly: 'So what are we going to do?' In this way, you will divert attention from damaging 'storytelling' and complaint towards commitment and agreement. By showing that something can be done, you can show people that they have power to change things.
CONVERSATION: THE HEART OF THE MEETING
At the heart of any meeting is conversation. It is by conversing that we express our thinking and relationships to each other. If we want to improve our meetings, we must improve the quality of the conversations that take place in them.
THE DYNAMICS OF CONVERSATION
Conversation is a verbal dance. The word, from Latin, has the root meaning of 'to keep turning with'. Conversation relies for its success on all participants moving.
Like any dance, conversation has rules and standard moves. These allow people to move more harmoniously together, without stepping on each other's toes. Different kinds of conversation have different conventions. Some are implicitly understood; others must be spelled out in detail and rehearsed.
This sense of a conversation is well expressed in the word 'dialogue'. The purpose of dialogue (from the Greek, 'meaning through') is to construct a new, shared meaning through conversation: a meaning that would not come into being if the conversation did not happen. We explore each other's perceptions, offer our own for examination and transform our thinking in the light of others'. This, at its very best, is what conversation can achieve.
Talking and listening
The dynamic of conversation involves two elements: talking and listening. These two activities do not happen merely in sequence, but simultaneously: each participant in a conversation is both speaker and listener throughout the conversation.
Most of us are better at talking than at listening. As managers, we are trained in the techniques of presenting, explaining and influencing. Our education mostly stresses the value of arguing: taking a position, holding it, defending it, convincing others of its worth and attacking any argument that threatens it. As a result, our conversations tend not to dance but to push and shove.
Adversarial thinking
In an attempt to impose order on our conversations, we have invented debate (from the Latin, 'to beat down')- Debate fosters adversarial thinking: a form of group thinking so common that, for many of us, it is the only way any group can think. Instead of enduring a verbal brawl, we set up a boxing match, in which ideas - preferably two opposing ideas - fight it out according to more or less strict rules. The idea left standing at the end is considered to be 'true'.
Much is made in management theory of the virtue of debate. It is said to be not merely unavoidable in business, but positively desirable: a recent article in Harvard Business Review calls it 'creative abrasion'. No less an authority than Peter Drucker has written: 'the understanding that underlies the right decision grows out of the clash and conflict of divergent opinions and out of the serious consideration of competing alternatives'.
By the rules of debate, if you prove the opposing idea to be wrong, you have somehow proved that yours is correct. This is clearly ridiculous: both arguments may be wrong; both may be partly right. Yet debate cannot allow us to consider these possibilities - or any others. A debate is a conflict of rigid opinions.
Opinions are ideas gone cold. They are our assumptions about
* what might, or should, be true rather than what is true in specific circumstances. They may take the form of:
- stories (about what happened, what may have happened,
* why it may have happened);
- explanations (for why something went wrong, or why we
* failed);
* justifications (for taking action or not);
* wrong making (I am right, you are wrong);
* gossip (to make us feel better at the expense of others);
* generalizations (to save us the trouble of thinking).
We are so used to voicing and listening to opinions that we can easily mistake them for the truth. Whenever you hear the word 'fact' in a meeting, you can be almost certain that somebody is voicing an opinion.
The overwhelming limitation of adversarial thinking is that it is destructive. The 'clash and conflict of divergent opinions' actually prevents people from exploring or developing ideas. They are too busy defending themselves, too frightened to venture from their corners, too battle-fatigued.
It is unusual for any meeting to avoid adversarial thinking. It
usually appears in one of four forms.
Critical thinking
For most of us, to think about something is automatically to look for something wrong with it. Take note next time you ask anybody for their response to an issue: invariably their first thoughts will be critical.
The rationale behind critical thinking is presumably that, by looking for the weaknesses in an idea, we can strengthen it. But we rarely receive criticism in this way; instead, we try to defend our idea from the criticism or attack the criticism itself, in an effort to discredit it.
Ego thinking
In adversarial thinking, we become identified with our ideas. Criticism of an idea quickly becomes an attack on the person holding it. Debate is used as a pretext for scoring points against others. Reason gets infected with emotion.
Meetings often devote enormous amounts of energy to preventing emotion from overwhelming debate, but the dynamic of debate makes emotional conflict inevitable.
Rigid thinking
All thinking starts from propositions about reality. Adversarial thinking merely pits these propositions against each other. It limits itself to their terms and their consequences: any thinking that questions the thinking behind a proposition, or strays beyond its boundaries, can be dismissed as 'irrelevant' (or 'deviant'). Indeed, the adversarial mode actually serves to entrench propositions rather than adapt or modify them. Rigid thinking is usually the result of:
* conforming to authority ('if senior management see it this
* way, it must be right');
* the influence of custom ('our profession has thought like
* this for the last two hundred years');
* habit ('this is the way we think around here');
* willful ignorance ('thinking like this saves us the bother of
* dealing with inconvenient detail or finding out more').
Political thinking
When ideas become identified with individuals, people realize that achieving action is a matter of aligning themselves with ideas, and with those promoting them. As rigid thinking limits the growth of ideas, propositions can only be attacked or defended. To attack an idea is to attack its sponsor; to support it is to create an alliance. We begin to use conversational gambits, ploys, manoeuvres and defence mechanisms, not to develop the conversation but to play politics: creating 'power bases' and undermining 'opponents', bureaucratic conniving, behind-the-scenes manipulation and rumour-mongering. We accord adversarial thinking enormous prestige. Managers
who can defend their ideas and withstand the onslaught of their peers - or, better still, their superiors - gain status and may be promoted on the basis of their 'strong character'. They become 'heroes' and the stuff of myth.
Adversarial thinking is self-perpetuating. Like other kinds of conflict, it is cyclical and can escalate easily. Being attacked for our ideas causes pain; we respond in kind and help to prolong the conflict. We may engage in 'pre-emptive strikes', attacking before being attacked. Adversarial thinking expresses our lack of security, and the need to protect ourselves from future threats.
Thus we become locked in a 'cold war' of argument and counter-argument. Although we may recognize that our behaviour is unproductive, we feel we cannot do anything different. We do not know how to; and we may be too frightened to
who can defend their ideas and withstand the onslaught of their peers - or, better still, their superiors - gain status and may be promoted on the basis of their 'strong character'. They become 'heroes' and the stuff of myth.
Adversarial thinking is self-perpetuating. Like other kinds of conflict, it is cyclical and can escalate easily. Being attacked for our ideas causes pain; we respond in kind and help to prolong the conflict. We may engage in 'pre-emptive strikes', attacking before being attacked. Adversarial thinking expresses our lack of security, and the need to protect ourselves from future threats.
Thus we become locked in a 'cold war' of argument and counter-argument. Although we may recognize that our behaviour is unproductive, we feel we cannot do anything different. We do not know how to; and we may be too frightened to
How, then, can we break out of the vicious spiral? What can we do to help meetings evolve beyond the fruitless and exhausting ritual of adversarial thinking? Perhaps the first step is to improve our listening.
The gentle art of listening
The quality of any conversation depends on the quality of the listening. Listening is far more than simply not speaking. The listener controls the speaker's behaviour by their own: by maintaining or breaking eye contact, by their body position, by nodding or shaking their head, by taking notes or doodling, and so on. Similarly, when we speak, we demonstrate the quality of our listening. If we interrupt, we demonstrate that we have stopped listening, that we are not interested in listening any longer. This, in turn, will affect the other's speaking and listening.
We all know the symptoms of poor listening. They are so familiar that we even expect them and develop tactics to cope with them. They include:
* outright condemnation of an idea;
* criticizing the speaker's delivery;
* only replying to a part of what somebody has said;
* interrupting;
* daydreaming;
* paying attention to a distraction;
* holding another conversation at the same time;
* evading the issue;
* using emotional words;
* going to sleep.
We are all able, however, to listen effectively. We listen well when we:
* like or admire the speaker;
* want to trip them up;
* think they have something interesting to say;
* expect to be rewarded or punished for listening well;
* know that we will be asked to comment;
* have an overwhelming need to listen;
* are not distracted;
* know or have learnt that effective listening improves group
behaviour and leads to improved results in the meeting.
The first step in improving our listening skills is to become aware of the obstacles. Some we will have control over; others we may have to endure.
Talking:
Arguing
Multiple conversations
Asking an irrelevant question
Changing the subject
Wandering off the point
Unfamiliar voice patterns
Ambiguity: double meanings, woolz use of language, jargon
Lack of detail in speaking
Speaking too long
Behavioral:
Avoiding eye-contact
Looking bored
Sending the wrong signals: head-shaking, foot-tapping
Yawning
Fidgeting
Clock-watching
Rustling papers
Misinterpreting behaviour
Cross-cultural confusion
Psihological:
Shyness
Aggressiveness
Intimidation
Inappropriate use of authoritz
Personalitz clashes
Bias
Favourism
Prejudice: race, gender, class, age, educational background
Cultural habits
Physical:
Noise
Other people
Other meetings
Sub-meetings
Interruptions from outside
Technical interruptions: phones, bleepers, computer malfunctions
Poor ventilation
Fierce air-conditioning
Extremes of temperature
Uncomfortable furniture
Sitting too long
Inappropriately shaped table
Disability not accomodated
Conversation is the way we think together. What we say is what we think. We are paid to think. Our success depends on our results; we think when we want results that are better than they would be without thinking. And yet most of us are not trained to think. Thinking is not yet regarded as a key managerial skill. As a result, we have developed a number of damaging misconceptions about thinking.
Thinking is not an alternative to doing. We can use thinking as an excuse not to act; and we can act without thinking. The reason we do both so much is that we regard thinking and action as opposed. They are not. Effective thinking improves the effectiveness of our actions; and our actions are a rich source of good ideas.
Thinking is not intelligence. Thinking unintelligently may still achieve something. Intelligence without thinking is useless.
Thinking is not a function of education. Highly educated people are not necessarily good thinkers; and many people with little education can think extremely effectively.
Thinking is not being clever. An increase of knowledge is not thinking: it is simply hoarding. Too much information can seriously hamper our ability to think.
Thinking is not only the operation of logic. It involves looking, exploring, choosing, designing, evaluating and having hunches. It includes considering priorities, objectives, alternatives, consequences and other people's opinions.
There is a Japanese proverb: 'None of us are as smart as all of us.' Yet most groups of people think far less well than any one of them individually. Two main reasons suggest themselves.
1. We confuse conversation about the task with conversation about process. We identify thoughts with people. We talk in code. We use conversation to express loyalties or alliances, to bid for power, to protect our position or sense of self-worth. We persist in old conventions or habits of conversation to feel more comfortable.
2. We fail to manage the structure of the conversation. A well-managed conversation will begin with clear objectives and end with clear actions. Many conversations have unclear agendas (or hidden agendas); others are combinations of several conversations at once. We allow our conversations to ramble, to get stuck, to be hijacked or stifled. Because the behavioural or 'political' aspects of conversation are so powerful, we find it difficult to influence the course of conversations productively - particularly in a meeting, when a group of people are involved.
Tackling these two failings is critically important if we want to help ourselves and others to think better in meetings.
Thinking 'hats'
Serious conversations should seek to distinguish ideas from people. Edward de Bono's 'Six Thinking Hats' are becoming increasingly popular as tools for clarifying this distinction. De Bono suggests that we label every contribution to a conversation by means of a coloured 'hat' that the speaker is 'wearing' as they make it. Chairs can also ask participants deliberately to make contributions 'wearing' a particular hat. The six 'hats' are:
White hat: facts and figures. Red hat: emotion, feelings, hunches and intuition ;lack hat: caution, judgement, fitting propositions to facts.
Yellow hat: advantages, benefits, savings.
Green hat: creativity, new ideas, exploration, suggestions.
Blue hat: thinking about thinking, control of the thinking
process, 'points of order'.
The beauty of de Bono's hats is that we can put them on and take them off very easily. It would be utterly inappropriate to suggest that someone is a 'red-hat thinker' or a 'black-hat thinker'. Anybody can use the hats whenever they want. Indeed,
using the hats allows people to make remarks that they might not ordinarily risk making.
We can use the hats informally or systematically. Judging which hat to pick at which point can become a sophisticated chairing skill in itself. Consultancies now exist that train managers in the use of the thinking hats.
The two stages of thinking ,
We can imagine thinking as a process in two stages.
First-stage thinking is concerned with perception: we recognize something because it fits into some pre-existing mental pattern. We can call these mental patterns 'ideas'. Ideas are arrangements of experience in our minds. They allow us to make sense of our experiences; they are the means by which we have experiences. In first-stage thinking, we encode experience so that we can use it at the second stage. We name an object or event; we translate complex activity into an equation; we simplify a structure by drawing a diagram.
In second-stage thinking, we make judgements about our
experience by manipulating the code. Having named something
as, say, a 'cup', we apply logic, custom and aesthetics to judge
its effectiveness as a cup. Having labelled a downturn in sales
as 'a marketing problem', we use market research, spreadsheets,
past experience and critical scrutiny of the marketing depart
ment to judge how best to solve it.
Managing our thinking begins by:
- separating the two stages of thinking;
- becoming conscious of which stage we are in at any point; - applying only the tools and techniques appropriate to that stage.
We are highly skilled in second-stage thinking. We are taught it at school: we learn verbal and mathematical languages, we are encouraged to analyse, to deduce, to argue and to evaluate. So sophisticated is our second-stage thinking that we can construct computers to do it for us. We are so good at it that we regard it as the sum total of thinking. IQ (intelligence quotient) is a measure of our ability to manipulate language and symbols.
We are not nearly so skilled at first-stage thinking. We are taught virtually no techniques to help us improve our perceptions. Yet a change in our first-stage thinking can have dramatic consequences at the second stage. If we decide that the cup is not a cup but a trophy - or a vase, a mug, a chalice - our second-stage thinking about it will change. Our 'marketing problem' may actually be a 'product quality problem', a 'distribution problem', 'a personnel problem', a 'macroeconomic problem' or a subtle combination of all five.
Second-stage thinking is focused on results. First-stage thinking is not focused at all, and this makes us uncomfortable. Where second-stage thinking is 'deep', concentrating our attention on a single idea, first-stage thinking is 'shallow', scanning a wide area of experience. It creates anxiety because it delays the moment of deciding, forces us to suspend judgement and challenges our current way of seeing reality.
We prefer to take our perceptions for granted, but no amount of good .second-stage thinking will be effective if it is based on limited or faulty perceptions. Good thinking pays attention at both stages of the process.
The great Swiss psychologist, Carl Jung, developed the two stages of thinking into two sets of paired complementary functions: sensation and intuition at the first stage; feeling and thinking at the second. Jung himself used this model as the basis of a theory of personality types; it will be familiar to many managers as the basis of the Myers-Briggs type indicator.
First-stage thinking questions include:
1. 'What can we see?' (Sensation). 2.'What might it mean?' (Intuition).
Second-stage questions include:
1. 'What can we do?' (Thinking). 2.'What shall we do?' (Feeling).
Vocabulary:
to chair- a prezida
chairman- presedinte
to decree- a decide, a emite un decret
meeting- întrunire, sedinta
to call a meeting- a convoca o sedinta
notice of meeting- notificare a aunarii generale
to brief- a rezuma, a instrui
briefing- instruire, informare
briefing conference- conferinta de îndrumare
to exchange- a face schimb
to establish- a stabili,a institui, a întemeia, a instala
establishment- institutie oficiala, stabiliment,organizatie publica sau privata, fondare
timing- sincronizare
outright- deschis, cistit, total
outright loan to a project- împrumut direct pentru proiect
outright grants for research- alocatii integrale pentru cercetare
bias- eroare sistematica, distorsiune
disability- neputinta, incapacitate
disabled- incapabil de
to trigger- a declansa, a porni, a lansa
liable- raspunzator, supus
commitment- angajament
to reinforce- a consolida,a întari
reinforcement- consolidare
to share- a împarti
to share in- a lua parte la
to share out- a repartiza, a distribui
Topics for discussion:
1.How important is conversation in a meeting?
2.Which are the symptoms of poor listening?
3.What happens to a meeting if it is stuck on a problem?
4.How important is timing in a meeting?
5.What is adversarial thinking?
Enlarge upon:
*"Meetings will not improve by magic. People must want change and be willing to implement it."
*"Thinking is an alternative to doing".
*"A decision is committing to a course of action: choosing from among a number of alternatives and making a rational and emotional commitment to that choice."
*"Meetings are the very heart of management."
*"Getting agreement is easy. Getting everyone to confirm afterwards about what exactly was agreed is the hard part!"
Dialogue
Mr. Brown is the General Manager of "Imperial Industries", an important Company. He is attending the Annual General Meeting in a huge hall crowded with shareholders, all very excited. Mr. Crossly , the Sales Manager is going to preside the meeting.
Mr. Crossly: Good morning and I am glad you are here today.
He turns the floor to Mr. Brown who is impatient and ready to convince the audience with facts and figures.
Mr. Brown: We must be very pleased with the turnover of the company which has enlarged considerably. Even if we had to face a tough competition, I'm glad to tell you that we are highly appreciated on the domestic and foreign markets. We have fine, reliable products for the next financial year and we do hope to merge with other well known companies. One of them will be " T&T" Company in the South of Europe.
Mr. Monro, Marketing Manager for the "Liox"Company in Germany :
How did you succeed in spite of the unsuitable buildings? It seems to me almost impossible now that I have in front of me the figures.
Mr. Brown: It is true that the buildings are in a deplorable condition but we have updated machinery and highly trained staff. We are extending within an area of 4 square miles. The new location will cost a fortune but it's worth. New openings abroad are to be found and new funds are being expected.
Mr. Monro: I cannot agree with this. Until money arrives what is going to happen? Are you aware of this? How can you be so optimistic?
Mr.Brown: We are very prompt and efficient, promising and hard working.
Mr. Monro: But we talk about huge sums of money!
More and more excitement among those present at the meeting as they are shaking their heads...
Mr. Crossly: You need not worry because we'll manage to carry on our plan. The outlook is good, we have no unemployment, the output is high, we have good forecasts, the percentage of the business is the expected one.
Mr. Monro: Which are the export outlets figuring in marketing plans?
Is there any drawback to be expected?
Mr. Crossly: Mostly Eastern European outlets, and as far as drawbacks are concerned, I'm thinking of a depreciation regarding the dollar any time.
In the end there was a unanimous consent to wait for the further funds and for an outright loan.
Additional Vocabulary:
guidelines- directive
deputy manager- director adjunct
sales manager- director commercial
acting manager- director interimar
layout of a meeting- amplasare
to take charge- a-si asuma responsabilitatea
turnover-cifra de afaceri
merger- fuziune
outright loan- împrumut direct
outlet- piata de desfacere
slump- criza
funding- finantare
boom- avânt
long term- pe termen lung
medium term- pe termen mediu
short term- pe termen scurt
restrictive practices- practice anticoncurentiale
leveraged- îndatorat
divestitures- sciziune
to bail out- a salva
golden parachutes- compensatii financiare garantate
lay offs, redundancies- concedieri, disponibilizari
joint ventures- societati mixte
ailing- în dificultate
to spin off assets- a distribui activele
tender offer- oferta publica de cumparare
junk bond- obligatiune speculativa
corporate governance- conducerea înterprinderii
leveraged buyouts- preluarea controlului prin împrumut, cumpararea de catre salariati.
to bid- a face o oferta financiara
buyout- cumpararea unei firme în totalitate
E- Business for the Small Business
What is e-commerce?
All businesses exist because they serve a market. Successful enterprises, big or small, keep their customers by providing what they need. In a traditional business it means knowing your market, buying in the necessary raw components, combining them in your own unique way, pricing products to suit the market and distributing them efficiently. The final element is collecting the money. All of these stages take time to get right, not to mention the boundless energy. Unless you are very lucky indeed most traditional businesses take up to three years to show a profit on the bottom line.
What the new technology has done is to solve, for some businesses, two basic issues which until now have been major causes of early failure: cash flow and distribution. Using the Internet as your shop-front, you can ask for the money before you dispatch any goods or services to customers, thereby reducing your exposure. In some cases you may not even need to produce the product until an order is received. The second main benefit of a Web site is being able to reach potential customers on a global basis with very little marketing cost. This makes your break-even model completely different from making profits in a traditional business. You could be profitable within a few months rather than having to wait for a couple of years or more.
But e-commerce is also about the back end of the business. The side benefits of installing linked PCs, whether they are all hooked up to the Internet or not, include a more efficient business in terms of dealing with enquiries, product data and pricing issues. These benefits extend back into your relationship with your suppliers, in other words, obtaining and debt collection. If your suppliers are themselves on the Internet, that is even better. At the very least you will no longer need to write letters or send confirmations by mail for agreement. Just imagine how much time that would save for the average business. By linking your staff together using a company-wide 'intranet" (people sending each other messages on a private, company-only system) would abolish the wasteful practice of internal paper memos at a stroke. Decision making right across the company would be improved both in its speed and the discussion of any relevant issues.
Whenever you need to do some research, the Internet can provide access to information and market data which until now has only been available to big companies with big resources and big margins or to members of expensive trade associations. National statistics, trade trends, other people's prices and terms, new products, impending legislation, competitor details are all available, often at little or no cost. All you need is a little patience and skill in knowing how to search out such information on publicly available and often free Web sites.
History of the Internet
The Internet did not suddenly come into being overnight. The system has been in development in one form or another for more than 35 years. Understanding how it all started provides current users with a better appreciation of what it can do.
When did it all start?
The US Department of Defense was concerned in the mid-1960s that in the event of a nuclear war the armed forces would not be able to communicate with each other through the usual telephone networks. These networks relied on central control exchanges. Scientists argued that such control exchanges would be the first to be attacked in hostilities and therefore could never be the basis of a secure telecommunications system. So they proposed that new technology should be developed whereby messages could be sent directly from one party to another without having to go through an exchange. Each sending station or 'node' had equal status within the system. Messages would be packaged in electronic parcels and let loose on the network to find their own way to their destination through the most efficient route. If any part of the network were to be destroyed, the message parcel simply found an alternative route.
The principles of the new system were tested in the UK at the National Physical Laboratory in 1968 and then later developed by the Pentagon. The first node was a supercomputer based in UCLA (University of California at Los Angeles) to which four more nodes were linked in 1969. For the first time scientists were able to share computer facilities even though they were in different locations, by exchanging data between the five nodes. By 1972 there were 37 nodes in the network known as ARPAnet (Advanced Research Projects Agency net). The Internet today is largely a development of ARPAnet.
When was e-mail invented?
During the trial periods it was noted that scientists were sending each other personal messages as well as academic data and were exchanging ideas of a less formal nature. The concept of 'e-mail' was born. By the late 1980s the National Science Foundation (NSF), a US federal agency, had taken up the task of developing its own network for some government employees using the technology of the ARPAnet, sending messages via new, higher speed transmission lines. To distinguish whether the sender was an academic or from the government, 'edu' or 'gov' was added to the sender's network address. Later on other codes were developed to distinguish the type of user and were included in their electronic address.
How did the system become available to the wider world?
As other organisations acquired computers that could convert messages into packages to be sent electronically (and receive them back) new commercial networks were developed. It was then a fairly simple idea for some of these organisations to link up to create even wider networks. In time, computers bought for businesses and the home came with the necessary decoding programs to send and receive messages through telephone lines which were in turn linked to other networks through Internet Service Providers (ISPs). It has been estimated that over 200 million people are now connected to the Internet via their nodes (computers) and the numbers are growing each month.
Is the World Wide Web something different?
It can be confusing. The terms 'Internet', 'Net' and 'World Wide Web' are often used to mean the same thing. To be more accurate, the World Wide Web is the multimedia part of the Internet. The Web is the collective name for all the documents on the Internet that can be accessed through programs stored on your computer. These access programs are called Web browsers. In essence, the Web browser converts electronic information from other computers into displayed material that you can read or see. Anyone can create a document and make it available on the World Wide Web for other computer users to read. This displayed material is known as a Web site.
The importance of the Internet as a business tool
When you are running a business you need to grasp issues quickly if you are going to keep ahead. You may already be wondering from the description above what relevance such a system would have for you in your everyday business life.
E-mail
The Internet provides the facility to send and receive written business messages through the telephone network. If you want you can set up your system to be available to receive messages on a 24-hour basis, which is important if you trade with overseas customers. You may want to place or receive an order late at night or during the weekend. Or you may need a rush order completed to help you meet a deadline for one of your own customers and you've missed the post. E-mail sends the message virtually instantaneouslv.
Data collection
Almost any type of information can be found on the World Wide Web. If you are not sure where the information is you can ask Internet companies called "search engines' to help you find it. If you know the name of the organization that has the information, you can visit its Web site from the comfort of your own office and print off or store in a file any parts or all of it without having to declare your identity.
Discussion groups
Sometimes in business, you just want to talk to someone who has been through a similar commercial experience so that you can avoid costly errors. Using the Internet you can join 'live' discussions on your computer monitor, often on a worldwide basis, and ask questions about your particular issue. You may want to know if there is a market for your products in a foreign country. Join a USHNET group or a news-group online and ask those people who actually live there what they think.
Long distance data transfer
You may need to send a 40-page document with complex diagrams to a potential client on another continent. If you mail it this could take days, possibly weeks to get there and even then there is no guarantee it will arrive in one piece. Using the Internet you can 'attach' the document to an e-mail and your client can print out the document on his or her own computer within seconds. Developments in the speed of data transfer mean that pictures and moving images can be sent by the same method.
The building blocks of e-commerce
Once you have realised the potential savings in time and expense which even average use of the Internet can deliver, you will be keen to get started. The process of getting online is not difficult, but as you will discover, once you are connected you may well have to change the entire way you do business.
Here are just some of the basic steps you will need to take to set up and develop your own e-commerce business:
• buy suitable computers;
• link them together;
• rent an extra telephone line(s);
• choose an ISP and go online;
• create a Web site;
•choose appropriate money collection and security software:
•decide what products you can sell online:
•think through sending products to overseas customers:
•be aware of any legal issues that may result:
•create a marketing strategy and business plan for e-business:
•consider how e-business will affect your existing trade:
•develop your database.
It looks like a simple list. From a mechanical viewpoint, it is. Some experts will tell you that they can get you online within a day but a Web site is not necessarily an e-business. Each step requires you, as a small business owner, to consider all the alternatives currently available if you want to achieve a profitable and sustainable business. It is not easy. The language suppliers use is often confusing as are the claims of speed, efficiency and suitability for your particular business.
Because the skills to help you develop e-commerce are all relatively new, the costs can vary enormously. Equally, because this way of doing business is so new, no one has all the answers. The advice from both start-ups and established players is to take each stage in sequence. Think through how you need to organise your staff to get the best results. It will be a frustrating as well as a rewarding experience, like all new businesses, so be prepared for some hard work.
Finally, do not be afraid to ask so-called experts to explain what they mean. The computer industry is probably the best example in the world of an industry that likes to cloud the issue. At times the jargon can be overwhelming. So do not suffer in silence. Get your new technology suppliers to explain in simple terms what the new piece of equipment can do specifically for your business. If you do not understand it you probably won't use it, so the investment will have been wasted. Remember that many so-called e-businesses are often nothing more than direct marketing operations that happen to take customer orders electronically. The vast majority of e-businesses still only use the Internet as a way to get enquiries or orders.
As you grow in confidence, so will your awareness of how products, particularly software, could enhance what you do. Use the Internet itself to ask for opinions and ideas. You'll be amazed how helpful other e-business owners around the world will be when you ask for advice.
From small business to big business
There is no doubt that the early years of the dot.com revolution have been littered with a number of high profile failures. Some of the losses have been spectacular. Such bad news has always been good news for the newspaper publishing industry - it is always much more entertaining for readers when things go wrong. But there have also been some remarkable success stories that have received less public attention.
Finding the right level of funds at the right time for a budding e-business on an ongoing basis needs to be planned for. It is likely that the funds will not come from the big banks as it has done in the past for most small businesses wishing to expand their business.
The current trading background for dot.coms
When two twenty something Cornell University graduates floated Theglobe.com on the New York Stock Exchange in the late 1990s the share price recorded the highest ever one-day rise on Wall Street - 606 per cent. Within 12 months the price had fallen by 9S.5 per cent and they were both replaced by a 50-year-old advertising executive.
The tale of high expectations followed by poor sales and dubious management has been repeated in the UK. There is even a Web site dedicated to tracking dot.com failures, although there are rumours, ironically, that this too may be having financial difficulties. The availability of investment funds seems to have receded in line with the absence of any real evidence of future profits. But it need not be the same for every dot.com business by any means. There are still many investors in the marketplace who are keen to back new e-businesses provided there is a convincing business plan.
Developing your e-business plan
Assuming you have a general idea that you are going to need more than you currently have in the bank to fund the development of your e-business, the first thing to consider is the main headings of expenditure over, say a five-year period:
• Salaries: list all the salaries you will need to pay including any secretarial help and the estimated outcomes of inflation.
• Benefits: add on all the salary-related extras like National Insurance, cars, expenses, travel, pensions, bonuses, overtime, recruitment fees.
• Marketing: allow for new campaigns and procedures, ongoing Web site development, selling aids, public relations, ASP software, trading licences.
• Distribution: postage or shipping costs, packaging, warehousing, dispatch, returns allowance, stocks and stocks unsold, insurances, taxes if applicable, percentage per country market.
• Central support: finance, legal, human resources, professional advice.
• Equipment: new office hardware, warehousing plant, buildings, cleaning, security, depreciation, servicing/leases.
The easiest way to approach this is to take your normal end-of-year list of costs as drafted by your accountant and complete a similar list for your new e-business. Depending on your market you may have other more specific costs without which you could not trade on the Internet or deliver your customers' orders. The next list is probably several tables showing what sales you expect to generate from various markets and at what margin:
• Sales from the traditional business: static, growing or declining.
• Sales from the e-business: speed of take-up, global markets.
• Sales from associates/affiliations/agents.
• Indirect sales from reciprocal site links.
This section will necessarily be estimated, but you should err on the side of caution and if possible give sound evidence as to why you think sales will be at the level stated within each category. It is quite possible that there may be no sales for some time, so you should come clean and say so. An overview of your intended market, with plausible-estimates of your share over the first five years, will help to add credibility to your claims that somewhere in all your figures is a viable business.
From this first pass through the planning stages you should be able to draw your own conclusions as to whether you think you have a viable business idea. If you do not believe it, neither will the investors. Case histories and anecdotal evidence may be the only third-party support you can get as to whether what you are proposing will work but it is worth compiling as there is unlikely to be any other market survey or industry statistics you could use to support your plan. Clearly the most important support you could receive for your plan would be future customers. Research could bring these out in the open, but do not rely too heavily on them as would-be customers can be notoriously fickle as soon as you ask them for money up front to fund your first year.
The business model
Once you have satisfied yourself that what you are attempting could actually return a sustainable profit, you need to articulate your business model in terms simple enough for a non-specialist to understand. You should also provide some evidence that you are ahead of the game in business terms and that your slant on the idea represents the way the market is going within your particular industry niche.
For example, the printing industry is already well advanced in most uses of the Internet so if you are in this field you may wish to highlight that you intend to do things using WAP technology. Or it could be that you supply archaeological site maps to academics but that you would supply them online as 3-D. all-around images. Whatever it is, it needs to add a new dimension to what already exists.
One of the main advantages of any business is its scalability. Could your e-concept be rolled out to many markets around the world, both geographically and across many industries? If so it stands a better chance of attracting development funds. You need to have worked out the estimated numbers of your market, both actual and potential, so that any backers can see the scale of the returns that are possible given the right level of investment.
How easily can your idea be replicated? If it can be, is there any way you can protect it through patents, licences, trading rights or special equipment to protect its growth over the first few years'? The technology needs to be bespoke whenever possible so that competitors will not be able to replicate easily what you intend to do.
Is there any way that you can persuade one or two strategic buyers to sign a letter of intent to work with you on an exclusive basis in the early stages? A useful way forward may be to give them some equity options in return for their use of your idea so that you will have at least one big customer even before you launch.
Another way to reduce the risk of early failure is to save cash by leasing rather than buying equipment and going for reciprocal marketing whenever possible rather than large scale brand-building. It goes without saying that excessive salaries and club class air tickets should not be "policy" in the first few years, if at all.
Do we really know who our competitors are and what they charge? It is not uncommon for a new e-business idea to be thought of at around the same time by several people around the world. There can be no copyright on an idea. The key thing is to get your idea to market as soon as possible and build volume. Attend seminars, go to exhibitions, read the trade press and start collecting articles about anything with even a remote connection to your big idea. At worst you could save yourself a great deal of time and effort if you discovered someone else had already done it. At best you might see a fatal flaw in the technical detail of your competitors' plan which could propel your idea into a world-beater.
Perhaps the most important aspect concerns the senior people who will take day-to-day charge of the business as it grows. They will need to be robust, know their industry, be well connected and get on well together as a team. When it comes to going for funds, the VCs (venture capitalists) will set great store by the maturity of the team and how they interact, as at the end of the day if there is a problem these are the people who are going to have to knuckle down and turn it around.
Finding the funds
There are many sources of funds for a business wishing to expand. In theory there is nothing special about e-businesses. The high profile stories about raising millions on the markets are really the tip of a very large iceberg and the vast majority of companies use the traditional routes to raise capital:
• friends and family;
• banks;
• private investors;
• VCs;
• government agencies;
• joint ventures with complementary businesses;
• customer equity partnerships.
Apart perhaps from the friends and family route, these sources will certainly want a detailed business plan and a defensible sales plan on which they can safely make a decision. All your assumptions need to be shown. You should also ensure that there are a number of 'safely factors' built in to the plan so that if things do not grow as fast as you said they would, you have an alternative scenario. Backers are never very keen on being asked for more money at some later stage when things go wrong, so getting your sums right in the first place makes good sense.
A further factor to consider is that your funding can come from a variety of sources: it does not all have to come from a single source. In fact the majority of e-business start-ups have a combination of private investors, founders money, local grants, some medium-term bank loans and perhaps one longer-term venture capital arrangement. Each of these sources will have different rates attached and different time-scales, so your cash flow plan becomes one of the most important business measures you will need to use in the first few years. Government support should not be sniffed at either. Often government agencies are very keen to have a local company "showing the way' to the rest of the business community and make it relatively easy for you to qualify for grants. Some can be as much as £250.000 or more, which for many c-businesses is more than enough to get you going in the right direction.
Venture capital
Of all the sources of funds, the largest will be either private investors known as "business angels", or VCs. Private investors may want less return and a longer payback period but may insist on some equity. They will be interested in how they could save tax from their investment, so you need to be prepared to be flexible as to how the investment is brought into the company. They are useful investors to have as they are generally the easiest people to go to if more funds are required at a later stage and are likely to have the least demands in terms of payback periods, if they are convinced you have a good idea.
VCs, on the other hand, tend to be very precise about what they want and when they want it. They will probably have a brochure explaining the type of businesses they want to be involved with and the type of funding they generally provide. They may specialise in start-ups or they may prefer to invest later in the cycle. They could introduce you to complementary business partners with whom they see synergies for your business. Or they might provide the missing technical or people management expertise to complete your senior team. You could do some initial research by logging on to the British Venture Capital Association to see the range of members they represent.
In general they will not be technical experts in your field but they have had a lot of experience of what works and what does not. So, when you are preparing your presentation to send them, you need to be as succinct as possible. Your accountant or solicitor might arrange an introduction to the three or four who would he most likely to look at your plan sympathetically. But unlike dealing with a bank, you are in the driving seat. The VCs will offer the finance if the plan stands up as viable, so you need to consider carefully each offer you receive and choose the one you think can add value to what you are doing. All of them will be looking for high returns within a three to five year period, so the relationship will not go on for ever, but it would be better to take the funding from people you get on with rather than sacrifice good business empathy for a few less generous terms.
The VC presentation
If your idea is attractive to the VC they will want to meet you and perhaps one other member of your senior team and have a presentation from you about your e-business. Meetings are normally scheduled for an hour or so. You need to be brief and direct. This is not the time for waxing lyrical about how you started your business 20 years ago in a garden shed. You need to plan your presentation carefully to leave yourself enough time to go through the basic idea and the figures in your plan. No more than a dozen laptop images will be required to get the main ideas across.
In this first session they will give you an opportunity to ask them questions, so prepare what you need to know beforehand and make a careful note of the answers, as you may need to compare what they say with what other VCs tell you. If all goes well you will be invited back for a longer discussion with perhaps an industry expert sitting in and more people from the VC. This session is to help them get a clearer picture of your depth of thinking and for you to see if you could work with the VC on a medium term basis as they will probably want to put one of their own consultants on your board and may even insist that they chair it to protect their investment.
The deal
Depending on the amount of money required, the VC will attach a range of terms and conditions to any funding offered. It will include the percentage of their equity, which will be based on their initial valuation of your new e-business. It will also include how much of the debt you need to repay on an ongoing basis and what happens if you default on any payments. These terms may change if after due diligence they find that your plan is not as watertight as they thought. So, if there is anything negative within the plan or perhaps a market change, you should declare it as soon as you can.
Becoming a dot.com millionaire
Typically, if things go well, your initial funding of, say. £1 million will have been enough to get things going. But a year or so later you find that you need to establish the brand on a national basis to get the real returns. So, you may need to go back and ask for £10 million.
Two years later the business model is working well in the UK hut you see an opportunity to expand the concept into Europe, so you go back and ask for £30 million. The stage after this could well be a flotation or IPO (Initial Public Offering) after which you may well realize all your initial equity and become a dot.com millionaire.
Topics for discussion:
1. Do you think E- commerce is being destined to become a big business?
2. What is the E revolution about?
3. Which are the advantages and disadvantages of the E commerce?
Enlarge upon the following:
"Within the E- business environment the journey from your first networked computer to your first million could be a very short step."
"The challenge is one of constant change and tuning to the new. If you can work these new changes into your unique e- business idea to gain the competitive edge, you stand to increase your chances of success...until another advance is made. Dealing with those changes will not be easy. But no one ever said running a business would be easy."
"Your business model should bring you sustainable profit".
Translate into English:
1.Îti trebuie bani pentru a demara o afacere? Bine-înteles ca îti trebuie. Multi? Depinde de specificul fiecarei afaceri, dar nu e greu de aflat câti anume- nu trebuie decât sa pui pe hârtie toate cheltuielile strict necesare si sa vezi ce iese. Te poti trezi cu o surpriza foarte placuta: poti sa descoperi ca banii de start nu constituie o problema chiar asa de mare si ca e posibil sa demarezi o afacere de care te vei putea bucura.
2. Orice succes porneste de la mintea omului si nici o decizie nu poate fi mai buna decât informatiile pe care se bazeaza. Exista oameni care fac lucrurile sa se întâmple, apoi cei care pivesc asteptând ca lucrurile sa se întâmple si cei care nu înteleg ce se întâmpla.
3. Aceste investitii au fost facute cu un scop: pentru a se crea conditii bune de munca iar astfel randamentul va fi mai bun, dar si pentru imaginea firmei. Sediile companiilor trebuie sa fie dotate cu sali de conferinte, cu computere si acces nelimitat la internet, cu mobilier ergonomic.
Negocierea se bazeaza pe principiul câstig- câstig, ambele parti având de câstigat în urma discutiilor. Flexibilitatea ne va ajuta sa nu capitulam în fata unor cerinte pe care nu le acceptam la început. Vom continua pentru a câstiga, vom tine cont si de nevoile celeilalte parti.
Se recurge la manipularea interlocutorilor pentru a ne îndeplini scopurile. Într-o lume ideala ar fi minunat daca n-ar trebui sa renuntam la nimic pentru satisfacerea nevoilor nostre, dar pentru ca acest lucru nu este posibil, renuntam la ceva pentru a obtine altceva în schimb.
Exista câteva lucruri în care cred persoanele care au success, ca de pilda : nu exista esec, ci doar rezultate, lucrurile nu se îmbunatatesc din întâmplare, ci numai în urma unor actiuni adecvate, succesul cere sacrificii, oamenii reprezinta resursa cea mai importanta, iar ceea ce faci trebuie sa fie util cuiva indifferent cât de bine este facut sau cât effort s-a depus.
Pentru directorul general, angajatul perfect este cel interesat de clienti si care încearca permanent sa îmbunatateasca serviciile companiei. Daca îti pasa de angajat, vei fi în afaceri pentru totdeauna. Trebuie sa-ti aduci mereu aminte ca ei, clientii sunt cei care îti platesc chitantele iar cei care reusesc sa se concentreze asupra clientilor sunt de fapt angajatii perfecti.
Prin onestitate, siguranta, inteligenta, inovatie, flexibilitate vom evolua. Pretuim inovatia, pentru ca modul nostru de a gândi este revolutionar. Chiar si atunci când suntem pe un drum batatorit îndraznim sa redescoperim noutatea si valoarea. Eficacitatea si pasiunea pentru servicii a fiecaruia dintre noi sunt conditii cerute de orice companie.
Compania Augsburg are un pachet larg de beneficii si indemnizatii, ce include, subventie pentru transport, masina de serviciu pentru cei din management, abonamente la o clinica medicala, preturi reduse la produsele firmei. Dorim sa-i fidelizam si sa-i stimulam pe angajatii firmei si sa completam oferta salariala.
Comertul electronic mondial are o dinamica ascendenta pe masura ce tot mai multi consumatori si tot mai multe afaceri se conecteaza la web. Principalele bariere în dezvoltarea comertului electronic ramân problemele legate de securitate si încredere. Pe masura cresterii utilizatorilor casnici de internet, procedurile legate de autentificare si criptare a datelor personale primesc o importanta tot mai mare si succesul comerciantilor de pe web depinde de succesul implementarii.
Obstacolul principal pentru o dezvoltare mai rapida este cel financiar. Romania este o tara cu constrângeri bugetare, iar varianta testarii unor solutii la nivel mic, precum si luarea unor decizii de extindere a acestora este destul de potrivita acum.
Translate into Romanian:
A truly effective client- service plan will include a set of activities that will help professionals to know the client's business better and in a more organized way. A good client service plan will include activities meant to deepen the business relationship by expanding the amount of client contact.
Business requires decisions: frequent, fast and often without much idea whether they are right or wrong. When a business consistently outperforms expectations, there is at least a good chance that it can be multiplied by ten or a hundred times. In these circumstances most people settle for modest growth. Those who seize the day become seriously rich.
In a firm which relies mostly on firmwide or group rewards, all the partners or owners share the consequences if an individual's performance is down. Accordingly, other professionals have a direct incentive to take steps to help that individual or group improve either formally through practice group leaders or informally through the efforts of fellow partners.
You do not need to be a high tech business to benefit from the Internet. The best success stories have been the more traditional businesses that have found new ways to do business by using the basic technology currently available. Like all new business you need to use your common sense and plan for profits on a gradual basis. But unlike traditional businesses the process of building e-commerce profits will differ both in scale and in the type of markets available. The more aware you are of what is likely to happen with your new e-commerce venture, the more sensible your decisions will be.
Vocabulary:
Boundless- nemarginit
Bottom line- de baza
To dispatch-a trimite, a rezolva rapid, promt
Cash flow- flux monetary
To draft- a redacta, a întocmi
To exchange- a face schimb
Web browser- program software pentru navigare pe internet
Joint venture- societate mixta
To display- a expune, a afisa
Impending- imminent
Expenditure- cheltuiala
Allowance- reducere
Scalability- capacitate de a grada
To hook- a prinde, a agata
Hook up- program comun, înlantuire
To knuckle down- a se apuca de
Tip- informatie
Secure- în siguranta, care nu prezinta risc, garantat
To secure- a proteja, a asigura
To store- a stoca, a memora
Ongoing- neîntrerupt
Backer- sustinator,girant
To back- a sprijini, a sustine, a gira,a da îndarat
To back down- a o lasa mai moale, a bate în retragere
To err- a gresi, a face o eroare
To bud- a începe
To litter- a murdari
Fickle- nestatornic, capricios
To highlight- a evidentia
Claims- cereri, revendicari
To comply with- a se conforma
Encasement- încasare, plata în numerar
Rental- valoare locativa
Obsolete- demodat, învechit
Would be customers- clienti potentiali
In sequence- în succesiune, unul dupa altul
Venture capital- capital de risc
Venture- speculatie, risc,actiune comerciala
Watertight- ireprosabil, impecabil, clar
To default- a fi în restanta, în întârziere cu plata
Diligence- osteneala
Due- cele cuvenite
To slant- a denature,a prezenta tendentios
Slant- punct de vedere, opinie, înclinatie, tendinta
Onerous- apasator,împovatator
THE JOY OF BEING CLIENTS
FOR LIFE
WE WOULD ALL LIKE to have loyal clients who come back to us year after year. Clients who treat us as valued professionals and seek our advice on their most important issues and problems. Clients who don't shop around each time they think about buying our services, who come back because they will always get fresh perspectives, insights, and ideas from us and because they trust us. Clients who will enthusiastically recommend us to others even if we aren't serving them at that moment.
Reflect for a moment on your own client relationships. If you're like most professionals, you may have a few loyal clients who have drawn you into their inner circle of advisers. They consult you on a broad range of issues and wouldn't dream of using a competitor to provide your service.
Others, though, are just buying your expertise-they use you because you have specific knowledge and skills that you deliver at a competitive price. The next time around, however, these same clients may very well turn to someone else. They view you as a commodity.
Somewhere in the middle, there are those bread-and-butter clients who keep asking you back, year after year, but never seem to let you get very close to them. You may have worked for them for years, but your influence and the scope of your work is limited; and although they feel some loyalty to you, it's not enough to prevent them from switching to someone else if they see a major economic benefit.
Do you wish you had more clients who would draw you into their inner circle?
Do you sometimes feel you're treated like a vendor instead of a respected professional?
Would you like to compete less on price and more on the value you can add?
Is it getting harder to differentiate yourself from other professionals in your field, be they other management consultants, lawyers, or accountants?
If you answered yes to some or all of these questions, we wouldn't be surprised. The fact is, most professionals are on a journey-defined by the role they play with their clients- and few have finished it. When it begins, you're an expert for hire who offers information and expertise to your clients on a transaction basis. Further along, you may earn the right to be a steady supplier, and you'll be asked back repeatedly. When you've reached the final and most rewarding stage, you'll become a trusted adviser who consistently develops collaborative relationships with your clients and provides insight rather than just information. At this stage you will have breakthrough relationships. Because of the broad, influential role that you play and the unusual degree of trust that you develop, these relationships will be of a significantly higher order than the run-of-the-mill associations that so many professionals have with their clients.
This developmental journey-from expert for hire to trusted adviser-is the focus of what we mean by studying about clients in general. From extensive research, there is a client-validated model for success-a roadmap of the specific characteristics that underlie extraordinary performance with clients-that will help you establish and sustain more of these enduring, advisory relationships.
FORGETING CONVENTIONAL WISDOM
The abiding client relationships not only bring us immense personal and professional satisfaction, but in fact they make our careers. Unfortunately, the conventional wisdom about how to develop them and achieve professional success is woefully inadequate.
"Do good work, act with integrity, and the rest will follow" has been the time-honored prescription for individuals who sell and deliver services.
"Find an area to specialize in, focus on it, and make your name there" could be added to it.
Clients today are highly sophisticated, educated, and informed buyers who select professionals from increasingly competitive and mature service industries. In a world of continual corporate cost-cutting and almost unlimited information, institutional buyers have less loyalty to suppliers than ever before. Studies have shown, for example, that over 50 percent of executives who switch providers say they were "satisfied" with them before switching. And though specialization is important to a point, the corporate leaders say that most of the highly specialized professionals they deal with are incapable of advising them on broader business issues. You have to do far more, in other words, than "satisfy" your clients and do a "good job" if you want to create long-term loyalty and enter into the collaborative relationships that allow you to have a major impact on your clients and their decisions.
WHY DO SOME PROFESSIONALS COMMAND ENDURING CLIENT LOYALTY?
There is a simple observation the telephones of some professionals we knew never stopped ringing-clients called them, rather than vice versa. At the same time, we saw others treated like vendors by their clients: these professionals were constantly challenged on price, and they often struggled to get new business through laborious RFPs (requests for proposal) that eliminate practically all human contact during the client's decision-making process. Was the difference just that the former worked harder, I were smarter, and did higher-quality work? These were the obvious reasons, and while certainly relevant, they did not provide anything near a satisfactory explanation for the intense client loyalty we observed. After all, we also knew many smart, hard-working professionals who were not able to develop so many loyal clients. Clearly, these qualities were necessary but not sufficient.
We must set out, then, to comprehensively research and answer a series of fundamental questions: Why do some professionals manage to develop long-term relationships and become trusted business advisers to their clients while others get called in on a one-off basis like commodities? What qualities do leaders look for in the professionals-in fields as diverse as law, consulting, finance, and technology-whom they bring into their inner circle? How do clients define value?
The starting point may be fifty years of combined experience in advising senior managers in many organizations around the world. People went well beyond their own personal experience, however, and spoke at length with the present and past leaders of dozens of major corporations, such as Kodak, BellSouth, Cox Communications, Motorola, American Express, Citibank, Eli Lilly, and General Electric, listening as these chief executives shared their lifetimes of experience in buying services and seeking advice from professionals. Such interviews were eye-opening, and they debunked many of the widely held notions about why clients value certain professionals over others.
What could strike us was the dissatisfaction many clients expressed about the outside professionals they engaged and by the difficulty they experienced in finding truly objective individuals to help them resolve their most important issues.
A number of well-known advisers who counsel and consult to leading executives and politicians, as well as many less-known but high-performing professionals who face the same day-to-day challenges that we all do in trying to build client relationships are ready to be interviewed.
Some of the greatest advisers in history, such as Aristotle, Thomas More, j. P. Morgan, George Marshall, David Ogilvy, and Henry Kissinger are always asked to be studied.
It is not easy to identify the essence of what it takes to become an extraordinary professional and consistently provide value to clients. There are some attributes and attitudes that will enable you to develop your own breakthrough client relationships.
The meaning about clients for life has several distinct connotations. The first is literal: how to develop lifetime clients-or at least long-term ones-when such a relationship is mutually beneficial for the client and the professional.
Second, is figurative because in some cases a continual relationship may not be practical, realistic, or even desired. A client, for example, may need the ongoing services of an accountant every year for many years, whereas he might call in a management consultant or executive recruiter only once every four or five years. A few professionals may also choose a transactional model of serving clients, where they work on specific issues rather than on a retainer basis (the law firm Wachtell, Lipton, Rosen & Katz, for example, successfully adopted this approach in the early 1970s). Even a transactional strategy, however, will succeed or fail based on having repeat clients.
Clients, thus, can be attitudinally loyal for life-they remember us for having done an outstanding job, they call us back if they ever need our particular service again, and they enthusiastically recommend us to others.
CLIENTS FOR LIFE: WHO CAN BENEFIT?
We define a professional as someone who practices an occupation requiring a high degree of education and training, and who has clients rather than customers. This definition includes not just service professionals, but also technology consultants and sales executives who sell a complex product. It does not include teachers or musicians, for example, because they don't have individual or organizational clients the way consultants and accountants do.
The professionals used as examples are drawn from a variety of fields, including consulting, law, accounting, advertising, finance, medicine, sales, and the military. Although each profession has specific skills and knowledge that its practitioners must master-consumer behavior for an advertiser, financial reporting requirements if you're an accountant, contract law if you're a lawyer, and so on - achieving client leadership is premised on a set of common factors that transcend individual professional requirements.
All types of professionals-and their clients-can benefit from long-term relationships. These relationships give you the opportunity to engage in extensive client learning, which greatly increases your ability to offer tailored solutions, develop new ideas, and provide germane insights rather than generic platitudes. They are also the proving grounds where you can expand your service offering and therefore your professional experience-a loyal client who trusts you will try you out in areas that a new client wouldn't let you touch.
Finally, the positive financial impact of having even just a few lifelong advisory relationships, if they are managed profitably, can be enormous.
The distinction between a client and a customer is more than semantic.
Customers, for example, buy a product or service with well-defined characteristics that match their needs, with little or no negotiation and discussion between buyer and seller; the professional's relationship with a client, in contrast, has a consultative aspect to it-there is give-and-take to clarify needs, identify problems, and recommend solutions. While there doesn't have to be a personal relationship between a customer and the seller of the product or service, with a client there is typically a close, personal relationship with a high degree of trust.
And finally, a professional offers a client an authoritative body of knowledge and expertise. So while the customer can have it his way at Burger King, a client taking tax advice can't always have it his way (unless he wants to get into trouble with the IRS).
The focus on clients, therefore, is a deliberate one. If you have customers, your relationships will tend to be narrow in scope, whereas if you serve clients, you have the opportunity to develop the collaborative, broad-gauge relationships that are the focal point.
A different approach is required for sophisticated clients who buy complex products and services. For example, although we may believe that the customer is always right-a standard prescription for managing customers-we sometimes have to tell our clients how they are wrong and why we disagree with them.
WHAT KIND OF PROFESSIONAL ARE YOU?
There are three types of professionals to be taken into account.
The first group includes service professionals-lawyers, management and technology consultants, accountants, corporate bankers, financial advisers, executive recruiters, advertising executives, and so on. These individuals are in an ideal position to become broad-based business advisers to their clients: their services are of high strategic importance to their clients, and they are intimately involved in the sale and delivery of the service. If you are one of these professionals, all of the material in this book should speak directly to you.
The second group consists of sales executives who want to be considered business consultants rather than simply salespeople. If you sell a complex product or service that is critical to your client's business, such as telecommunications systems, computer equipment, power plants, or mission-critical software, your client will have a significant need for advice and consultation, and the opportunity exists for you to become an adviser to him rather than just a salesperson.
Finally, there are professionals who are staff or functional managers within corporations. Human resources or finance specialists who report to line executives, for example, face the same challenges that outride professionals do in creating value, and they are held back by similar barriers.
It's interesting to look at some extraordinary professionals who have consistently engaged clients for life, identify how they add value, and discuss the barriers that prevent other professionals from achieving the same level of success, to grasp core attributes of great client advisers-the ingredients for success with clients-and provide specific suggestions for how you can cultivate these qualities, to see the major pitfalls that professionals can fall into as they develop and manage client relationship.
Virtually all of the large service firms endeavor to develop advisory or consultative relationships with their clients, emulating those very few-McKinsey in consulting, for example, or Goldman Sachs in investment banking-that have a history and culture of building deep relationships. Stockbrokers are now "financial advisers"; accounting and consulting firms aspire to advise senior management, not just undertake reengineering projects; software programmers are referred to as "consultants"; and companies like Reuters don't just sell databases but want to be your "information adviser." Often, however, the words "adviser" and "consultant" lack substance and have a hollow ring to them.
Ironically, just at a time when the professions are experiencing their greatest growth in history, just as so many are striving to become trusted advisers, many clients are in fact dissatisfied with the quality of the advice they receive and the attitude of those who give it. It's getting harder and harder for them to find professionals like James Kelly and Nancy Peretsman.
Why then? What holds professionals back from an undeniably attractive role that is highly valued by clients?
BARRIERS TO DEVELOPING BREAKTHROUGH RELATIONSHIPS
Three barriers stand in the way of becoming a business adviser to your clients, and of experiencing the client loyalty and professional fulfillment that accompany this role:
1. Most professional service firms demand specialization. If you work for a large consulting or accounting firm, you might become a reengineering expert for the chemical industry or an auditor for automotive companies. This is fine for starters, but the problem is that the more expert you become in the niche where your company has placed you, the more "valuable"-at least in the short term-your firm thinks you are. This becomes a disincentive to providing you with other experiences.
While there is great benefit in developing a deep expertise, this specialization will eventually become a liability if you want to play a broader-gauge role with clients. Some firms recognize this issue and try to address it by systematically diversifying the experience of their junior staff, but many do not. (This push for specialization, by the way, is pervasive not just in the business world but in medicine, academia, science, and other fields.) In addition, while large firms provide tremendous opportunities and training for young professionals, they also have financial and growth goals that must be met (many are now publicly held companies). Sometimes, these short-term pressures override the long-term process necessary to build deep, trusted client relationships.
2. Expertise is becoming automated and reduced to a commodity. Ironically, while service professionals have been major beneficiaries of the late twentieth-century information economy, there are now signs that many types of expertise are losing value. Just as the industrial revolution replaced skilled craftsmen with low-wage factory workers during the early nineteenth century, the "expertise" sold by professionals is becoming easily replicable, more widely available, and increasingly cheaper in our Internet-speed, technology-driven economy. Already, the average incomes of some classes of professionals-doctors, for example-are starting to decline.
Several forces combine to diminish the value of expertise:
• The supply of service professionals is growing significantly. The historically rigid controls on the supply of graduates have been relaxed, and many individuals with lesser certifications (e.g., paralegals, physicians' assistants) are doing the work formerly entrusted to degreed professionals such as lawyers or doctors.
Price based competition has become a permanent feature of the market for professional services. In the corporate world, most major contracts for professional services are now competitively bid, and the competition (for management consulting and advertising services, for example) can be ferocious.
The internet and expert software now provide unparalleled access to all kinds of expertise, at far lower prices than ever before.
Market research reports that used to cost thousands of dollars or that investment banks provided only to their big-spending corporate clients can now be obtained free over the Internet. Increasingly, professionals are paying to have their "expertise" put in front of clients. A new Web site for CEOs, which already has the participation of big names such as Michael Dell of Dell Computer Corporation, is charging professional firms $50,000 for the privilege of putting their articles or research up on the site.
In other areas, Web-based sales automation is reducing the need for expensive sales forces; and millions of consumers use inexpensive software like TurboTax to do their taxes and even write wills, thus avoiding tax advisers and lawyers.
Labor mobility among knowledge workers is increasing. U.S. firms, for example, are tapping into pools of English-speaking talent in countries such as India, South Africa, and Australia. Law school graduates are crossing over into adjacent fields, such as consulting and investment banking.
The effects of these trends are readily apparent. In fields as diverse as law, accounting, consulting, and technology services there is significant consolidation occurring, with new mergers being announced almost monthly. What used to be the "Big 8" accounting firms are now the "Big 5." Law firms, which historically enjoyed long-term retainer relationships with their clients, are being asked to bid competitively for work; some even went out of business altogether in the 1990s, and we are now beginning to see a growth in mergers as law firms consolidate. Consulting firms are being asked by major corporations to submit breakdowns of their cost structure, their partner-to-associate ratios, and their billing schedules so that the profitability of their projects can be managed and reduced. Many companies are now conducting frequent, tough reviews of their advertising agencies, forcing incumbents to continually justify their relationship.
These and other signs of intense competition and industry maturation are now widespread. High-end services, such as merger and acquisition advisory work, may never become commodities. But just as we can now put a vacation out to bid on the Internet to see which airline wants to sell us a ticket at the best price, we believe the day is not far away when this will be done for services as well. Imagine asking doctors to "bid" to conduct a routine surgical procedure or inviting lawyers to compete for your estate planning business.
3. Many professionals are held back by stereotypes about what clients want them to be and how they should behave. Here are typical statements we have heard from these professionals:
• "My job is to provide answers."
• "I need to become as expert as possible in one specific subject area within my field and then to make my name in it."
• "When I meet prospective clients, I need to demonstrate my expertise. After all, that's what they're buying from me."
• "If I work in a new industry or function, I will be ignorant of basic concepts. I will add little value, and clients will reject me."
• "This is a professional, business relationship. The personal side is separate. Furthermore, my loyalty is to the greater goals of the institution, not to the individual."
• "Clients will take advantage of you. You have to stick up for your own interests."
There is some validity to all these statements. They are incomplete, however. In contrast, consider these comments from clients who have spent a lifetime using professionals:
• "The really good professionals ask great questions. Often, they enable solutions rather than supply them."
• "The best business advisers have a good understanding of my industry, but also breadth.. Some of the best insights I have gotten have come from professionals who bring analogies from other fields."
• "Good professionals are great listeners. They hear what you mean, not necessarily what you say."
• "It's very tough finding 'honest brokers" who are unbiased and not pushing their own agenda with you. Everyone walks in here wanting something."
• "Investment bankers cannot be true advisers. They are too focused on the deals."
• "Our consultants always end the session with a half-hour presentation on 'next steps,' the execution of which cannot, of course, be accomplished without the consultants. What I really value instead are working sessions which advance our thinking."
• "Our lawyers focus on every detail with equal emphasis. That's OK to a point, but they rarely pull back and help us see the big picture."
Many professionals, in short, focus on providing answers, being perceived as "experts," doing great analysis, and specializing more and more during their careers. Clients, in contrast, seek professionals who can ask the right questions, provide knowledge breadth as well as depth, demonstrate big-picture thinking as well as analysis, and listen rather than just tell.
Professor J. Brian Quinn of Dartmouth's Amos Tuck School of Business, who has spent nearly forty years advising business and political leaders, including several U.S. presidents, puts his own slant on the issue of stereotypes: "I used to believe that solving the problem was paramount. In reality, when the good advisers deliver their recommendations, most of them have already been implemented. I realize now that the process of problem solving is more important than the solution."
Clients do value professionals who can play a broad advisory role. Theodore Sorensen, in his book The Kennedy Legacy,
reports that just a few days before his inauguration, John F. Kennedy was presented with a list of 250 items requiring a decision from him. He apparently blurted out, "Now I know
why Ike had Sherman Adams!" (Adams was President Eisenhower's trusted adviser). The fact is, clients at any level, whether they are presidents of nations or corporate managers, appreciate someone who can help them put there issues in perspective, solve problems, and make better, faster decisions.
THE INGREDIENTS
FOR BREAKTHROUGH RELATIONSHIPS
There are seven key attributes that, when blended together in the right quantities and in the right manner, facilitate the development of insight and the formation of deep, trusting relationships. These characteristics are a blend of innate talent, acquired skill, and attitude, and it's pointless to try to determine exactly which is which. That's why we use the more general term "attribute" to describe them. Empathy, for example, is definitely something you develop at a young age (a "talent"), yet we know that people can improve their empathetic ability late in life. Native ability certainly counts, but hard work and openness to change can improve any of these qualities, an assertion borne out by the experiences of the many great professionals we've studied.
There is a natural, logical progression to the development of these attributes and to the order in which they usually come into play in building an advisory relationship. The two foundational attributes for any professional who aspires to serve clients are selfless independence and empathy. Great advisers have an attitude of complete financial, intellectual, and emotional independence. They balance this independence, however, with selflessness-they are dedicated, loyal, and focus on their client's agenda, not their own. It is a fine line to draw: on the one hand, being responsive to a client's needs and problems and, on the other, maintaining objectivity and honesty at all times. This selfless independence illustrates why clients are different from customers.
The second attribute, empathy, is what opens the door to learning. Empathy fuels your ability to discern a client's emotions and thoughts, and to appreciate the context within which that client operates. It enables you to diagnose what the problem really is and later underpins a learning relationship with your client. Dr. Michael Gormley, a London-based physician and renowned diagnostician who treats several members of the British royal family, provides an apt medical metaphor when he tells us, 'You can't just chop the patient up into little pieces and then examine each one of them under the microscope. You have to understand the whole context of his daily life."
The next three attributes concern your ability to think and reason. You simply have to have something valuable to say before you can develop the long-term professional relationship. A passion for learning drives the professional to develop a core expertise and then to become a deep generalist by continually broadening her knowledge. Synthesis is the ability to see the big picture, to draw out the themes and patterns inherent in masses of data and information. It includes related skills, such as critical thinking and problem solving. The ability to synthesize sets the business adviser apart from the subject matter expert who relies mainly on analysis. Judgment is often-but not always-the culmination of a particular engagement or advice session, drawing on all the learning and synthesis you have undertaken.
Conviction and integrity constitute two important character attributes that are common to all of the extraordinary professionals we have studied. When credibility of content has been established, trust can follow, and the depth of a client's trust in you will be very much governed by his assessment of your character.
Conviction comes into play as the adviser begins to offer opinions, recommendations, and judgments in earnest. Conviction, however, does not exist in a vacuum; it is based on a set of compelling, explicit personal beliefs and values. Properly harnessed, it is a powerful force that can motivate and energize both professional and client.
The attribute of integrity comprises a constellation of skills and behaviors that build trust, including discretion, consistency, reliability, and the ability to discern right from wrong. Without this trust, it is unlikely you will develop a collaborative relationship. Your client will always keep you at arm's length and treat you like a supplier.
There are other qualities, of course-motivation, optimism, tenacity, determination, analytical skills, and so on- that are valuable for professionals and indeed necessary to be a successful expert. The seven we have identified, however, are the ones that truly stand out and make a difference in a professional's effectiveness. They enable you to go beyond expertise and become a broad-based adviser. These are the qualities that foster the development of the insights and relationships that lead to consistent value creation for clients, and they are the characteristics that great advisers themselves have intuitively developed. If you want, in short, to become an extraordinary professional who commands unwavering client loyalty, you need especially to develop and strengthen these attributes.
Becoming an Integrated Professional
These attributes build on and interact with each other to create a whole that is greater than the sum of the parts. Casual observers might call an individual who has successfully integrated them a "seasoned professional" or someone who really "has a head on her shoulders." Drawing on his thirty-eight years as a successful client adviser, James Kelly articulates this state of integration and its benefits:
"I have come to accept that I am constantly learning, and will never, ever know it all. I've learned to become an intense observer of people-I know that situations are never quite what they seem at first. I accept that sometimes I'm wrong, but that's the cost of intellectual boldness, of daring to be right. I have a constant sense of being surrounded by expert resources that I can call on-they're everywhere. When you get your ego out of it and allow yourself to relax and observe, you really do get into the flow of events and ideas. I'm working for my clients, but I'm also feeling quite independent from them-I'm driven not because I'm being paid but by a desire to help my clients, to learn, to satisfy a higher purpose. The ideas and solutions come quite freely in this state.
This happened just last week-I was the last speaker at a three-day conference for a group of top executives. When I was younger, I would have prepared a canned speech days in advance. This time I listened intensely for the first two days. I observed the participants carefully. I opened up my mind to the variety of ideas that were being presented and discussed-even though I didn't like some of them. On the third morning, I got up early and took out a pen and paper."
Characteristics of a Successful Client Adviser
• Clients often ask you for advice, both on subjects directly within your field of expertise and in peripheral areas that happen to be of concern.
• Most of your client relationships are long-term ones. The vast majority of your clients would enthusiastically recommend you to someone else.
• There is strong mutual trust, on a professional and a personal level, between you and your clients.
• You collaborate extensively with your clients to define the product or service you deliver to them and match it to their needs.
• You frequently approach your clients with unsolicited ideas and suggestions.
• Your clients believe you consistently deliver value in excess of your fees. They rarely if ever shop around to see if they can get the kind of services you offer more cheaply elsewhere.
THESE BUILDING-BLOCK attributes are fundamental and straightforward. The reality, however, is that most professionals don't practice or actively develop them. Or they delude themselves into thinking that they have already mastered them. Often, what they think passes for insight is, to their clients, merely expertise. They forget that this year's insight has a very limited shelf life and can quickly revert to simple expertise-debt underwriting and reengineering consulting used to be value-added services, for example. Now they are virtual commodities.
THE IMPORTANCE OF KEEN JUDGMENT
Consultants, attorneys, bankers, accountants, and other professionals are involved in high-risk, high-stakes decisions every day: Should the case go to trial or be settled out of court? Should a microchip manufacturer invest another 1 billion dollars to increase production capacity? Do the company financial statements represent the actual condition of the business? A keen judgment is one of the most valuable asset a professional can have. Few clients, for obvious reasons, go back to a professional whose judgment is poor. Many of the executives we have interviewed, in fact, remember all too clearly the poor judgments offered by some of their advisers, even though the incidents occurred years ago.
Good judgment, in contrast, is invaluable to clients. Win Bischoff, chairman of the British merchant bank Schroders, recalls a seminal decision he made and how the accurate judgment of his adviser contributed to Schroders' international success:
It was in the early 1980s, and we felt we needed tore-capitalize our U.S. bank, which engaged in commercial lending. We were convinced we could issue debt to do this. I went to see the head of Warburgs [a major British merchant bank], David Scholey, to seek advice. In the space of an hour he delivered an unequivocal set of judgments. Issuing debt would be all but impossible, he offered, quickly turning the conversation to the topic of Schroders' overall strategy, and the need for us to assess it in detail at this critical juncture.
We were already considering undertaking a strategic review, and Scholey's advice was important encouragement. We subsequently made a series of important decisions, including eventually selling the U.S. bank instead of recapitalizing it, as well as making other strategic choices that enabled us to prosper as an institution.
That short, singular conversation, and the rapid-fire but incisive views provided by Scholey, became a significant influence on our thinking.
Instinctively, Scholey did several things when asked to advise Schroders. First, he made a rapid, intuitive judgment about the feasibility of issuing debt. The situation fit a pattern in his experience, and he knew what the answer was without hesitating. In the process, he thought two or three steps ahead, and was able to visualize the chain of events following a hypothetical debt issue by Schroders, and the negative consequences that could ensue. In effect, he helped Bischoff avoid a potentially bad judgment. Second, he reframed the question Bischoff was asking. The right question wasn't "Should we recapitalize our American bank?" but "Should we be in the U.S. banking business at all?" Since that time, Schroders' market value has increased fifteen-fold, from about $300 million to $5 billion today.
FIVE JUDGMENT TRAPS TO AVOID
Before we look at the specific practices that allow great professional advisers to arrive at high-quality judgments, we have to understand how to avoid bad judgments. First, bad judgments can be deadly for an organization; second, they will ruin your reputation as a professional-your clients will never forget the poor decisions you recommend; and third, it's very common to make mistakes of judgment, since so many factors can cloud our decision making. The fact is, avoiding bad decisions is one-half of the battle: even if you don't make particularly good ones, you can muddle along and survive, whereas a poor judgment can put you out of business, for good. The exceptional professional, therefore, constantly examines his client's thinking and behavior to help prevent these wrong turns.
Here are five of the most important judgment traps that professionals should be aware of as they advise their clients:
I. Weak Premises: Starting Out on the Wrong Foot
Many clients approach a problem or decision with wrong or partial facts at the outset, resulting in a chain reaction of faulty thinking. The two most common errors that bias clients are anchoring-the decision maker allows himself to get "anchored" on a specific starting number-and availability, the tendency to use the most available, recent, or vivid information.
If two real estate appraisers, for example, are asked to assess a house that is already for sale, their valuations will vary based on what selling price they're given. The appraiser who thinks the house is for sale at $200,000 will assign a lower valuation than the second appraiser who is told it's on the market for $250,000, even though it's the same house. Where you start often determines where you end up.
Clients can get anchored in many ways. Incumbent corporations in deregulated industries like telecommunications and utilities, for example, often get anchored in their old growth paradigms. Compared to their historic growth rates of 3 percent or 4 percent a year, achieving 5 percent or 10 percent now seems wondrously high. But the new standard, in order for a company to be considered a "growth" business, is more like 15 percent annual growth. Because many of these companies are anchored on the old standards, they end up being acquired.
Whatever happens to be the most available, recent, and vivid data can also bias us. This perception bias can operate when managers go out and talk to just a few customers and then draw sweeping conclusions about their company's products and positioning. Bad personnel decisions are often rooted in this judgment trap-we sometimes pick people we already know for a job rather than the most qualified candidate.
2. Confirmation: Seeing What You Want to See
Many people start out wanting to confirm-consciously or unconsciously-what they already believe and tend to ignore subsequent evidence that contradicts their beliefs.
The confirmation trap is often triggered during mergers or acquisitions. Some years ago, two large professional service firms decided to pursue a merger, which, if completed, would have resulted in large financial payouts to management. A subsequent study commissioned to assess the cultural compatibility of the two companies pointed out very major differences in the two cultures, and an unbiased observer would have concluded that the organizations were virtually incompatible and shouldn't merge. Some partners who read the report, however, came to the opposite conclusion-that there was a strong cultural fit. They ignored the differences that the study cited, or reframed them as "strengths" that would actually aid the merger. As a result, the two firms went through significant post-merger trauma as their different cultures clashed, resulting in bitter conflicts and an exodus of partners.
3. Overconfidence:
Underestimating What It Takes to Succeed
Overconfidence is probably the most common and fatal judgment trap. In his book, When Giants Stumble, historian Robert Sobel chronicles famous business blunders by major corporations. He sums up by saying, "If there is any single moral to the tales [about corporate failures] it is that for all but one of these entities failure was preceded by great success." Business success, Sobel cautions, can breed overconfidence and complacency.
Clearly, the Decca record executive was suffering from a major case of over-confidence (and maybe incompetence as well) when he so brusquely turned down the Beatles. A famous historical example of overconfidence is Germany's invasion of Russia during World War II. Adolf Hitler, buoyed by easy victories over Poland, France, and other European countries, became filled with hubris as the war progressed. He then ignored the warnings of his generals and insisted on invading Russia nearly a month too late. His armies were virtually destroyed by the combination of the severe Russian winter and the unexpectedly large number of Russian troops that Stalin was able to mobilize.
Several other classic judgment traps that are related to overconfidence include an over-reliance on rules of thumb and a misunderstanding of base-rates. Rules of thumb include "When writing an ad, use sentences of no more than twelve words," or "Summer is the best time of year to sell your house." We tend to simplify our experiences and reduce them to easy-to-remember rules and guidelines. Problems arise when these cherished rules just don't apply. For example, Long Term Capital, a hedge fund manager, had leveraged $160 billion worth of securities with just $4.8 billion in capital (the underlying value of the derivatives was estimated at$l trillion). The company bet large sums of money that the yields on twenty-nine-year government bonds would converge with the yields on thirty-year bonds-something that had always happened in the past (this expected convergence was a "rule of thumb"). In July and August of 1998 the yields actually diverged and Long Term Capital lost virtually all of its capital, nearly causing a global panic in the process.
Misunderstanding or ignoring the underlying statistics regarding an event is also common. For example, most studies on the success of corporate acquisitions demonstrate that 50 to 60 percent of acquisitions are considered failures within five years. The figure is even higher for cross-border mergers, which only succeed 30 percent of the time. Yet many executives pay no attention to these sobering statistics.
4. Prior Commitments: Making New, Inappropriate Commitments Based on Previous Ones
Prior investments or decisions can unduly influence the formulation of new commitments: once we take a stand or position, we often resist changing our mind. This phenomenon may explain why President Kennedy gave the go-ahead for the Bay of Pigs incursion-it was already planned, organized, and ready to go when he was elected. Companies frequently ignore an analogous rule of finance-don't consider sunk investments when making new ones-and they mistakenly pour good money after bad.
In his classic book Influence: The Psychology of Persuasion, Robert Cialdini cites many examples of how even very small prior commitments can induce level-headed individuals to agree to things that make no sense. In one study, for example, homeowners consented to have large billboards encouraging traffic safety installed on their front lawns, simply because they had previously agreed to put a small sticker bearing a similar message in the corner of a window!
5. Groupthink: Believing That It's "Us Against Them"
The author Irving Janis, in a book entitled Groupthink, identifies eight symptoms that can distort judgments and behaviors. These include:
• An illusion of invulnerability, which leads to excessive risk taking
• An unflinching belief in the morality and Tightness of the group
• Stereotyped views of adversaries as either evil or incompetent, and therefore not worth dealing with
Corporate organizations often suffer from groupthink, and it can lead their managers to make poor judgments.
When Mexico deregulated its long-distance telephone market, for example, several large U.S. telecommunications companies entered the Mexican market believing they could easily dislodge the national phone company. They held its management in disdain and considered it a stodgy, unworthy competitor. To their surprise, they sustained heavy losses as the national company beat them at every turn with innovative marketing and pricing strategies.
During World War I, this attitude resulted in the slaughter of tens of thousands of soldiers in Turkey. In The Broken Years: Australian Soldiers in the Great War, Bill Gammage describes the first Australian soldiers who went into action at Gallipoli: "They thought themselves the equal to twenty Turks, they bowed to no man, and with the eagerness of children they restlessly awaited their glory." Within nine months they had suffered appalling casualties and were forced to creep away in defeat.
How to Avoid Bad judgments
You need to be constantly vigilant for signs that your client is about to fall into one of these judgment traps. Do you see a client using rules of thumb that are shopworn and outdated? Has your client already made up his mind and just wants your stamp of approval? Do you have clients who rush to judgment based on too much "intuition" and too few facts, or who grossly underestimate what it will take to succeed?
Here are some specific actions you can take as an outside professional to help your client avoid lapses in judgment:
• Always vigorously challenge your clients' assumptions. What makes their starting number right? What would justify a number that was 50 percent less or 50 percent more? Do their customers really only buy on price? Do their products really have the highest quality? Introduce as much contradictory information as you can and ask lots of "discontinuing" questions whose answers might undermine the initial premise.
• Keep yourself up-to-date on key statistics and research in your field-remember, there's a lot of folklore out there. Beware of accepted wisdom: the "dogs of the Dow" stock-buying strategy, for example-popular for many years with investors-has worked poorly during the last five years. (This popular investment strategy involves buying the ten stocks in the Dow Jones Industrial Average with the highest dividend yields during the previous year; holding them for one year; and then going through the same selection process again for the following year, picking a new group of ten).
• Be careful how you ask and frame questions. "Do you feel the market is saturated now?" is a leading question; a better phrasing would be "What is the market potential?" Many professionals ask questions that are biased and reflect what they think or what they feel their clients already believe.
• Try to identify independent thinkers who can help challenge your clients' thinking. These can be outside speakers, for example, or perhaps mid-level managers who see the need for change more clearly than top management does.
• Finally, don't ever let yourself be used simply to confirm something a client already believes-your collusion may help undo the client. An assignment like this may help out with short-term bookings, but it won't build your reputation as a professional with integrity and an independent point of view. (The exception would be the case of a legal advocate who commits to demonstrating the truth of her client's story in court).
WHAT IS SOUND JUDGMENT?
What is sound judgment and how does a professional develop it? We are concerned with a definition of judgment that is the ability to arrive at opinions about issues; the power of comparing and deciding; good sense.
The elements that contribute to sound judgment can be expressed in a formula with three basic parts:
Judgment = (Facts) X (Experience) X (Personal Values)
The facts about the issue at hand-too few and you'll be hip-shooting, too many and you'll risk overanalyzing the situation-represent the first major input. Experience, which fuels intuition, is the mechanism by which the adviser adds to and processes these facts. Good decision makers then filter the resulting options through a strong set of personal beliefs and values.
Historically, good judgment was associated with age and experience. The elders in a society were considered the wisest, and therefore they were consulted on the most important decisions. Today, there are several, contradictory schools of thought on what constitutes good judgment and decision making. Most researchers in the field embrace the cognitive model and believe that solid judgments can only be reached through a highly logical, step-by-step, rational process, focusing almost exclusively on the factual inputs described in our judgment formula. Many popular books have been written that propose this approach, and they're filled with elaborate, quantitative tables and charts, which decision makers are supposed to use in order to come to sound conclusions. Unfortunately, research into decision making in the real world clearly demonstrates that good decision makers rarely undertake this much rational analysis.
Another, smaller group of scholars believes that judgment is essentially intuitive, and that most real-world decisions are made with little analysis. Based on our own research into professionals and the clients who employ them, we believe that the best decision makers blend these two approaches-cognitive and intuitive-and they add a third dimension, which is the personal value system.
FIVE STEPS TO GOOD JUDGMENT
Great professionals excel at a number of specific practices that underpin sound judgment. They:
• Frame problems appropriately at the outset
• Engage in creative but selective fact gathering
• Use intuition: they leverage their personal experience to find similar patterns and relevant analogs
• Filter their judgments through a clear set of personal beliefs and values
• Are honest enough to learn from experience
I. Frame the Problem
The first critical step is to identify the right problem and frame it correctly. Diagnosing the wrong problem is one of the most common mistakes that professionals make, regardless of their field. Many corporate executives will ask consultants to help "reorganize," when the real problem-for example, ineffective communication or poor leadership- often has nothing to do with organizational structure.
Professor Joseph Bower of Harvard Business School, who actively consults to industry leaders, told the following story about problem framing, or rather, reframing:
"The head of a large company called me in to advise on a major revitalization program that he wanted to launch. He had identified a host of problems with his organization structure, distribution network, technology platforms, and so on. He was also going to engage a large consulting firm to help with the effort. I sat in on the kick-off meeting with the CEO and his fifteen top executives. For two hours the CEO waxed eloquent about the need to change, and the new program he was about to launch. There was little discussion, and the meeting ended. Afterward, I sat with the CEO and he asked me for my reaction. I looked at him and said, "Did you see the faces in that room? There isn't one of your top executives who buys into your program. I think that's your real problem." Initially, he was stunned, but then he nodded his head. He began to smile. "You're right," he said quietly. "They're not on board at all, are they?"
Ironically, that was the end of the consulting assignment for both me and the large firm he had lined up. In his mind, the engagement had been a success and was over. The real problem had been identified and he set to work fixing it, personally. The consultants were a bit stunned, but to me it was a good outcome. The CEO subsequently replaced half his senior team with outsiders, and they went on to be quite successful."
2. Engage in Creative but Selective Fact Gathering
Horserace handicappers use historical data on horses to set the odds for each race. In a classic study, a group of professional handicappers was asked to make predictions for various races. In the study they were given increasingly more facts about each horse and then, after absorbing the new batch of facts, asked to predict its performance. For the first round, they were given only five facts on each horse; for the second round, ten; the third round, twenty; and finally, forty pieces of information on which to make a judgment. What happened? After each round, the handicappers' confidence in their judgments increased. But their accuracy stayed the same! After a minimum threshold of key facts is reached, having more information does not increase the quality of decision making. In certain business situations where time is of the essence, gathering more information can actually decrease the quality of decisions because key actions are delayed as managers conduct more and more analysis.
While somewhat counterintuitive, the idea that more information and expertise isn't always helpful has been born out in a variety of settings. In our largest corporations, for example, the careful review and analysis of decisions by large numbers of internal staff experts and external professional advisers often decreases rather than increases the quality and robustness of decision making. This may happen because excessive analysis screens out promising creative ideas that do not stand up to the scrutiny of traditional financial benchmarks.
3. Use Intuition to Leverage Facts and Personal Experience
Intuition is a powerful tool for making judgments. Just look at this example: a fire chief leads his men into a house where a kitchen fire is burning. It is a relatively small fire and shouldn't be a problem for the half-dozen trained fire fighters arrayed to put it out. Suddenly, the chief has a terrible feeling about the fire. Without thinking, he orders his men to evacuate immediately. They rush outside, and as they leave the house, the entire first floor collapses in an explosive inferno. They have just escaped with their lives. When a postmortem is done on the situation, the chief believes that his "sixth sense" perceived the danger and saved him and his men."
Researcher and author Gary Klein, who studies decision making under pressure, recorded this case, and he knows that it wasn't the chiefs extrasensory perception that saved the day (Klein's book Sources of Power examines how people make decisions in real life as opposed to the laboratory). Using innovative interview techniques, Klein reveals the real reason: the chief's experience-based intuition. The fireman sensed that, even though the fire was small, it was generating an unusually large amount of heat. Furthermore, there was very little noise-it was too quiet for such a hot fire. In fact, what had happened was that the basement was on fire, and what seemed like a kitchen fire was actually a huge basement conflagration leaking upstairs. Subconsciously, the chief compared this fire to similar fires in his experience. It didn't fit established patterns, and this set off warning bells. He knew something was wrong-he didn't know exactly what yet. So he ordered a retreat to reexamine the situation from a safe vantage point.
The example of the kitchen fire illustrates the first key component of intuition: the subconscious analysis of 'patterns. We often experience it as "good feel," but a better description would be "experience feel." After we have seen many, many similar cases, we develop an ability to sense whether a new example fits-or diverges from-the patterns we have come to recognize. Chess grandmasters function very much the same way. They spend most of their time studying games and positions, and they develop the ability to rapidly size up any situation they encounter on the chessboard. As you can see, developing your powers of observation, a theme we highlighted in the previous two chapters on learning and synthesis, will help sharpen your judgment skills. In order to leverage your experience, you have to cultivate the ability to observe intensely what is going on around you.
The second step in using intuition involves imagining how the decision will play out. Various researchers use expressions like "mental simulation" or "imagining the outcome" to describe this. Very skilled professionals can rapidly simulate scenarios in their minds. Bain & Company CEO Orit Gadiesh implicitly refers to this when she tells us: "The good client advisers always keep three or four moves ahead. They are constantly imagining steps two, three, four, and five of the process while their clients are still focused on step one."
The intuitive part of judgment also involves the ability to identify analogs-to be able to say, "This here is like that over there." Analogies are also an important tool for synthesis. Here, we are trying to use analogies to make better judgments, to enhance our understanding of the immediate decision we have to make. American military advisers during World War II, for example, might have foreseen the attack on Pearl Harbor if they had studied the history of the Russo-Japanese war. In that situation, the war was also preceded by a Pearl Harbor-like attack on the Russian fleet at Port Arthur in 1905.
4. Incorporate Your Personal Values and Standards
Good judgment, or at least judgment that is consistent with your own character, is also based on having a strong, explicit set of personal beliefs and values that guide your decisions .
The following story, told by the chief executive of a $2 billion company, illustrates the power of an adviser's personal value system. You may not agree with the values, but you can't argue with the result:
"Some years ago, we faced a class action suit from a group of dealers, which potentially was going to cost us $50 million. We believed we had done nothing wrong, but our lawyers advised us that if it went to court, we stood only a 50-50 or worse chance of winning. A major distributor, who used to be the chairman of my company, originated the suit. He had died just shortly after the suit was filed, and on his deathbed he had his sons swear they would not relent in their pursuit of the lawsuit.
One of my long-standing advisers is a minister who excels at taking principles from the scriptures and applying them to business problems. I explained the situation to him, and he gave me this advice: he told me to go see the sons of the major distributor (who had just died) and tell them that we were donating $200,000 to a charity of their choice "to honor their father." "He was the founder," I was to tell him, and "this is to honor him." I did this, and they accepted. Then my adviser told me to go around and personally visit each distributor who was a party to the lawsuit. He told me to ask them what their issues really were and what they needed. I spent six weeks traveling to see them. At the end of this, I offered to settle for something like $2 million over three years.
Eventually they settled for $1 million up front. This advice saved the company tens of millions of dollars and helped reestablish the loyalty of our key distributors."
The pharmaceutical company Merck's development of Mectizan, a drug for river blindness, is another example of how a clear set of personal values can and should influence business decision making. In The Leadership Moment, Professor Michael Useem of the Wharton School of Business chronicles the story of Roy Vagelos, who was the head of Merck's laboratories in the 1980s. Vagelos made a personal decision to support development of a revolutionary drug that could cure or forestall the spread of river blindness, which is caused by a devastating parasite infection affecting 60 million people in developing nations. The problem was that none of the customers for Mectizan could afford to pay for it.
Vagelos advised Merck's management committee, and later, when he became CEO, its board of directors, to support the production and distribution of Mectizan-for free, forever. This was a huge and risky decision that by 1997 cost Merck $200 million in lost income. Yet Vagelos never hesitated. A physician himself, he deeply espoused a personal mission to "preserve and improve human life." His own beliefs and values were carefully factored into his decision making.
5. Don't Be Misled by Your Experience
On November 23, 1951, Ivy League rivals Dartmouth and Princeton played a hotly contested football game. The game was marked by fierce rivalry and very rough play on the field. Princeton's star player broke his nose and a Dartmouth player broke his leg. Afterward, a bitter dispute erupted about the way the game was played, with each side accusing the other of unsportsmanlike conduct. A psychologist from Dartmouth, Albert Hastorf, and a researcher from Prince-ton, Hadley Cantril, teamed up to study the incident. They surveyed students who had seen the game, and they showed a film of the game to students at both colleges who had not attended the match. Predictably, each side reported that the other team had committed the most infractions. Even with the benefit of objective evidence-a film that recorded everything-the students couldn't agree. The researchers concluded, "It seems clear that the 'game' was actually many different games. It is inaccurate and misleading to say that different people have different 'attitudes' concerning the same 'thing.' For the 'thing' simply is not the same for different people."
As this example illustrates, although it would seem very natural for us to learn from experience, memories are "reconstructed" after the fact and sometimes not very accurately. Researchers in the legal field, for example, have found that eyewitness" accounts can be very unreliable. In short, we lend to see what we want to see.
Physicians can be particularly susceptible to this phenomenon. A study done many years ago asked a group of experienced doctors to assess who among 500 children needed tonsillectomies. They concluded that about 50 percent needed to have their tonsils removed. They then separated out the 50 percent whose tonsils were deemed healthy and asked another group of doctors to examine them. Again, just under 50 percent were deemed in need of surgery to remove their tonsils. The "healthy" children were again culled from this group and assessed by yet a third group of doctors. Incredibly, nearly 50 percent were still diagnosed with unhealthy tonsils requiring removal!
There are three major pitfalls that prevent us from learning from experience:
• We claim credit for all successes. Not all good things are due to our genius; luck and happenstance affect a lot of outcomes. We have to recognize this and develop a measured understanding of our capabilities.
• We minimize and dismiss failures. Often, we will reframe events with hindsight so they are more favorable to us, or we simply forget them. This keeps us from learning.
• We distort actual events, in our favor. Like the students at Dartmouth and Princeton, we allow personal biases to color our recollections.
You can enhance your ability to learn from experience by doing a few simple things. First of all, keep track of your advice. Six or twelve months after the fact, ask yourself if you would give the same advice, or if, perhaps, you would say or do something different. Second, think about how past events might have turned out differently. Research has shown that you can reduce hindsight biases by looking at how the results of decisions could have been different. It's not enough to say, "Why did things turn out the way they did?" You also have to ask, "How else might it have turned out, and why?"
TECHNIQUES TO DEVELOP BETTER JUDGMENT
Based on our observations of professionals who have great judgment, here are some suggestions for improving your own decision-making ability:
Overinvest in problem identification. Lack of up-front investment in thorough understanding of the issues that the client faces is one of the biggest mistakes professionals make. At least 50 percent of the time, the "problem" presented by your client will change and evolve from the one you discussed at your initial meeting. It is a dangerous mistake to accept your client's first "problem statement" at face value.
Examine alternative problem definitions. Be creative in examining all the root causes of the issue at hand. Harvard's Joseph Bower, in our earlier example, correctly identified that his client's first problem was executive alignment and buy-in, not antiquated processes or information systems.
Make sure the problem is really apriority. Given the strategy, goals, and current situation of the organization or individual you're dealing with, does it make sense to work on this problem? A few years ago, a major bank had lost nearly $500 million in just twelve months. Management began soliciting multimillion-dollar bids to develop a "cultural change" program. Was this really the place to start, given the huge losses and other associated problems of cost efficiency and strategic positioning that the bank faced?
Ask "disconfirming" questions. As we mentioned earlier, you can avoid the confirmation judgment trap by asking questions and collecting data that you suspect might disprove the initial hypothesis. For example, the United States decided to drop the atom bomb on Japan in 1945 because of a firm belief that the Japanese would never surrender. U.S. officials believed that an invasion of mainland Japan, which would cost an estimated 1 million Allied casualties, was the only other viable option. But what if the following question had been seriously pursued: "Short of dropping the atom bomb or invading the mainland, what event could lead the Japanese to surrender?" This line of inquiry, if advanced in a thorough manner, might have revealed other options to the Allies, including the obvious one of just waiting for a few more weeks, since constant American firebombing had already destroyed a large number of Japanese cities.
Develop both standard and outlandish alternatives. We often put boundaries around our thinking, and this severely limits the range of alternatives or possibilities we are able to consider. What if we do nothing? What if we do the opposite of what everyone is suggesting? An outlandish alternative proposed at a Drexel Burnham brainstorming session in 1983 was the concept of an "air fund" for corporate acquisitions---a fund with no money in it. At first, the idea seemed absurd. But it eventually evolved and developed into the "highly confident" letter that Drexel would send out prior to a takeover. Basically, the letter stated that Drexel was highly confident the financing could be raised in the high-yield bond market.
There was no money available yet, just the promise of billions of dollars soon to materialize.
Engage in prospective hindsight. Try stating a question about the future in two different ways:
• How likely is it that our closest competitor will take ten points of market share away from us in the next two years and surpass us in revenue? Give reasons why this might occur.
Here is a slightly different version of this question:
• Pretend it is two years from now. Our closest competitor has increased its market share by ten points and surpassed us in revenue. Explain how and why this has happened.
When a hypothetical event is stated as a reality-as in the second question above-people are far more creative in coming up with reasons for why it could happen, and the quality of their thinking improves dramatically.
Understand your client's tolerance for risk and uncertainty. Every client has different levels of tolerance for risk, and this tolerance will vary from situation to situation. Several years ago, for example, a leading European travel company commissioned a group of consultants to review its U.S. operations. Although the firm's U.S. office was at a serious disadvantage against bigger players, and losing money, the consultants believed that with a great deal of work and further investment it could grow and achieve greater market clout and economies of scale, finally becoming profitable.
Their conclusions bothered the CEO, however, and he asked a friend, a former top executive in the travel business who had retired, to come see him. Sitting over lunch the next week, his friend said, "It all comes down to what management really wants here. So what do you really want out of your U.S. operations? And what risks will you tolerate?" The CEO paused, since no one had bothered to ask him these questions in quite this way. He replied, "I basically need to show the flag in the United States. The business doesn't have to be big-in fact it can be very small-we just need a visible presence. And I can't risk it ever losing any money. I just cannot afford it anymore-the government won't put up with the losses." The CEO declined the follow-on consulting contract and instead spent a month downsizing the U.S. office to the point where it could break even under any circumstances. The CEO was happy, and so were his shareholders, who were more interested in national representation-"showing the flag"-than market share. The consultants, in short, had misjudged their client's appetite for risk and misunderstood his business objectives in the United States.
Enhance your ability to reach for patterns in your experience. You can deepen your effective experience by learning from other, more seasoned peers. Get them to share stories and anecdotes. You might consider questions like: "What was the most difficult client you ever had? What was the most awkward professional moment of your career, and how did you handle it? Have you ever taken on a case that seemed hopeless? Why?" Stories are a powerful means of enhancing your experience.
BECOMING A GOOD THINKER
Good judgment flourishes, first of all, in the absence of bad judgments. Great professionals help their clients avoid the many subtle judgment traps that can lead to poor decisions. Then they actively exploit each part of the judgment equation in a balanced fashion. They combine known facts with their experience and assess the alternatives through the lens of their beliefs and values, by becoming a deep generalist, cultivating your powers.
Do You Have Good Judgment?
• When your clients face tough choices, they often use you as a sounding board. They share their dilemmas with you.
• You're right more than 50 percent of the time.
• You have the confidence to make judgments relatively quickly. You identify and marshal the key facts and perspectives that you need, but it doesn't bother you if you don't have all the facts.
• If you're asked by a client to judge an issue where you lack experience and important information, you're not afraid to come out and say you just don't know.
• You're honest about your track record at giving advice and making recommendations. You've made mistakes and learned from them.
• You're very aware of your clients' tolerance for risk and loss, having discussed this openly with them.
Of synthesis, and developing good judgment, you will be well on the road to becoming a good thinker, a person aptly defined by Vincent Ruggiero in his book The Art of Thinking:
Good thinkers produce both more ideas and better ideas than poor thinkers. They become more adept in using a variety of invention techniques, enabling them to discover ideas. More specifically, good thinkers tend to see the problem from many perspectives before choosing any one, to consider many different investigative approaches, and to produce many ideas before turning to judgment. In addition, they are more willing to take intellectual risks, to be adventurous and consider outrageous or zany ideas, and to use their imaginations and aim for originality.
IF YOU ARE able not only to demonstrate sound judgment yourself but also help your clients arrive at their own good judgments, your value as an adviser will increase significantly. By developing a reputation among your clients as a good thinker, you will be asked back by them again and again.
WHAT MONEY CANNOT BUY
Creating Trust through Integrity
QUESTION: Is not commercial credit based primarily upon money or property ?
j. PIERPONT MORGAN: No, sir, the first thing is character.
QUESTION: Before money or property ?
j. PIERPONT MORGAN: Before money or anything else. Money cannot buy it. . . . Because a man I do not trust could not get money from me on all the bonds in Christendom.
J. P. MORGAN'S 1912 Congression Testimony'
AMERICA is slowly becoming a low-trust society. In 1960, 58 percent of Americans surveyed felt that "most people could be trusted," but when asked the same question in 1993, only 37 percent replied in the affirmative. Evidence of low trust is everywhere: politicians routinely lie, litigation proliferates, and the confidence we have in a variety of professional figures-doctors, lawyers, consultants, stockbrokers, journalists, and others-appears to be at a low ebb. Even our trust in respected institutions such as local police, the FBI, clergy, and the military has waned in recent years.
A lack of trust in business and personal dealings carries many costs. Corporate managers and public officials, for example, are reluctant to share information that could empower their organizations, resulting in sharply reduced employee loyalty. Transaction costs, such as legal fees and overly detailed contracting, are major expenses for both corporations and individuals. And because of a fear that they will be sued, many employers refuse to give recommendations for former employees-the two parties, in essence, don't trust each other.
Service professionals, who have historically enjoyed a reputation for unimpeachable integrity, have contributed their fair share to the diminution of trust that clients place in them. Stories are reported in the press-and also occasionally circulated among clients-about investment banks whose client loyalties are a function of deal size rather than prior commitments; about consultants who oversell and put inexperienced staff on projects; of lawyers who create conflicts of interest by allowing themselves to become financially intertwined with their clients; and so on. Litigation against large professional service firms, once rare, has become commonplace.
The basic patterns are all fairly familiar by now: confidential information is misused; a client's interests are put last rather than first; standards are compromised in order to retain client business; and conflicts of interest are not disclosed. As the service industries become more competitive, there is an increasing tendency to compromise principles in order to meet growth and profitability objectives. Integrity, inexorably followed by a decline in trust, is the casualty.
Great professionals, however, never concede their integrity in order to win. They may be bold and determined in pursuit of their objectives, but integrity and their clients' needs-not selling the next assignment, not earning a large bonus, not pleasing their boss-come first. And if there ever is a conflict between the two-between what a client wants and what the professional's integrity dictates-integrity always wins out.
YOUR MOST POWERFUL ALLY
Trust is especially important in situations where there is a "high degree of dependence on someone else-precisely the situation when a client hires a professional for advice or buys a complex product or service from him. Trust between a client and a professional is both a necessity and an important asset for both parties: if there is mutual trust, everything works better, faster, and more smoothly. When a client trusts her professional adviser, a number of positive things happen:
• When you suggest additional work to your client, she believes you are proposing the work because you honestly believe it will help her, not because you need more business.
• Your client will be willing to buy services from you that extend beyond your core expertise. Trust allows you to increase the depth and breadth of the relationship.
• If you make an honest mistake or slip up in some way, your client will most likely forgive you and won't hold it against you.
• You will be able to work with your client on a more informal basis, leading to a more relaxed and creative process. There will be a decreased need to carefully document and check everything you do.
• When you make recommendations, they will have more impact. Your client will believe that your words are backed with integrity and that your only agenda is to help solve her problem.
Trust, in other words, is a professional's most powerful ally. Trust is worth a fortune (it is, literally, if we're talking about keeping a client for life), yet you can't purchase it, a fact noted b. P. Morgan when he testified before Congress in 1912. What is trust, exactly? We know it's missing in many aspects of our society, and we know how powerful it can be when it's present, but it's easier to articulate the feeling of trust than the elements that actually create it. Trust is complex: in some situations, it means "I believe you are competent to perform this service"; in others, "I know you will act in my interests, not yours." Author Robert Shaw proposes a general definition of trust: "A belief that those on whom we depend will meet our expectations of them."
Harry Hopkins: Franklin Roosevelt's Most Trusted Adviser
Harry Hopkins, who served as an adviser to Franklin Roosevelt from 1936 to 1945, was one of the most remarkable political advisers in U.S. history. Much of his success was based on a relationship of extraordinary trust that he developed not just with the U.S. president but with other world leaders at the time, such as Winston Churchill and Joseph Stalin. Hopkins, who had almost no formal position in the White House during World War II, was influential in both the success of the New Deal and the effective conduct of the war. The trust he engendered, added to his native abilities, enabled him to play a highly unusual role in both increasing Roosevelt's effectiveness as president and in facilitating a highly productive relationship among the Allied war leaders. Secretary of the Army George Marshall, who was not prone to hyperbole, said that Hopkins "rendered a service to this country which will never even vaguely be appreciated."
A professional social worker by training, Hopkins as a young man showed little hint of the greatness he would achieve as the most important adviser to a famous U.S. president. He headed the Federal Emergency Relief Administration and the Works Progress Administration during the mid-1930s and was secretary of commerce from 1938 to 1940. Ironically, it was when Hopkins abandoned any personal political aspirations that his power increased exponentially. He had a bout with cancer, then was diagnosed with a chronic, wasting intestinal ailment that doctors believed would be fatal. Because of his health, he gracefully stepped down as commerce secretary in 1940, but soon after Roosevelt was re-elected, he asked Hopkins to move into the White House and become his informal adviser. It was during the war years, when he held no major post, that Hopkins established a unique relationship with Roosevelt.
Living in a guestroom at the White House, Hopkins joined Roosevelt for virtually all his meals and attended every important meeting with him. Roosevelt got to know Hopkins intimately, reinforcing their personal chemistry and a sense that they shared many of the same values. Based on Roosevelt's deep trust in Hopkins, he sent him as his personal emissary to London in January 1941, to meet with Churchill (Roosevelt and Churchill did not yet know each other personally, although they had met once years earlier). Hopkins and Churchill spent two weeks together, including three weekends in the countryside at Chequers, the prime minister's country estate, where they talked, drank, and relaxed together. The relationship Hopkins established with Churchill during this trip built a foundation of trust that allowed Hopkins to create an unusual link between the two leaders.
Moreover, as Hopkins's biographer, Robert Sherwood, notes, "there was by now an intimacy between the two men which developed to such a degree that it is no exaggeration to say that Churchill reposed the same confidence in Hopkins that Roosevelt did." After yet a second visit with Churchill, Sherwood tells us, "there was started at this time correspondence without precedent: an informal, off-the-record but none the less official correspondence between the heads of two governments through a third party, Hopkins, in whose discretion and judgment each had complete confidence. Time and time again, when the Prime Minister wanted to sound out the President's views on some new move, he would address a private cable to Hopkins . . .
Hopkins exercised impeccable discretion. Despite being privy to virtually every state secret and private conversation of the president, he never, ever-not even once-betrayed the confidences placed in him. He never leaked news or used his information for personal gain. In July 1941, shortly after the Germans had invaded Russia, Roosevelt sent Hopkins to meet with Stalin in Moscow to assess the situation.
It was a historic set of meetings, the first between Stalin and a direct representative of the U.S. president. Very little was reported in the newspapers, however. During the press conferences he held afterward, Hopkins revealed virtually nothing about the substance of their talks, even though to do so would have enhanced his prestige and highlighted the powerful and unprecedented role he was playing. Roosevelt knew that Hopkins was as silent as a tomb, and it magnified his ability to trust him.
Hopkins's reliability and consistency further reinforced Roosevelt's belief in his integrity. He never overstepped his bounds; if Roosevelt sent him on a mission to meet with a foreign leader, he knew that Hopkins would assiduously adhere to the agenda and limits that had been set for him.
After every meeting, Hopkins would carefully draw up a detailed memo for the president that succinctly laid out the key points and issues to consider.
Hopkins didn't believe in political patronage, and he was incorruptible. When he administered relief funds for Roosevelt as head of the Federal Emergency Relief Administration, he did it strictly by the book, favoring no particular state or constituency. A few times, Roosevelt had to intervene to satisfy some political ally whom Hopkins had treated too impartially.
Hopkins never profited from his position of enormous influence; when he died in 1945, his estate was worth only a few hundred dollars. Yet this had been a man who had personally overseen the disbursement of $9 billion in aid during the Depression and who had been a director of the lend-lease program during World War II, which allocated over $50 billion in military spending.
In Roosevelt and Hopkins, Robert Sherwood sums up Hopkins the adviser: "Hopkins did not originate policy and then convince Roosevelt it was right. He had too much intelligence as well as respect for his Chief to attempt the role of mastermind. He made it his job to provide a sounding board for discussions of the best means of attaining the goals that the President set for himself. Roosevelt liked to think out loud, but his greatest difficulty was finding a listener who was both understanding and entirely trustworthy. That was Hopkins. Because he had set aside his own personal ambitions for formal office, Hopkins's agenda was Roosevelt's agenda. This, together with his unwavering integrity, made it easy for Roosevelt to trust him.
If we look at Harry Hopkins and his relationship with Roosevelt-indeed, if we examine any business relationship with a high degree of trust-several factors stand out that uniquely affect the level of trust that a client has in you.
The first major quality that underpins trust is integrity. The discretion, consistency, and reliability that you demonstrate, and your sense of right and wrong-these will influence, more than just about anything else, the degree of trust people place in you. Hopkins exhibited these qualities to Roosevelt on a daily basis, always coming through for the president, never forgetting a commitment, as incorruptible on the last day of his tenure as on the first.
Hopkins's strong performance at every task Roosevelt gave him illustrates an additional factor that builds trust: competence. In a business setting, a client's trust will naturally be influenced by whether or not he thinks you're competent to do the job you've promised. The risk of trusting someone is a final consideration, and that perceived risk will raise or lower the total amount of trust that a client has in you.
These three factors-integrity, competence, and risk- can be combined into a trust formula:
Trust = (Integrity X Competence)
Risk
Your clients' perception of each factor in the equation will raise or lower the trust they place in you.
INTEGRITY: THE BACKBONE OF TRUST
Integrity is a state of wholeness in which you act in accordance with a set of coherent values or principles. In other
words, you know what's right, you're clear about what you believe in, and you consistently follow your beliefs.
Integrity has several main dimensions to it. The first, according to Yale law professor Stephen Carter, is discernment between right and wrong.7 Just acting consistently with your beliefs is not enough; you have to have beliefs that are ethical and moral. Adolph Hitler, for example, passed many of the tests of integrity-he acted on his beliefs quite consistently- but he had evil, wrong beliefs. There was no discernment.
In Dante's Inferno, which is the first part of his Divine Comedy, the "false counselors" are found in the eighth circle of hell, one of the lowest, just below common thieves.
These false counselors are spiritual thieves, who advised others to commit fraud. They used their intellect to rob people of their integrity, and as a result must walk for eternity enveloped in painful flames.
Using one's intellectual powers to deceive and encourage wrongdoing was, for Dante, an especially egregious crime. Honesty is an important manifestation of discernment.
HOW YOU CAN BUILD TRUST
Trust is like a fine Oriental rug that is carefully woven over many months or even years, rather than an edifice that is set up overnight. Lots of small things go into building trust. Here are some areas to consider:
1. Face Time with Clients
"One of my few client relationships that went badly," Spencer Stuart's Andrea de Cholnoky tells us, "was due to lack of face time. The client told me that he just hadn't seen enough of me, that it didn't seem like I had the energy in the assignment. I immediately called up every single one of my other clients and took them out to lunch! You've got to invest, continually, in face-to-face time with clients."
There is simply no substitute for meeting with a client and allowing time so that the two of you can come to know each other personally. The purpose is not to make the client like you-we're not talking about "schmoozing." And there's no guarantee that if you spend time together the trust will increase.
If, however, there is personal chemistry, as well as shared values and interests, personal time together will bring this out, and it will subtly facilitate the development of trust. Face time provides an opportunity for your client to see your sterling qualities firsthand. It amplifies your competence and integrity.
2. Setting and Reviewing Expectations
We said early on that a client's satisfaction is a function of expectations versus actual (or perceived) performance. Trust works the same way: you may very well fulfill your commitments on time, but if you and your client don't agree on what a particular commitment was in the first place, your perceived integrity will suffer and trust will diminish.
3. Carefully Making Promises
The worst kind of professional is someone who constantly promises things and never delivers. This kind of credibility gap, once established, is almost insuperable. Lewis Smedes, an ordained minister, beautifully sums up the meaning of a promise in a sermon entitled "The Power of Promises": "When a person makes a promise, he stretches himself out into circumstances that no one can control and controls at least one thing: he will be there no matter what the circumstances turn out to be."
Here are some suggestions for how to keep commitments:
• Don't be cavalier with promises. Don't say, "Let's have lunch" or "I'll call so-and-so for you" unless you really mean it. Being known as a person of your word is a powerful thing. Don't dilute your integrity with thoughtless commitments.
• If necessary, make conditional agreements. If an event or occurrence could get in the way of a promise, state it clearly up front. This way there will be no surprises.
• If you can't keep a promise, let the other person know as early as possible. The longer you wait to reveal the bad news, the worse things get. If you have built up trust by keeping your previous commitments, then that client will probably understand.
• Learn to say no. Busy, successful people are the ones who are always asked to do things. Be selective about what you commit to.
4. Demonstrating Loyalty
Loyalty means having an allegiance to your client and putting her agenda before your own. When clients experience a sense of loyalty from you, it reinforces their perception of your integrity and strengthens their ability to trust you. Someone who feels third or fourth on your list of priorities, who gets the impression that she's just one of dozens or hundreds of clients, is never going to trust you very deeply. Think about how you feel when a doctor barely recognizes you and has to visibly reorient himself as he walks into the examining room. Everyone wants to feel special-your clients are no different.
It's also important never to criticize anyone who is not present. You win the trust of the people you're with by showing loyalty to those who aren't there. If someone is indiscreet and tells you a piece of gossip or confidential information, it becomes difficult to trust that individual. If he or she is always criticizing other people, it makes you wonder, What will this person say about me to others?
5. Nurturing Trust on a Daily Basis
There is no doubt that one dramatic event can establish a great deal of trust. For example, when George Washington voluntarily relinquished the presidency after his second term had expired, he instilled a deep public trust both in himself and in the new American government. Few if any major heads of state before him had ever stepped down of their own free will. What really cements and develops a sense of trust, however, is the daily nurturing of your relationships. Stephen Covey's metaphor for this reservoir of trust is the emotional bank account. When an action reinforces trust, you have made a deposit; when you do something to undermine trust, such as letting someone down, you make a withdrawal. You have to make lots of deposits, regularly, to sustain trust.
6. There Are No "Minor" Commitments
At Beth Israel Hospital in Boston, legendary chief of surgery Dr. William Silen tells his residents, "I don't know what the difference is between 'major' and 'minor' surgery. I just know that no one performs 'minor' surgery on me!" In a similar vein, there is no such thing as a minor commitment. Each promise you make, large or small, should be treated with the same seriousness. "Character is made in the small moments of our lives," offered nineteenth-century clergyman Phillips Brooks. It's all the little things that you do-often when no one is looking- that constitute your character and define your integrity.
7. Knowing What You Stand For
By definition, integrity is a wholeness or completeness that is underpinned and bounded by a set of beliefs and values. What are your principles? What do you stand for? What guides your professional and personal life? Where do you draw the line when your beliefs are challenged or threatened?
Law professor and best-selling author Alan Dershowitz told us this story about clarity of principles and integrity: "Several years ago I helped a large law firm win a very important case. To celebrate, the partners took me out to dinner to a private club. I learned that the club did not allow women inside the door, however, a practice that violated one of my basic beliefs about equality between the sexes and non-discrimination. When I refused to go to the club, they said 'but there's no other good place to eat.' I insisted, and we ended up holding the victory dinner at McDonalds."
8. Being Prepared to Talk on TV
All professionals are faced with ethical and moral dilemmas just about every week of their lives. Some are relatively minor. Should I fly first class or economy? Should I put hotel laundry on my expense report? Some are major. Should I agree to an accounting practice that I feel is wrong? There are no simple rules for how to conduct yourself. Hemingway's quip that "I only know that moral is what you feel good after and immoral is what you feel bad after" can take you only so far.
One good principle to follow as a professional is what we call the "light-of-day" test. Whatever action you take, be it staying in a certain class of hotel or meeting with a client's competitor, would you be comfortable discussing it with your client the next morning in the full light of day? What if you were interviewed on television and asked about something you did? Would you feel comfortable explaining it?
"Anything related to issues of integrity, trust, and ethics are fatal flaws" commented Rebecca Guerra, the vice president for human resources at eBay, the online auction house. Speaking to The New York Times, she emphasized that while failure in one's past was OK, questions about character were unacceptable to her company.
Another way of looking at this is that you shouldn't have any secrets. By secrets we don't mean confidential client information, which you are duty-bound to protect. Rather, you should have nothing to hide; you should be comfortable sharing details of your professional conduct with a client, without embarrassment or defensiveness.
9. Reducing Your Client's Risk
Recall that the amount of trust a client has in you will go up or down depending on the risk he perceives. You can do several things to reduce this risk. First of all, you have to demonstrate consistency and reliability right from the start, even for the smallest of things. Showing integrity itself, in other words, reduces risk.
Second, you can either implicitly or explicitly guarantee your work. A guarantee doesn't have to take the form of a certificate that your clients mail in to you. More likely, it will be an understanding between you and your client. You want your clients to feel that if they are not satisfied at any time with your work, you will rectify it as best you can-period. The words "we'll work on this until you're satisfied" can be the occasional reminder of the fact that you'll stand behind your work and strive to address any issues they may have with your performance.
WHEN TRUST IS LOST
Sometimes, even though you feel you have demonstrated a high level of integrity and competence, trust is lost. Here are some principles to remember about losing trust:
Clients don't inform you when they stop trusting you. Trust can vanish rapidly and mysteriously, and you're always the last to know. Because the symptoms of a loss of trust can be so varied, and because some of them can also signify other problems or issues, it's always hard to pinpoint when your client stops trusting you. Perhaps you lose a follow-on assignment that you were sure you would win; or suddenly the client throws your business open for a competitive bid. Often, a client can't even articulate that she's lost trust in you. She feels a vague dissatisfaction, and she stops sharing information with you and turning to you for advice. You have to watch and listen very carefully.
It's useful to hold a frank and open discussion with your client when the engagement ends, something that is easier to do if you set the expectation, right up front, that you'll be having this discussion three or six months down the road. Unfortunately, by the time you discover that the trust has dried up, it may be too late to do anything about it.
Clients don't care why you let them down. Unless a catastrophe has occurred-an earthquake or a death in the family- clients, like most people, don't particularly care what the reason was that caused you not to deliver on a commitment. You may believe you had perfectly good reason to let them down, and the excuses are myriad: you caught a cold, the work took longer than you had planned, another client had an emergency, your computer crashed, you forgot to write it down in your agenda, you wrote it down in the wrong agenda, your secretary forgot to tell you about it, and so on. But your client doesn't really care, and trying to explain it won't help. It's better to say, "I let you down, I'm sorry, and it won't happen again." If you have built up a reservoir of trust with your client, he may let it pass.
Sometimes, repairing a lapse in trust can enhance your relationship. If you let a client down, you may be able to recover her confidence. How you react to the incident and the way in which you go about remediating it are critically important. Several years ago, a management consultant conducting an assignment for a large West Coast company carelessly left a draft copy of his report on a BART train in San Francisco. An unscrupulous passenger found it, contacted the client, and demanded $50,000 in ransom for the return of the document. All hell broke loose: the company threatened not just to terminate its relationship with the consultants, but to file a major lawsuit as well. The consulting firm went into action immediately. Its president flew out to California the next day and met with the CEO of the client company. He apologized for the incident, offering no excuses. He informed the CEO that the consultant had been disciplined and that the firm was assigning a task force of partners to develop new policies and procedures to minimize the possibility that such an incident could reoccur. Then he offered to conduct a major study for the client, free of charge, on a key issue the company faced. The client accepted, and the relationship continued successfully for another four years.
This anecdote illustrates some cardinal rules for dealing with a breach of trust:
• Admit that you've made a mistake. Own up to the lapse.
• Don't make excuses-no one wants to hear them.
Have You Developed Trust with Your Clients?
• Sometimes, you conduct assignments based on a minimum of documentation. Once you and your client have agreed on the objectives and deliverables, your client trusts you to follow through.
• Clients may remind you of something you're supposed to do, but they rarely "check up" on you.
• Clients ask you to tackle issues that are of major importance to them.
• If on a rare occasion you slip up and miss a commitment, your clients are very forgiving.
• There is a quality of openness to your client relationships. Both you and your clients feel free to bring up touchy or awkward subjects with each other.
• Your clients have become familiar with your particular skills as well as your values and beliefs. They can predict how you will react to a particular situation or dilemma.
• Clients' trust in you extends beyond their belief that you will do good work; it is a deeper, broader trust based on both professional competence and personal integrity.
• Provide value-added compensation to the client. Some clients might value having the fee reduced; for others, such as the client in the example above, a free piece of work can he appropriate.
• Learn from the incident, and let your client know that you are learning from it. Tell them what you're going to do to make sure it doesn't happen again.
There may be situations where you feel that you are 100 percent in the right and that the client is absolutely in the wrong. Even in these cases, keep in mind that the client perceives that you have let him down. You may have to walk away from the relationship, but be careful about how you deal with it; you don't want to leave burned bridges behind you. If there has been good communication between you and the client, however, and expectations have been set, you should be able to avoid this kind of confrontation.
DEEP PERSONAL and professional trust, which boils down to a client's belief in your integrity and your competence, is a hallmark of the long-term relationships that great professionals are able to develop. Clients expect and will forgive occasional errors of judgment, but lapses of integrity are a red flag to everyone around you. As the fifth-century religious leader St. Augustine wrote in his essay On Lying. "When regard for the truth has been broken down or even slightly weakened, all things will remain doubtful." Set high standards of conduct for yourself. Tirelessly develop your reputation for integrity and honesty, and it will become one of your biggest assets as a professional.
THE SOUL OF THE GREAT PROFESSIONAL
This is the true joy of life, the being used by a purpose recognized by yourself as a mighty one; the being thoroughly worn out before you are thrown on the scrap heap; the being a force of nature instead of a feverish, selfish little clod of ailments and grievances complaining that the world will not devote itself to making you happy.
GEORGE BERNARD SHAW, Man and Superman
GREAT PROFESSIONALS become extraordinary client advisers by developing some important attributes. These attributes encompass the important talents, skills, and attitudes that enable professionals in any field to build and sustain long-term, broad-gauge client relationships on a consistent basis.
The great advisers we've studied also possess certain outlooks that frame and inform their work. We call these outlooks the soul of the great professional. They are not so much personal characteristics as they are ways of looking at the world. If you cultivate them, your ability to add value will be enhanced, and you'll become a more appealing person to your clients-someone they will both respect and enjoy spending time with. In addition, you'll be better able to shape and manage your own career. These outlooks-the elements of this soul-can be discerned in virtually all of the professionals we have studied who command strong client loyalty.
Great Professionals Have an Abundance Mentality
An abundance mentality allows you to see the possibilities and opportunities inherent in every situation.1 The opposite is a scarcity mentality, which focuses on limitations and risks.
Professionals with an abundance mentality:
• Always look for opportunities, growth, and expansion
• Constantly generate new ideas
• Are positive and upbeat in their demeanor
• Feel that there are rewards enough to go around for everyone-they know that a "rising tide" lifts all boats
• Are willing to invest time and money in the short term in order to earn more later on.
Professionals with a scarcity mentality, in contrast, have very different attitudes. They:
• Are primarily concerned with what might go wrong and what won't work
• Focus on the risks of new proposals rather than the potential rewards
• Believe that life is a zero-sum game, with a limited amount of opportunity to go around
• Are concerned with "getting their fair share" at all times
• Won't make investments that don't show an immediate return
If you were a client, whom would you rather spend time with? There's no contest here: all of us would prefer a positive, energizing individual to someone who always sees the dark side of things. Some situations, such as a tax audit, may benefit from the scarcity mentality we've described. But in general, clients prefer and benefit from the expansive thinking of the professional who sees abundance, not scarcity.
Don't confuse an abundance mentality with laxness, laziness, or imprudence. The professionals who perceive abundance often have a healthy dissatisfaction with the way things are done today. They know there's often a better solution. Like strong organizational leaders, they push and stretch for new ideas and innovations; they don't wait for them to float down from the sky. That's why clients like having them around so much: these professionals constantly energize, motivate, and inspire others.
The sources of your fundamental outlook on life-abundance versus scarcity-are varied and complex. Your early childhood experiences and upbringing clearly have a strong influence on this dimension of your personality. Someone who suffers physical or emotional deprivation as a child, for example, may always harbor a deep-seated sense of scarcity. A lack of love and affection damages self-esteem, making it hard to have an abundance outlook. There is no doubt an element of personal "constitution" involved-some individuals just seem to be born with more resilience against the vicissitudes of life-but family and parental role models are also an important influence on your adult attitudes of either abundance or scarcity.
We believe that the education you receive plays a critical role as well. Economics and engineering, which are typical backgrounds of many professionals in business, are founded on principles of scarcity. Both disciplines are concerned with the optimal use of scarce resources. They focus on the tradeoffs that have to be made-for example, "guns versus butter," a graph recognizable to many readers, which is found in many introductory economics textbooks. The liberal arts, in contrast, are premised on abundance. The liberal arts perspective sees a world of nearly infinite ideas and resources, a world where trade-offs are not always necessary. It also raises important philosophical questions.
Rajat Gupta, McKinsey's worldwide managing director, says that he reads poetry at the end of each partners' meeting: "At first, that took people by surprise. But over time, poetry has affected what we're doing. Poetry helps us reflect on the important questions: What is the purpose of our business? What are our values?"
The European Renaissance, which was a time of enormous scientific as well as artistic ferment and innovation, exemplifies the power of the liberal arts perspective. The concept of humanism, which fueled the Renaissance, was based on a belief in the potential of human beings and their ability to reach self-fulfillment without recourse to higher powers or supernatural means. The most accomplished and inventive figures of the period, from Niccolo Machiavelli to Leonardo DaVinci, were consummate liberal arts scholars, equally at home with art, science, mathematics, philosophy, history, and literature.
Does this mean you have to study liberal arts to become an accomplished professional and develop lifelong clients? Yes and no. What we have found is that the best client advisers, regardless of what they majored in at college or studied in graduate school, become deep generalists. They read widely, take an interest in a variety of subjects and disciplines, and cultivate personal interests as well as professional expertise. Recall Peter Drucker, for example, who has a passion for Japanese art, or David Ogilvy, who had a deep interest in French culture (he eventually went to live in France). The risk of burrowing too deeply into one discipline like economics, engineering, or accounting is that you will begin to adopt a scarcity mentality. Broad knowledge and learning, in contrast, open the way for an outlook of abundance.
Great Professionals Have a Mission Orientation
The individuals who have had a significant impact on history-figures such as Jesus, Buddha, Joan of Arc, Gandhi, and Abraham Lincoln-had clear missions that led them to perform at extraordinary levels. The great advisers we've
looked at in this book also had well-developed personal missions. For Thomas More, it was fulfilling God's work in this life; for Niccolo Machiavelli, it was creating a stable, unified Italian state; for J. P. Morgan, it was establishing an orderly financial system in the absence of regulatory agencies. Gertrude Bell's mission was to promulgate an understanding of the Arab world among Westerners and ensure peaceful cohabitation of the Iraqis and the British. Early on, General George Marshall was driven by a desire to create a professional, respected U.S. Army founded on principles of excellence, efficiency, compassion, and hard work; later, his mission became no less than ensuring that the United States kept the world safe for democracy.
For most of us, our personal missions are perhaps more down-to-earth but no less sincere, sacred, and important to us. When you ask great professionals what drives them in their careers, you will hear phrases such as "making a difference to my clients' business"; "enriching management practice through my ideas"; "being a teacher-teaching and explaining the importance of people's rights"; "educating managers so they lead more successful, effective lives"; or simply "practicing excellence in everything I do."
Fred Brown, who descends from the famed Brown Brothers Harriman banking family, is an example of an extraordinary adviser who has a clear mission that drives his daily behavior. A highly successful personal financial consultant, Brown has authored several books on financial management. He writes a weekly newspaper column entitled "Money and Spirit," and he has a waiting list of clients. He could well afford a trophy house and late-model luxury cars, but his relatively modest home in the Southwest and his utilitarian Subaru suit him just fine-he prefers to live his values of moderation and balance rather than flaunt his achievements through flashy possessions. Using a powerful, unique approach to financial management that blends cutting-edge financial expertise with a deep understanding of each client's personal, familial, professional, and spiritual life, Brown has developed an intensely loyal following of individuals and families who come back to him year after year.
Brown charges an hourly rate that is a fraction of what the market could bear, but this is a conscious choice he has made that is consistent with his mission of helping people lead better lives through improved financial management. "By charging what I do," Brown tells us, "I am able to serve a very broad clientele-I get the millionaires but also people who are scraping by and desperately need help just to survive."
The opposite of a mission orientation is the strictly material orientation. Your main focus becomes money, title, promotion, or publicity. When a professional has no sense of mission, he or she risks becoming a mercenary-someone that Machiavelli cautioned against five hundred years ago when he wrote, "Mercenaries are disunited, thirsty for power, undisciplined, and disloyal." Machiavelli urged the creation of national militias-citizens' armies with an overriding purpose and an intense loyalty to their home state-a revolutionary concept at the time but now the accepted norm.
The author Victor Frankl, who survived the Nazi concentration camp at Auschwitz during World War II, wrote that "Nothing is more likely to help a person overcome or endure troubles than the consciousness of having a task in life." A mission orientation not only helps you overcome difficulties, but it will give you great strength in practicing the seven attributes. It will be easier for you to be an empathetic listener; your conviction will intensify; your integrity will be strengthened; and it will be far easier to practice selfless independence.
Great Professionals Channel Adversity into Wisdom and Confidence
The extraordinary client advisers we've profiled have all gone through difficult experiences. They've made mistakes, suffered reversals of fortune, and even been humiliated. Whereas many people become embittered, cynical, or distrustful as a result of these setbacks, the really great professionals get stronger. They become wiser, more confident, and humble. Their comfort zones expand, enabling them to tackle an ever-broader variety of situations and client assignments. Laura Herring's story illustrates how extraordinary setbacks can create resolve and determination. In less than ten years, Herring's firm, The IMPACT Group, has grown to 120 professionals who deliver a variety of relocation support services, from counseling to resume preparation. It had an inauspicious beginning, however. The concept got its start when Herring, originally a family therapist, pointed out to a Fortune 500 executive that relocation was one of the toughest personal issues facing his employees. Challenged to develop a solution, Herring invested $360,000 and months of time to create a program called Momentum. Just after the company placed a major order for her services, however, its relocation manager vetoed the idea, leaving Herring with no business. "I had double-mortgaged my house," she tells us, "and sold some real estate my husband and I owned. I was deeply in debt, with no cash flow. Panic set in." She goes on to say:
I was unable to go home and tell my husband what had happened. So I went to the phone book, and began looking through the Yellow Pages for other companies that I could sell the program to. I called the vice president of marketing at United Van Lines and told him I thought he should have the first shot at buying our services. He agreed to meet the next day. He loved the materials so much that he immediately placed an order for 10,000 tapes, books, and related services-it was a $1 million sale. I was ecstatic. Two days later, however, he called me back with terrible news. "We've decided to develop this internally," he told me. "We can't go forward with the order." Unfortunately, I didn't have a signed contract.
Shortly afterward, Herring flew to a relocation conference being held in Florida-her last hope-but after arriving, she learned she couldn't actively market to any of the participants. There, after three fruitless days walking the
floors of the conference hall, she finally met a top Johnson & Johnson executive who was literally walking out the door. Intrigued with her new (but still untested) service, he invited Herring to come to his office to make a presentation. "Gary Gorran," Herring concludes, "was the J&J executive. He became our first client, and thirteen years later he is still one of our best and largest clients."
When asked about how this and other difficult experiences affected her, Herring replies: "The other day I took my young niece to a club I belong to in St. Louis. When we walked in, a lot of people came over and greeted me. My niece was a bit shocked-she said to me, 'Everyone knows you-do you ever marvel at how far you've come? And I told her that I know what it's like to be invisible, and therefore I never take the end result for granted-you've got to earn it. There's always someone out there who is better and smarter than you are. There's always someone's uncle who knows more. You just have to keep driving toward your goals. I believe that failure is not a possibility."
Herring's account, and how it steeled rather than diminished her resolve and determination, is typical of great professionals. Consultant James Kelly tells another story of early-career trauma:
When I finished business school, Professor Dick Vancil hired me with the idea of building a faculty-based consulting firm [which under Kelly's leadership became the MAC Group, a $125 million strategy consul ting business]. The second year we did so well that we extended employment offers to a dozen top MBA graduates from around the country. But suddenly our backlog of business just died. It was early summer, and we were going to go bankrupt if we took on all these new hires. I had to call each one of them up, tell them what had happened, and rescind the offers. It was one of the worst days of my professional life.
Although it may seem that Kelly (who was twenty-six at the time) exercised poor judgment in hiring so many new people, he learned from the episode. He could have become gun-shy, retrenched, and never made a bold hiring move again. Instead, he assimilated the experience in a balanced, constructive way. His subsequent careful management of revenues, backlog, and professional staffing at the MAC Group resulted in twenty-five years of continual growth and profitability under his leadership-a far better record than most consulting firms can show.
Great Professionals Always View Old Clients As New Clients
A marriage requires constant work and investment--just ask any Couple that has successfully been together for fifteen or twenty years. When a couple divorces, the partners will often look back and describe a long period of mutual neglect prior to the eruption of real acrimony. If one spouse is working in a demanding occupation, for example, it may seem as if his or her job gets all the time and attention, leaving little energy for the other person.
The bases for successful marriages and successful long-term client relationships are similar. When you've been working with a client for many years, the tendency is to take each other for granted. If you're like the vast majority of professionals, most of your marketing and promotional resources go to new, prospective clients rather than to your existing clients. As benign neglect sets in, your long-term client may become intrigued by other professionals in your field competitors whose ideas seem newer and fresher, who are courting him aggressively. Just as in a marriage, the antidote to wandering clients is constant reinvestment that revitalizes the relationship.
When we look at professionals who have long-term, broad-based client relationships, who inspire great client loyalty, they all have a similar approach: they treat each assignment as if it were the first one for that client. They bring the same energy, creativity, and drive to their long-term clients as they do to the new client they are trying to impress. They communicate constantly, and the flow of ideas never stops. Even if they aren't working on an assignment for the client at that moment, they are in touch at least two or three times a year. The courtship, so to speak, never stops.
Great Professionals Engage in Continual Self-renewal
Most professionals focus on their income statement- their annual tally of expenses and revenues, leading to a figure that represents their total income for that year. This is true whether you work for a large firm or on your own. If you invested a lot in a client proposal that fell through, your year-end bonus may be reduced. If you sold a large piece of follow-on business, your bonus may be larger than usual. The focus is this year's sacrifices and rewards.
If you earnestly develop the attributes and outlooks we've been discussing, however, you will naturally build your balance sheet assets. Deep generalists, for example, make investments in learning and acquiring knowledge that may have no immediate payback but bring rewards two or three years down the road.
Your personal capital-the sum of your talents, skills, experiences, and knowledge-can be developed in many ways. This personal development can but doesn't have to occur through dramatic actions, such as taking a formal sabbatical or making a career change. Often, professionals embed it in their daily routines, indulging in leisurely reading, self-study, and the gradual cultivation of new areas of interest.
Harvard Law School professor Alan Dershowitz, for example, after writing a series of very successful nonfiction books, recently published his first novel. Renowned management consultant Ram Charan just followed up several years of work on how effective corporate boards function with a book on growth strategies. Although part of the pre-Internet generation, financial consultant Fred Brown is going up learning curve and setting up an interactive Web site, which may not yield significant results for a year or two, to extend the reach of a steep his innovative financial counseling.
How do you know when it's time to push into new areas? Peter Drucker counsels that it's time for a change "When the harder you work, the less you seem to accomplish-or when you're sure that you know all the answers, and you've stopped asking, 'What are the right questions?' "5
Just as successful professionals take a long-term view of client relationships, they also have a multiyear perspective on their own personal and professional development. They follow Thomas More's injunction to "live as if you are to die tomorrow, study as if you were to live forever." When you focus on building your balance sheet-on self-renewal- remember that your income statement may take some hits. This is why it's so important to cultivate qualities such as independence and conviction. Without them it will be difficult to navigate the inevitable squalls that are part of asset building.
Great professionals successfully develop and integrate the seven core attributes into a powerful whole, and then in-
The Ingredients for Breakthrough Relationships
Knowledge Depth and Breadth
Selfless .
Independence Abundance Empathy " '
The Soul of the Great Professional,
fuse everything they do with their soul of abundance, mission, and self-renewal. This combination of attributes and outlooks, summarized in the accompanying illustration, enables professionals to create broad-based, abiding client relationships that engender collaboration and insight.
TOPICS FOR DISSCUSSION
1. What happens when client loyalties shift unpredictably?
2. What do professionals focus on ?
3. Can you anticipate client needs?
4. What makes you a deep generalist?
5. How important is keen judgment?
6. Is overconfidence a judgment trap?
7. Can we use intuition to leverage facts and personal experience?
8. Do you have a good judgment?
9. What do the lack of trust in business and personal dealings entail?
10. How can you build trust in a low trusted world?
11. Can overconfidence be considered the most common judgment trap?
12. Can you be misled by experience?
13. How can you improve your own decision making ability?
ENLARGE ON:
1. A professional adviser should be independently wealthy; then he would be objective, independent.
2. The great client advisers are constant learners not wedded to past concepts, they help accelerate learning within the organizations they serve.
3. One cool judgment is worth a thousand hasty councils. The thing to do is to supply light and not heat.
4. Clients don't care why you let them down, they don't inform you when they stop trusting you.
5. Princes like to be helped, but not surpassed. When you counsel someone, you should appear to be reminding him of something he had forgotten, not the light he was unable to see.
Tips on Managing Relationship Value
If you want to keep a relationship on an even keel, manage it as you would any other activity that matters to you.
• Create trust. Trust is created when people see tangible evidence that one's words and actions are in harmony. So avoid making commitments you may be unable to honor, and always do what you have committed to do. Trust is also created when you acknowledge and demonstrate respect for the other party's core interests.
• Communicate. The different parties should communicate their interests, their capabilities, and their concerns to each other. For example, if you agreed to complete a customer survey for the marketing vice president within thirty days but have hit a logjam, communicate that information to him.
• Never sweep mistakes under the rug. Mistakes are bound to happen. Acknowledging and addressing them-quickly-is always the best course of action.
• Ask for feedback. If everything appears to be going as planned, never assume that the other side sees it the same way. Be proactive in uncovering problems. The other side will respect you for it. Ask questions such as these: "Is everything happening as you expected?" "Are the parts reaching your plant on schedule?" "Did my report cover all important points?"
Negotiation
Negotiation is a means by which people deal with their differences. Whether such differences involve the purchase of a new car, a labor contract dispute, the terms of a sale, a complex alliance between two companies or a peace accord, resolutions are sought through negotiations. To negotiate is to seek mutual agreement through dialogue.
Negotiation became an ever present feature of our lives both at home and at work.
A business negotiation may be a formal affair that takes place across the bargaining table where you haggle over price and performance or the complex terms of a partnership venture. It may be less formal such as a meeting between you and several employees whose collaboration is needed to get a job done. Whether a supervisor, manager or executive you will probably spend a good part of your day negotiating with people inside or outside your organization. If you are closing a sale or getting a subordinate to agree to certain performance goals you are negotiating too.
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The basic types of negotiation you're likely to encounter are the following:
• A distributive negotiation which pits two or more parties in competition for a fixed amount of value. Here, each side's goal is to claim as much value as possible, as in the sale of a rug at a street bazaar. Value gained by one party is unavailable to others.
• Integrative negotiation is about creating and claiming value. Through collaboration and information sharing, the parties look for opportunities to satisfy the key objectives of each, recognizing that they will probably have to give ground on other objectives.
• The negotiator's dilemma describes the situation faced by people who enter any type of bargaining situation. They must determine which game to play: aggressively claim the value currently on the table (and possibly come out the loser), or work with the other side to create even better opportunities that can be shared.
• No matter which type of negotiation you're faced with, it's bound to be more complex if it is multi phased or involves multiple parties. If your negotiation is multi phased, use the early phases to build trust and to become familiar with the other parties. If many parties are involved, consider the benefits of forming a coalition to improve your bargaining power.
When people don't have the power to force a desired outcome, they negotiate- but only when they believe it is to their advantage to do so. A negotiated solution is advantageous only under certain condition, that is when a better option is not available. Any successful negotiation must have a fundamental framework based on knowing the following: the alternative to negotiation, the minimum threshold for a negotiated deal, how flexible a party is willing to be and what trade offs it is willing to make. We consider three concepts important for establishing this framework: BATNA (best alternative to a negotiated agreement), reservation price and ZOPA (zone of possible agreement).
*BATNA is the best alternative to a negotiated agreement. It is one's preferred course of action in the absence of a deal. Knowing your BATNA means knowing what you will do or what will happen it you fail to reach agreement. Don't enter a negotiation without knowing your BATN A.
• It your BATNA is weak, do what you can to improve it. Anything that strengthens your BATNA improves your negotiating position.
• Identity the other side's BATNA. (Fit is strong, think of what you can do to weaken it.
* Reservation price is the price at which the rational negotiator will walk away. Don't enter a negotiation without a clear reservation price.
* Z0PA is the zone of possible agreement. It is the area in which a deal will satisfy all parties. This area exists when the parties have different reservation prices, as when a home buyer is willing to pay up to $275,000 and the home seller is willing to take an offer that is at least $250,000.
* Value creation through trades is possible when a party has something he or she values less than does the other party- and vice versa. By trading these values, the parties lose little but gain greatly.
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If your aim is to be an effective negotiator, take the time and make the effort needed to become fully prepared. There are nine preparatory steps:
1. Know what a good outcome would be from your point of view and that of the other side. Never enter into a negotiation without first asking yourself: what would be a good outcome for me? Then ask the same question from the perspective of the other side.
2. Look for opportunities to create value in the deal. You can identify areas of common ground, compromise, opportunities for favorable trades.
3. Know your BATNA and reservation price. Make an effort to estimate those benchmarks for the other side.
4. If your BATNA isn't strong, find ways to improve it. Good negotiators work to improve their BATNA before and during deliberations with the other side.
5. Find out if the person or team you're dealing with has the authority to make a deal. You find real advantages to negotiate with the person who has the power to sign on the dotted line: all of your reasoning is heard directly by the decision maker, the benefits of the good relationship build at the bargaining table are likely to be reflected in the deal and its implementation, there are fewer chances of disputes or misinterpretation of particular provisions..
6. Know those with whom you're dealing. Learn as much as you can about the people and the culture on the other side and how they've framed the issue.
7. If a future relationship with the other side matters, gather the external standards and criteria that will show your offer to be fair and reasonable.
8. Don't expect things to follow a linear path to a conclusion. Be prepared for bumps in the road and periodic delays.
9. Alter the agenda and process moves in your favor. Learning about the issues and about the other side is always limited by time, the cost of gathering information and the fact that some information will be deliberately hidden. We have to be prepared to learn as negotiations unfold.
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The first challenge in negotiation is to get the other side to the table.
This won't happen unless the other side sees that it is better off negotiating than going with the status quo. Encourage negotiation by uttering incentives, making the status quo expensive, and by enlisting the help of allies.
Once you've gotten the other side to the table, get things off to a good start by relieving tension, making sure that all parties agree with the agenda and the process, and setting the right tone.
Several tactics are particularly useful in distributed (or win-lose) deals:
* Establish an anchor, an initial position around which negotiations make adjustments.
" It an initial anchor is unacceptable to you, steer the conversation away from numbers and proposals. Focus instead on interests, concerns, and generalities. Then, after some time has passed and more information has surfaced, put your number or proposal on the table, and support it with sound reasoning.
* Make concessionary moves if you must. But remember, many interpret a large concessionary move as an indicator that you're capable of conceding still more. A small concession, on the other hand, is generally seen as an indication that the bidding is approaching the reservation price and that any succeeding concessions will be smaller and smaller.
Tactics for distributive (win-win) negotiations are fundamentally different from those just described since value creation is one of the goals. So concentrate on these tactics:
• Active listening: keep your eyes on the speaker, take notes as appropriate, don't allow yourself to think about anything but what the speaker is saying, resist the urge to formulate your response until after the speaker has finished, pay attention to the speaker's body language, ask questions to get more information and to encourage the speaker to continue, repeat in your own words what you've heard to ensure that you understand and to let the speaker know that you've processed his or her words.
• Exploiting complementary interests
• Packaging options for more favorable deals
Some of the questions in negotiation are organized under three categories: price, procedures, and people.
1. Should I ever state my acceptable range? (Some negotiators will ask you to state a monetary range of what you are willing to pay).
Should I tell the other side my real bottom line?(you can reveal your bottom line only if you've reached it)
2. Is it ever acceptable to bid against myself- to make two moves in a row? (Just say: wait, you seem to be asking me to make another move here. I made the last offer; I don't want to bid against myself; give me your offer).
3. Is it smart or fair to bluff?( as long as what you bring to the table has real value, you need not reveal all the circumstances that make you willing to conclude a deal. You may describe the major projects for which you have been responsible if negotiating the terms of a job offer)
4. Is it better to reach agreement issues by issue or wait until the end? (It's better to aim for tentative agreements or agreed upon ranges for each issue, one at a time).
5. Is it better to deal with difficult or easy issues first? (Dealing with easier issues will build momentum, deepen the parties' commitments to the process, enable the parties to become familiar with each other's negotiation and communication styles before hitting the tough stuff).
6. What if there is an unexpected turn in the road before or after an agreement? (You have to determine if a deal still makes sense or if you need to undo the deal that has been negotiated)
7. What happens when you pit a collaborative negotiator against a positional hard bargainer? (if the collaborative negotiator is effective, he should be able to tease out some of the interests underlying the hard bargainer's positions)
8. How should I respond if the other side seeks to change something in its offer after a deal has been reached? (express surprise or disappointment)
9. What should I do when the negotiator on the other side has a temper tantrum?(help him regain control, the right response will depend upon how angry or upset you feel, the value of the deal).
10. I don't believe what the other side is saying. What should I do?(you require that they provide back up documentation and that the deal be explicitly contingent on its accuracy)
11. When is it appropriate to negotiate, over the telephone or by e-mail? Or is it essential to insist on a face to face meeting? ( e-mail communication is devoid of emotions; for an inexperienced negotiator this can be a big plus)
12. How should I react when the other side challenges my credentials, status, authority to make a deal?(the best approach is to shift the discussion to general ground rules).
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Typical barriers to negotiated agreements and what you can do to overcome or eliminate them
• Die-hard bargainers will pull for every advantage and try to make every concession come from you. You can deal with these people if you understand the game they are playing, withhold useful information from them (they'll only use it against you) unless they demonstrate a willingness to reciprocate, and make it clear that you don't mind walking away. If you don't want to walk away-or cannot-do whatever you can to strengthen your position and your alternative to a deal.
• Lack of trust is a serious impediment to making a deal. Nevertheless, agreements are possible if you take precautions, require enforcement mechanisms, build incentives for compliance into the deal, and insist on compliance transparency.
• It's difficult to make a deal-and impossible to create value-in the absence of information. What are the other side's interests?
What does it have to offer? What is it willing to trade? Ironically, fear of advantaging the other side encourages parties to withhold the information needed to create value for both sides. Each is reluctant to be the first to open up. This is the negotiator's dilemma. The solution to this dilemma is cautious, mutual, and incremental information sharing.
Structural impediments include the absence of important parties at the table, the presence of others who don't belong there but get in the way, and lack of pressure to move toward an agreement. Remedies to these impediments were provided.
Spoilers are people who block or undermine negotiations. Several tips were offered for neutralizing or winning over these individuals, including the creation of winning coalitions.
Cultural and gender difference can be barriers to agreement, particularly when one of the parties brings to the table a set of assumptions that the other side fails to notice: assumptions about who will make key decisions, what is of value, and what will happen if agreement is reached. Negotiators who represent organizations with conflicting cultures (e.g., entrepreneurial versus bureaucratic) are also likely to experience problems in reaching agreements.
Communication problems can also create barriers .You can diffuse them by insisting that each team be led by an effective communicator and by practicing active listening, documenting progress as it is made, and establishing real dialogue between parties.
Dialogue can eliminate or lower all of the barriers.
Mental errors by negotiators can result in no deal or a bad deal.
• Escalation-that is, irrational escalation-is the continuation of a previously selected course of action beyond the point where it continues to makes sense. Some people commit this error because they cannot stand losing. Others fall prey to auction fever.
• Partisan perception is the psychological phenomenon that causes people to perceive truth with a built-in bias in their own favor or toward their own point of view.
• Irrational expectations are an error insofar as they eliminate zones of possible agreement.
1. Overconfidence in negotiating is dangerous. It encourages negotiators to overestimate their strengths and underestimate their rivals. It is reinforced by groupthink, a mode of thinking driven by consensus that tends to override the motivation to realistically appraise alternative courses of action. The antidote to both overconfidence and groupthink is to have one or more objective outsiders examine one's assumptions.
Unchecked emotions are frequently observed in business negotiations, and generally result in self-injury. Among the remedies recommended are a cooling-off period and the use of an objective moderator. In the absence of a moderator we have to do the following:
-determine what is making the other negotiator angry. What does this deal or this dispute mean to him? listen very carefully when he gets angry.
-respond to what appears to be the emotional problem.
-remember that people are most often angered and frustrated at a personal level by perceived deception, unfairness, humiliation or loss of pride and lack of respect. You can avoid these land mines by focusing discussion on the issues and the problems instead of on individuals and their personalities.
The relationship value that is part of so many of today's agreements, both between separate entities and between employees of the same organization.
• Flatter organizations and the desire of companies to build long-term links with suppliers are two important reasons why relationships matter in many of today's negotiations.
• Relationship value moderates extreme value-claiming behavior. Negotiating parties understand that trying too hard to claim value today will risk losing opportunities for claiming value in future transactions.
• Parties who perceive no relationship value will aggressively claim value.
• Even when both parties recognize a relationship value, there is likely to be an imbalance in how strongly each party feels about that value. This can lead to manipulation of the party to whom the relationship matters most.
• Negotiators must separate the deal from the broader relationship.
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People and organizations represent their own interests but in many other cases, they are represented by others. These others may be independent agents contracted to represent one of the parties. They may be non independent agents- employees- charged with representing their companies; or they may be officials of an organization whose responsibility is to represent the interests of their members.
• An agent is a person charged with representing the interests of another (a principal) in negotiations with a third party.
• People engage agents to represent them in negotiations when the agent has greater expertise and when they want to reduce the risk of damaging their relationship with the other side.
Information asymmetries, divided interests, and conflicts of interest are three important problems in the agent/principal relationship.
Information asymmetry means that one party has more information than the other. If the principal has much more information than the agent, the agent may have a difficult time representing the principal's interests; in the reverse situation, the agent may discover value-creating opportunities that the principal does not understand or appreciate.
Not every organization is of one mind as to its core interests. This fact puts those who represent the organization into a difficult position.
Principals face the problem of preventing agents from putting agent interests ahead of their own. Incentive systems that align the agent's interests with those of the principal can help, especially when combined with oversight and communication.
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It's one thing to develop one's individual negotiating skills. Developing the negotiating skills of an organization at many levels is a very different challenge, but one with great potential rewards.
• The discipline of continuous improvement can develop the effectiveness of an organization's internal capabilities and, over time, improve bottom-line results. This same discipline can be applied to the negotiation process.
• The first step toward continuous improvement in negotiations is to treat negotiation as a process with a fairly universal set of process steps: pre-negotiations, preparation, negotiations, agreement or non agreement, postmortem learning, and learning capture. Learning capture feeds back to the next negotiating experience. The second step is to organize to learn from the process as it takes place, and at the conclusion of the negotiation itself.
• An organization can improve its overall negotiating skill and turn that skill into an important capability by doing the following: providing training and preparation for negotiators, clarifying organizational goals and expectations from any agreement and clarifying when negotiators should walk away, insisting that every negotiating team develop a BATNA and work to improve it, developing mechanisms for capturing and reusing lessons learned from previous negotiations, and developing negotiating performance measures and linking them to rewards.
Because organizational competence is the sum of the competences of an organization's individual members, we have to know the characteristics of effective negotiators. These define the goals that management should aim for in developing organization-wide capabilities. An effective negotiator
• Aligns negotiating goals with organizational goals
• Prepares thoroughly and uses each negotiating phase to prepare further
• Uses negotiating sessions to learn more about the issues at stake and the other side's BATNA and reservation price
• Has the mental dexterity to identify the interests of both sides, and the creativity to think of value-creating options that produce win-win situations
• Can separate personal issues from negotiating issues
• Can recognize potential barriers to agreement
• Knows how to form coalitions
• Develops a reputation for reliability and trustworthiness
Difficulties in Communication
Communication is the medium of negotiation. You cannot make progress without it. Poor communication renders the simple treacherous and the difficult impossible. Communication problems cause deals to go sour and disputes to ripen. When you suspect that communication is causing the negotiation to go oft track, try the following tactics:
• Ask for a break. Replay in your mind what has been communicated, how, and by whom. Look for a pattern. Does the confusion or misunderstanding arise from a single issue? Were important assumptions or expectations not articulated? After the break, raise the ...
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Difficulties in Communication
Communication is the medium of negotiation. You cannot make progress without it. Poor communication renders the simple treacherous and the difficult impossible. Communication problems cause deals to go sour and disputes to ripen. When you suspect that communication is causing the negotiation to go oft track, try the following tactics:
• Ask for a break. Replay in your mind what has been communicated, how, and by whom. Look for a pattern. Does the confusion or misunderstanding arise from a single issue? Were important assumptions or expectations not articulated? After the break, raise the issue in a non accusatory way. Offer to listen while the other side explains its perspective on the issue. Listen actively acknowledging their point of view. Explain your perspective. Then, try to pinpoint the problem.
If the spokesperson of your negotiating team seems to infuriate the other side, have someone else act as spokesperson. Ask the other side to do the same if their spokesperson drives your people up the wall.
Jointly document progress as it is made. This is particularly important in multiphase negotiations. It will solve the problem of someone saying, "I don't remember agreeing to that."
In multiparty negotiations, certain stakeholders may prefer "no deal" as the outcome. They may have the power to block or sabotage your negotiations. They are called spoilers. They may have seats at the table or they may not. The president of the USA may negotiate a trade deal with a foreign nation, but two or three powerful senators may block ratification in Congress. An influential executive who has the ear of key board members can sometimes accomplish the same result. This barrier can be anticipated by identifying all key stakeholders, their respective interests and the power of each to affect the agreement and its implementation. Then it's important to identify potential spoilers and consider the necessity of sweetening the deal in a way that would neutralize their incentive to sabotage an agreement.
Many internal negotiations aim to create change within the organization; change is a necessary condition of vitality but it often creates winners and losers. And those who see themselves as potential losers do what they can to resist or undermine change. Some people enjoy advantages that they view as threatened by change. They may perceive change as a threat to their livelihoods, perks, workplace social arrangements, status in the organization. Anytime they expect resistance and possible sabotage. Resistance may be passive, in the form of non commitment to the goals and the process for reaching them, or active indirect opposition or subversion. Some tips for dealing with resistance and possible sabotage:
# always try to answer the question: where and how will this change create pain or loss in the organization?
# identify people who have something to lose and try to anticipate how they will respond.
# communicate the "why" of change to potential resisters.
# emphasize the benefits of change to potential resisters. Those benefits might be greater future job security, higher pay.
# help resisters find new roles that represent genuine contributions .
# remember that some resist change because it represents a loss of control over their daily lives. You can return some of that control by making them active partners in your change program.
# built a coalition with sufficient strength to overpower the spoilers.
The Power of Dialogue
Dialogue is a powerful mode of communication and an effective antidote to most, if not all, of the human barriers identified in this chapter. It is a time-tested communication form in which parties exchange views and ideas with the goal of reaching amicable agreement.
Dialogue is usually the very best way to peel back the layers of problems, bring undisclosed concerns to center stage, develop solutions, and reach common understandings.
Though the practice of dialogue between two or more individuals undoubtedly goes back into the mists of time, Plato, through his Socratic dialogues, helped the Western world appreciate its power. Plato's purpose was not to tell us what he thought directly, but to teach us how to toss ideas back and forth in a logical process that eventually leads to the truth and common understanding. That same logical process makes negotiations run more smoothly, draws out the best ideas, and builds agreement around them.
Dialogue can also help you give direction without telling people what to do in so many words-which is what managers in today's participatory organizations must learn to do. For such managers, negotiating with people is as important as directing them.
For example, instead of saying, "Have the inventory report on my desk at 3 P.M. tomorrow," try something like this:
Manager: What progress have you made on the inventory report?
Employee: It's almost ready. I only have one section to complete.
Manager: Good. Do you see any problem in getting it all wrapped up by tomorrow afternoon?
Employee: No, not if you need it by then.
Manager: Yes, I do need it by 3 P.M. at the latest.
Employee: You can count on it.
What works between managers and their people can also work between negotiating parties if they start slowly, practice active listening, and gradually develop the level of trust that problem solving requires.
TOPICS FOR DISCUSSION:
1. What are some of the impediments to making a deal?
2. Is information necessary in creating value?
3. What are spoilers?
4. Does dialogue help people give direction?
5. When do people negotiate?
6. How can you be more flexible in a negotiation?
7. Is it important to be prepared for changes on both sides: new people and unanticipated developments?
8. Have you ever felt that your ideas were ignored during meetings?
9. What happens when communication is poor?
10. What tactics can be useful in distributed deals?
11. What is the first challenge in negotiations?
12. Which are the most frequent errors made in dealings?
13. What does active listening help you to do?
14. Why is the two way exchange of information important?
15. What happens when one or another party has better alternatives elsewhere?
Accounting
The purpose of accounting is to provide information about the economic affairs of an organization. This information may be used in a number of ways: by the organization's managers to help them plan and control the organization's operations; by owners and legislative or regulatory bodies to help them appraise the organization's performance and make decisions as to its future; by owners, lenders, suppliers, employees, and others to help them decide how much time or money to devote to the organization; by governmental bodies to determine how much tax the organization must pay; and occasionally by customers to determine the price to be paid when contracts call for cost-based payments. Accounting provides information for all these purposes through the maintenance of files of data, analysis and interpretation of these data, and the preparation of various kinds of reports. Most accounting information is historical--that is, the accountant observes the things that the organization does, records their effects, and prepares reports summarizing what has been recorded; the rest consists of forecasts and plans for current and future periods. Accounting information can be developed for any kind of organization, not just for privately owned, profit-seeking businesses. One branch of accounting deals with the economic operations of entire nations.
COMPANY FINANCIAL STATEMENTS
Among the most common accounting reports are those sent to investors and others outside the management group. The reports most likely to go to investors are called financial statements, and their preparation is the province of the branch of accounting known as financial accounting. Three financial statements will be discussed: the balance sheet, the income statement, and the statement of cash flows.
The balance sheet.
A balance sheet describes the resources that are under a company's control on a specified date and indicates where these resources have come from. It consists of three major sections: (1) the assets: valuable rights owned by the company; (2) the liabilities: the funds that have been provided by outside lenders and other creditors in exchange for the company's promise to make payments or to provide services in the future; and (3) the owners' equity: the funds that have been provided by the company's owners or on their behalf. The list of assets shows the forms in which the company's resources are lodged; the lists of liabilities and the owners' equity indicate where these same resources have come from. The balance sheet, in other words, shows the company's resources from two points of view, and the following relationship must always exist: total assets equals total liabilities plus total owners' equity. This same identity is also expressed in another way: total assets minus total liabilities equals total owners' equity. In this form, the equation emphasizes that the owners' equity in the company is always equal to the net assets (assets minus liabilities). Any increase in one will inevitably be accompanied by an increase in the other, and the only way to increase the owners' equity is to increase the net assets. Assets are ordinarily subdivided into current assets and noncurrent assets. The former include cash, amounts receivable from customers, inventories, and other assets that are expected to be consumed or can be readily converted into cash during the next operating cycle (production, sale, and collection). Noncurrent assets may include noncurrent receivables, fixed assets (such as land and buildings), and long-term investments. The liabilities are similarly divided into current liabilities and noncurrent liabilities. Most amounts payable to the company's suppliers (accounts payable), to employees (wages payable), or to governments (taxes payable) are included among the current liabilities. Noncurrent liabilities consist mainly of amounts payable to holders of the company's long-term bonds and such items as obligations to employees under company pension plans. The difference between total current assets and total current liabilities is known as net current assets, or working capital. The owners' equity of an American company is divided between paid-in capital and retained earnings. Paid-in capital represents the amounts paid to the corporation in exchange for shares of the company's preferred and common stock. The major part of this, the capital paid in by the common shareholders, is usually divided into two parts, one representing the par value, or stated value, of the shares, the other representing the excess over this amount. The amount of retained earnings is the difference between the amounts earned by the company in the past and the dividends that have been distributed to the owners. A slightly different breakdown of the owners' equity is used in most of continental Europe and in other parts of the world. The classification distinguishes between those amounts that cannot be distributed except as part of a formal liquidation of all or part of the company (capital and legal reserves) and those amounts that are not restricted in this way (free reserves and undistributed profits). The income statement is usually accompanied by a statement that shows how the company's retained earnings has changed during the year. Net income increases retained earnings; net operating loss or the distribution of cash dividends reduces it.
The statement of cash flows.
Companies also prepare a third financial statement, the statement of cash flows. Cash flows result from three major groups of activities: (1) operating activities, (2) investing activities, and (3) financing activities. The income statement differs from the cash flow statement in other ways, too. Cash was received from the issuance of bonds and was paid to shareowners as dividends; neither of those figured in the income statement. Cash was also paid to purchase equipment; this added to the plant and equipment asset but was not subtracted from current revenues because it would be used for many years, not just this one. Cash from operations is not the same as net income (revenues minus expenses). For one thing, not all revenues are collected in cash. Revenue is usually recorded when a customer receives merchandise and either pays for it or promises to pay the company in the future (in which case the revenue is recorded in accounts receivable). Cash from operating activities, on the other hand, reflects the actual cash collected, not the inflow of accounts receivable. Similarly, an expense may be recorded without an actual cash payment. The purpose of the statement of cash flows is to throw light on management's use of the financial resources available to it and to help the users of the statements to evaluate the company's liquidity, its ability to pay its bills when they come due.
Consolidated statements.
Most large corporations in the United States and other industrialized countries own other corporations. Their primary financial statements are consolidated statements, reflecting the total assets, liabilities, owners' equity, net income, and cash flows of all the corporations in the group. Thus, for example, the consolidated balance sheet of the parent corporation (the corporation that owns the others) does not list its investments in its subsidiaries (the companies it owns) as assets; instead, it includes their assets and liabilities with its own.
Some subsidiary corporations are not wholly owned by the parent; that is, some shares of their common stock are owned by others. The equity of these minority shareholders in the subsidiary companies is shown separately on the balance sheet. For example, if Any Company, Inc., had minority shareholders in one or more subsidiaries, the owners' equity section of its Dec. 31, 19--, balance sheet might appear as follows:
The consolidated income statement also must show the minority owners' equity in the earnings of a subsidiary as a deduction in the determination of net income. For example:
Disclosure and auditing requirements.
A corporation's obligations to issue financial statements are prescribed in the company's own statutes or bylaws and in public laws and regulations. The financial statements of most large and medium-size companies in the United States fall primarily within the jurisdiction of the federal Securities and Exchange Commission (SEC). The SEC has a good deal of authority to prescribe the content and structure of the financial statements that are submitted to it. Similar authority is vested in provincial regulatory bodies and the stock exchanges in Canada; disclosure in the United Kingdom is governed by the provisions of the Companies Act. A company's financial statements are ordinarily prepared initially by its own accountants. Outsiders review, or audit, the statements and the systems the company used to accumulate the data from which the statements were prepared. In most countries, including the United States, these outside auditors are selected by the company's shareholders. The audit of a company's statements is ordinarily performed by professionally qualified, independent accountants who bear the title of certified public accountant (CPA) in the United States and chartered accountant (CA) in the United Kingdom and many other countries with British-based accounting traditions. Their primary task is to investigate the company's accounting data and methods carefully enough to permit them to give their opinion that the financial statements present fairly the company's position, results, and cash flows.
MEASUREMENT PRINCIPLES
In preparing financial statements, the accountant has several measurement systems to choose from. Assets, for example, may be measured at what they cost in the past or what they could be sold for now, to mention only two possibilities. To enable users to interpret statements with confidence, companies in similar industries should use the same measurement concepts or principles. In some countries these concepts or principles are prescribed by government bodies; in the United States they are embodied in "generally accepted accounting principles" (GAAP), which represent partly the consensus of experts and partly the work of the Financial Accounting Standards Board (FASB), a private body. The principles or standards issued by the FASB can be overridden by the SEC. In practice, however, the SEC generally requires corporations within its jurisdiction to conform to the standards of the FASB.
Asset value.
One principle that accountants may adopt is to measure assets at their value to their owners. The economic value of an asset is the maximum amount that the company would be willing to pay for it. This amount depends on what the company expects to be able to do with the asset. For business assets, these expectations are usually expressed in terms of forecasts of the inflows of cash the company will receive in the future. If, for example, the company believes that by spending $1 on advertising and other forms of sales promotion it can sell a certain product for $5, then this product is worth $4 to the company. When cash inflows are expected to be delayed, value is less than the anticipated cash flow. For example, if the company has to pay interest at the rate of 10 percent a year, an investment of $100 in a one-year asset today will not be worthwhile unless it will return at least $110 a year from now ($100 plus 10 percent interest for one year). In this example, $100 is the present value of the right to receive $110 one year later. Present value is the maximum amount the company would be willing to pay for a future inflow of cash after deducting interest on the investment at a specified rate for the time the company has to wait before it receives its cash. Value, in other words, depends on three factors:
(1) the amount of the anticipated future cash flows,
(2) their timing, and (3) the interest rate. The lower the expectation, the more distant the timing, or the higher the interest rate, the less valuable the asset will be. Value may also be represented by the amount the company could obtain by selling its assets. This sale price is seldom a good measure of the assets' value to the company, however, because few companies are likely to keep many assets that are worth no more to the company than their market value. Continued ownership of an asset implies that its present value to the owner exceeds its market value, which is its apparent value to outsiders.
Asset cost.
Accountants are traditionally reluctant to accept value as the basis of asset measurement in the going concern. Although monetary assets such as cash or accounts receivable are usually measured by their value, most other assets are measured at cost. The reason is that the accountant finds it difficult to verify the forecasts upon which a generalized value measurement system would have to be based. As a result, the balance sheet does not pretend to show how much the company's assets are worth; it shows how much the company has invested in them. The historical cost of an asset is the sum of all the expenditures the company made to acquire it. This amount is not always easily measurable. If, for example, a company has built a special-purpose machine in one of its own factories for use in manufacturing other products, and the project required logistical support from all parts of the factory organization, from purchasing to quality control, then a good deal of judgment must be reflected in any estimate of how much of the costs of these logistical activities should be "capitalized" (i.e., placed on the balance sheet) as part of the cost of the machine.
Net income.
From an economic point of view, income is defined as the change in the company's wealth during a period of time, from all sources other than the injection or withdrawal of investment funds. Income is the amount the company could consume during the period and still have as much real wealth at the end of the period as it had at the beginning. For example, if the value of the net assets (assets minus liabilities) has gone from $1,000 to $1,200 during a period and dividends of $100 have been distributed, income measured on a value basis would be $300 ($1,200 minus $1,000, plus $100). Accountants generally have rejected this approach for the same reason that they have found value an unacceptable basis for asset measurement: Such a measure would rely too much on estimates of what will happen in the future, estimates that would not be readily susceptible to independent verification. Instead, accountants have adopted what might be called a transactions approach to income measurement. They recognize as income only those increases in wealth that can be substantiated from data pertaining to actual transactions that have taken place with persons outside the company. In such systems, income is measured when work is performed for an outside customer, when goods are delivered, or when the customer is billed. Recognition of income at this time requires two sets of estimates: (1) revenue estimates, representing the value of the cash that the company expects to receive from the customer; and (2) expense estimates, representing the resources that have been consumed in the creation of the revenues. Revenue estimation is the easier of the two, but it still requires judgment. The main problem is to estimate the percentage of gross sales for which payment will never be received, either because some customers will not pay their bills ("bad debts") or because they will demand and receive credit for returned merchandise or defective work. Expense estimates are generally based on the historical cost of the resources consumed. Net income, in other words, is the difference between the value received from the use of resources and the cost of the resources that were consumed in the process. As with asset measurement, the main problem is to estimate what portion of the cost of an asset has been consumed during the period in question. Some assets give up their services gradually rather than all at once. The cost of the portion of these assets the company uses to produce revenues in any period is that period's depreciation expense, and the amount shown for these assets on the balance sheet is their historical cost less an allowance for depreciation, representing the cost of the portion of the asset's anticipated lifetime services that has already been used. To estimate depreciation, the accountant must predict both how long the asset will continue to provide useful services and how much of its potential to provide these services will be used up in each period. Depreciation is usually computed by some simple formula. The two most popular formulas in the United States are straight-line depreciation, in which the same amount of depreciation is recognized each year, and declining-charge depreciation, in which more depreciation is recognized during the early years of life than during the later years, on the assumption that the value of the asset's service declines as it gets older. The role of the independent accountant (the auditor) is to see whether the company's estimates are based on formulas that seem reasonable in the light of whatever evidence is available and whether these formulas are applied consistently from year to year. Again, what is "reasonable" is clearly a matter of judgment. Depreciation is not the only expense for which more than one measurement principle is available. Another is the cost of goods sold. The cost of goods available for sale in any period is the sum of the cost of the beginning inventory and the cost of goods purchased in that period. This sum then must be divided between the cost of goods sold and the cost of the ending inventory:
Accountants can make this division by any of three main inventory costing methods: (1) first in, first out (FIFO), (2) last in, first out (LIFO), or (3) average cost. The LIFO method is widely used in the United States, where it is also an acceptable costing method for income tax purposes; companies in most other countries measure inventory cost and the cost of goods sold by some variant of the FIFO or average cost methods. Average cost is very similar in its results to FIFO, so only FIFO and LIFO need be described. Each purchase of goods constitutes a single batch, acquired at a specific price. Under FIFO, the cost of goods sold is determined by adding the costs of various batches of the goods available, starting with the oldest batch in the beginning inventory, continuing with the next oldest batch, and so on until the total number of units equals the number of units sold. The ending inventory, therefore, is assigned the costs of the most recently acquired batches. For example, suppose the beginning inventory and purchases were as follows:
The company sold 1,900 units during the year and had 1,100 units remaining in inventory at the end of the year. The FIFO cost of goods sold is:
The ending inventory consists of 1,100 units at a FIFO cost of $5.50 each (the price of the last 1,100 units purchased), or $6,050. Under LIFO, the cost of goods sold is the sum of the most recent purchase, the next most recent, and so on, until the total number of units equals the number sold during the period. In the example, the LIFO cost of goods sold is:
The LIFO cost of the ending inventory is the cost of the oldest units in the cost of goods available. In this simple example, assuming the company adopted LIFO at the beginning of the year, the ending inventory cost is the 1,000 units in the beginning inventory at $5 each ($5,000), plus 100 units from the first purchase during the year at $5.25 each ($525), a total of $5,525.
Problems of measurement.
Accounting income does not include all of the company's holding gains or losses (increases or decreases in the market values of its assets). For example, construction of a superhighway may increase the value of a company's land, but neither the income statement nor the balance sheet will report this holding gain. Similarly, introduction of a successful new product increases the company's anticipated future cash flows, and this increase makes the company more valuable. Those additional future sales show up neither in the conventional income statement nor in the balance sheet. Accounting reports have also been criticized on the grounds that they confuse monetary measures with the underlying realities when the prices of many goods and services have been changing rapidly. For example, if the wholesale price of an item has risen from $100 to $150 between the time the company bought it and the time it is sold, many accountants claim that $150 is the better measure of the amount of resources consumed by the sale. They also contend that the $50 increase in the item's wholesale value before it is sold is a special kind of holding gain that should not be classified as ordinary income. When inventory purchase prices are rising, LIFO inventory costing keeps many gains from the holding of inventories out of net income. If purchases equal the quantity sold, the entire cost of goods sold will be measured at the higher current prices; the ending inventory will be measured at the lower prices shown for the beginning-of-year inventory. The difference between the LIFO inventory cost and the replacement cost at the end of the year is an unrealized (and unreported) holding gain. In the inventory example cited earlier, the LIFO cost of goods sold ($10,275) exceeded the FIFO cost of goods sold ($9,750) by $525. In other words, LIFO kept $525 more of the inventory holding gain out of the income statement than FIFO did. Furthermore, the replacement cost of the inventory at the end of the year was $6,050 (1,100 $5.50), which was just equal to the inventory's FIFO cost; under LIFO, in contrast, there was an unrealized holding gain of $525 ($6,050 minus the $5,525 LIFO inventory cost). The amount of inventory holding gain that is included in net income is usually called the "inventory profit." The implication is that this is a component of net income that is less "real" than other components because it results from the holding of inventories rather than from trading with customers. When most of the changes in the prices of the company's resources are in the same direction, the purchasing power of money is said to change. Conventional accounting statements are stated in nominal currency units (dollars, francs, lire, etc.), not in units of constant purchasing power. Changes in purchasing power--that is, changes in the average level of prices of goods and services--have two effects. First, net monetary assets (essentially cash and receivables minus liabilities calling for fixed monetary payments) lose purchasing power as the general price level rises. These losses do not appear in conventional accounting statements. Second, holding gains measured in nominal currency units may merely result from changes in the general price level. If so, they represent no increase in the company's purchasing power. In some countries that have experienced severe and prolonged inflation, companies have been allowed or even required to restate their assets to reflect the more recent and higher levels of purchase prices. The increment in the asset balances in such cases has not been reported as income, but depreciation thereafter has been based on these higher amounts. Companies in the United States are not allowed to make these adjustments in their primary financial statements.
MANAGERIAL ACCOUNTING
Although published financial statements are the most widely visible products of business accounting systems and the ones with which the public is most concerned, they are only the tip of the iceberg. Most accounting data and most accounting reports are generated solely or mainly for the company's managers. Reports to management may be either summaries of past events, forecasts of the future, or a combination of the two. Preparation of these data and reports is the focus of managerial accounting, which consists mainly of four broad functions: (1) budgetary planning, (2) cost finding, (3) cost and profit analysis, and (4) performance reporting.
Budgetary planning.
The first major component of internal accounting systems for management's use is the company's system for establishing budgetary plans and setting performance standards. The setting of performance standards requires also a system for measuring actual results and reporting differences between actual performance and the plans.
Figure 1: Budget planning and performance reporting.
The simplified diagram in Figure 1 illustrates the interrelationships between these elements. The planning process leads to the establishment of explicit plans, which then are translated into action. The results of these actions are compared with the plans and reported in comparative form. Management can then respond to substantial deviations from plan, either by taking corrective action or, if outside conditions differ from those predicted or assumed in the plans, by preparing revised plans.
Although plans can be either broad, strategic outlines of the company's future or schedules of the inputs and outputs associated with specific independent programs, most business plans are periodic plans--that is, they refer to company operations for a specified period of time. These periodic plans are summarized in a series of projected financial statements, or budgets. The two principal budget statements are the profit plan and the cash forecast. The profit plan is an estimated income statement for the budget period. It summarizes the planned level of selling effort, shown as selling expense, and the results of that effort, shown as sales revenue and the accompanying cost of goods sold. Separate profit plans are ordinarily prepared for each major segment of the company's operations.
Figure 2: Relationship of company profit plan to responsibility structure.
The details underlying the profit plan are contained in departmental sales and cost budgets, each part identified with the executive or group responsible for carrying out that part. Figure 2 shows the essence of this relationship: the company's profit plan is really the integrated product of the plans of its two major product divisions. The arrows connecting the two divisional plans represent the coordinative communications that tie them together on matters of mutual concern. The exhibit also goes one level farther down, showing that division B's profit plan is really a coordinated synthesis of the plans of the division's marketing department and manufacturing department. Arrows again emphasize the necessary coordination between the two. Each of these departmental plans, in turn, is a summary of the plans of the major offices, plants, or other units within the division. A complete representation of the company's profit plan would require an extension of the diagram through several layers to encompass every single responsibility centre in the entire company. Many companies also prepare alternative budgets for operating volumes other than the volume anticipated for the period. A set of such alternative budgets is known as the flexible budget. The practice of flexible budgeting has been adopted widely by factory management to facilitate evaluation of cost performance at different volume levels and has also been extended to other elements of the profit plan. The second major component of the annual budgetary plan, the cash forecast or cash budget, summarizes the anticipated effects on cash of all the company's activities. It lists the anticipated cash payments, cash receipts, and amount of cash on hand, month by month throughout the year. In most companies, responsibility for cash management rests mainly in the head office rather than at the divisional level. For this reason, divisional cash forecasts tend to be less important than divisional profit plans. Company-wide cash forecasts, on the other hand, are just as important as company profit plans. Preliminary cash forecasts are used in deciding how much money will be made available for the payment of dividends, for the purchase or construction of buildings and equipment, and for other programs that do not pay for themselves immediately. The amount of short-term borrowing or short-term investment of temporarily idle funds is then generally geared to the requirements summarized in the final, adjusted forecast. Other elements of the budgetary plan, in addition to the profit plan and the cash forecast, include capital expenditure budgets, personnel budgets, production budgets, and budgeted balance sheets. They all serve the same purpose: to help management decide upon a course of action and to serve as a point of reference against which to measure subsequent performance. Planning is a management responsibility, not an accounting function. To plan is to decide, and only the manager has the authority to choose the direction the company is to take. Accounting personnel are nevertheless deeply involved in the planning process. First, they administer the budgetary planning system, establishing deadlines for the completion of each part of the process and seeing that these deadlines are met. Second, they analyze data and help management at various levels compare the estimated effects of different courses of action. Third, they are responsible for collating the tentative plans and proposals coming from the individual departments and divisions and then reviewing them for consistency and feasibility and sometimes for desirability as well. Finally, they must assemble the final plans management has chosen and see that these plans are understood by the operating executives.
Cost finding.
A major factor in business planning is the cost of producing the company's products. Cost finding is the process by which the company obtains estimates of the costs of producing a product, providing a service, performing a function, or operating a department. Some of these estimates are historical--how much did it cost?--while others are predictive--what will it cost? The basic principle in cost finding is that the cost assigned to any object--an activity or a product--should represent the amount of cost that object causes. The most fully developed methods of cost finding are used to estimate the costs that have been incurred in a factory to manufacture specific products. The simplest of these methods is known as process costing. In this method, the accountant first accumulates the costs of each separate production operation or process for a specified period of time. The total of these costs is then restated as an average by dividing it by the total output of the process during the same period. Process costing can be used whenever the output of individual processes is reasonably uniform or homogeneous, as in cement manufacturing, flour milling, and other relatively continuous production processes.
A second method, job order costing, is used when individual production centres or departments work on a variety of products rather than just one during a typical time period. Two categories of factory cost are recognized under this method: prime costs and factory overhead costs. Prime costs are those that can be traced directly to a specific batch, or job lot, of products. These are the direct labour and direct materials costs of production. Overhead costs, on the other hand, are those that can be traced only to departmental operations or to the factory as a whole and not to individual job orders. The salary of a departmental supervisor is an example of an overhead cost. Direct materials and direct labour costs are recorded directly on the job order cost sheets, one for each job. Although not traceable to individual jobs, overhead costs are generally assigned to them by means of overhead rates--i.e., the ratio of total overhead cost to total production volume for a given time period. A separate overhead rate is usually calculated for each production department, and, if the operations of a department are varied, it is often subdivided into a set of more homogeneous cost centres, each with its own overhead rate. Separate overhead rates are sometimes used even for individual processing machines within a department if the machines differ widely in such factors as power consumption, maintenance cost, and depreciation. Because output within a cost centre is not homogeneous, production volume must be measured by something other than the number of units of product, such as the number of machine hours or direct labour hours. Once the overhead rate has been determined, a provision for overhead cost can be entered on each job order cost sheet on the basis of the number of direct labour hours or machine hours used on that job. For example, if the overhead rate is $3 a machine hour and Job No. 7128 used 600 machine hours, then $1,800 would be shown as the overhead cost of this job. Many production costs are incurred in departments that don't actually produce goods or provide salable services. Instead, they provide services or support to the departments that do produce products. Examples include maintenance departments, quality control departments, and internal power plants. Estimates of these costs are included in the estimated overhead costs of the production departments by a process known as allocation--that is, estimated service department costs are allocated among the production departments in proportion to the amount of service or support each receives. The departmental overhead rates then include provisions for these allocated costs. A third method of cost finding, activity-based costing, is based on the fact that many costs are driven by factors other than product volume. The first task is to identify the activities that drive costs. The next step is to estimate the costs that are driven by each activity and state them as averages per unit of activity. Management can use these averages to guide its efforts to reduce costs. In addition, if management wants an estimate of the cost of a specific product, the accountant can estimate how many of the activity units are associated with that product and multiply those numbers by the average costs per activity unit.
For example, suppose that costs driven by the number of machine hours average $12 per machine hour, costs driven by the number of production batches average $100 a batch, and the costs of keeping a product in the line average $100 a year for each kind of material or component part used. Keeping in the line a product that is assembled from six component parts thus incurs costs of 6 $100 = $600 a year, irrespective of volume and even if the product is not made at all during the period. If annual production amounts to 10,000 units, the unit cost of product maintenance is $600/10,000 = $.06 a unit. If this product is manufactured in batches of 1,000 units, then batch-driven costs average $100/1,000 = $.10 a unit. And, if a batch requires 15 machine hours, hour-driven costs average 15 $12/1,000 = $.18 a unit. At the 10,000-unit volume, then, the cost of this product is $.06 + $.10 + $.18 = $.34 a unit plus the cost of materials. Product cost finding under activity-based costing is almost always a process of estimating costs before production takes place. The method of process costing and job order costing can be used either in preparing estimates before the fact or in assigning costs to products as production proceeds. Even when job order costing is used to tally the costs actually incurred on individual jobs, the overhead rates are usually predetermined--that is, they represent the average planned overhead cost at some production volume. The main reason for this is that actual overhead cost averages depend on the total volume and efficiency of operations and not on any one job alone. The relevance of job order cost information will be impaired if these external fluctuations are allowed to change the amount of overhead cost assigned to a particular job. Many systems go even farther than this. Estimates of the average costs of each type of material, each operation, and each product are prepared routinely and identified as standard costs. These are then readily available whenever estimates are needed and can also serve as an important element in the company's performance reporting system, as described below. Similar methods of cost finding can be used to determine or estimate the cost of providing services rather than physical goods. Most advertising agencies and consulting firms, for example, maintain some form of job cost records, either as a basis for billing their clients or as a means of estimating the profitability of individual jobs or accounts. The methods of cost finding described in the preceding paragraphs are known as full, or absorption, costing methods, in that the overhead rates are intended to include provisions for all manufacturing costs. Both process and job order costing methods can also be adapted to variable costing in which only variable manufacturing costs are included in product cost. Variable costs are those that will be greater in total in the upper portions of the company's normal range of volumes than in the lower portion. Total fixed costs, in contrast, are the same at all volume levels within the normal range. Unit cost under variable costing represents the average variable cost of making the product. The main argument for the variable costing approach is that average variable cost is more relevant to short-horizon managerial decisions than average full cost. In deciding whether to manufacture goods in large lots, for example, management needs to estimate the cost of carrying larger amounts of finished goods in inventory. More variable costs will have to be incurred to build the inventory to a higher level; fixed manufacturing costs presumably will be unaffected. Furthermore, when a management decision changes the company's fixed costs, the change is unlikely to be proportional to the change in volume; therefore, average fixed cost is seldom a valid basis for estimating the cost effects of such decisions. Variable costing eliminates the temptation to assume without question that average fixed cost can be used to estimate changes in total fixed cost. When variable costing is used, supplemental rates for fixed overhead production costs must be provided to measure the costs to be assigned to end-of-year inventories because generally accepted accounting principles in the United States and in most other countries require that inventories be measured at full product cost for external financial reporting.
Cost and profit analysis.
Accountants share with many other people the task of analyzing cost and profit data in order to provide guidance in managerial decision making. Even if the analytical work is done largely by others, they have an interest in analytical methods because the systems they design must collect data in forms suitable for analysis. Managerial decisions are based on comparisons of the estimated future results of the alternative courses of action that the decision maker is choosing among. Recorded historical accounting data, in contrast, reflect conditions and experience of the past. Furthermore, they are absolute, not comparative, in that they show the effects of one course of action but not whether these were better or worse than those that would have resulted from some other course. For decision making, therefore, historical accounting data must be examined, modified, and placed on a comparative basis. Even estimated data, such as budgets and standard costs, must be examined to see whether the estimates are still valid and relevant to managerial comparisons. To a large extent, this job of review and restatement is an accounting responsibility. Accordingly, a major part of the accountant's preparation for the profession is devoted to the study of methods and principles of analysis for managerial decision making.
Performance reporting.
Once the budgetary plan has been adopted, accounting's next task is to prepare information on the results of company activities and make it available to management. The manager's main interest in this information centres on three questions: Have his or her own actions had the results expected, and, if not, why not? How successful have subordinates been in managing the activities entrusted to them? What problems and opportunities seem to have arisen since the budgetary plan was prepared? For these purposes, the information must be comparative, relating actual results to the level of results that management regards as satisfactory. In each case, the standard for comparison is provided by the budgetary plan. Much of this information is contained in periodic financial reports. At the top management and divisional levels, the most important of these is the comparative income statement. This shows the profit that was planned for this period, the actual results received for this period, and the differences, or variances, between the two. It also gives an explanation of some of the reasons for the difference between a planned and an actual income. The report in this exhibit employs the widely used profit contribution format, in which divisional results reflect sales and expenses traceable to the individual divisions, with no deduction for head office expenses. Company net income is then obtained by deducting head office expenses as a lump sum from the total of the divisional profit contributions. A similar format can be used within the division, reporting the profit contribution of each of the division's product lines, with divisional headquarters expenses deducted at the bottom. By far the greatest number of reports, however, are cost or sales reports, mostly on a departmental basis. Departmental sales reports usually compare actual sales with the volumes planned for the period. Departmental cost performance reports, in contrast, typically compare actual costs incurred with standards or budgets that have been adjusted to correspond to the actual volume of work done during the period. This practice reflects a recognition that volume fluctuations generally originate outside the department and that the department head's responsibility is ordinarily limited to minimizing cost while meeting the delivery schedules imposed by higher management.
For example, a factory department's output consists entirely of a single product, with a standard materials cost of $3 a unit and standard labour cost of $16. Materials cost represents three pounds of raw materials at $1 a pound; standard labour cost is two hours of labour at $8 an hour. Overhead costs in the department are budgeted at $10,000 a month plus $2 a unit. Under normal conditions, volume is 7,000 units a month, but during October only 6,000 units were produced. The cost standards for the month would be as follows:
The actual cost this month was $17,850 for materials (17,000 pounds at $1.05), $101,250 for labour (12,500 hours at $8.10 an hour), and $23,000 for overhead. A summary report would show the following:
These variances may be analyzed even further in order to identify the underlying causes. The labour variance, for example, can be seen to be the result of both high wage rates ($8.10 instead of $8.00) and high labour usage (12,500 hours instead of 12,000). The factory accountant ordinarily would measure the effect of the rate change in the following way:
In most cases, the labour rate variance would not be reported to the department head, because it is not subject to his or her control. Standard costing systems no longer have the central importance they commanded in many industries up to the 1970s. One reason is that significant changes in management technology have shifted the focus of cost control from the individual production department to larger, more interdependent groups. Just-in-time production systems require changes in factory layouts to reduce the time it takes to move work from one station to the next. They also reduce the number of partly processed units at each work station, thereby requiring greater station-to-station coordination. At the same time, management's emphasis has shifted from cost control to cost reduction, quality enhancement, and closer coordination of production and customer deliveries. Most large manufacturing companies and many service companies have launched programs of total quality control and continuous improvement, and many have replaced standard costs with a more flexible approach using prior period results as current performance standards. Management is also likely to focus on the amount of system waste by identifying and minimizing activities that contribute nothing to the value that customers place on the product. Reducing set-up time, inspection time, and time spent moving work from place to place while maintaining or improving quality are some of the results of these programs. Advances in computer-based models have enabled companies to tie production schedules more closely to customer delivery schedules while increasing the rate of plant utilization. Some of these changes actually increase variances from standard costs in some departments but are undertaken because they benefit the company as a whole. The overall result is that control systems are likely to focus in the first instance on operational controls (real-time signals to operating personnel that some immediate remedial action is required), with after-the-fact analysis of results focusing on aggregate comparisons with past performance and the planned results of current improvement programs.
OTHER PURPOSES OF ACCOUNTING SYSTEMS
Accounting systems are designed mainly to provide information that managers and outsiders can use in decision making. They also serve other purposes: to produce operating documents, to protect the company's assets, to provide data for company tax returns, and, in some cases, to provide the basis for reimbursement of costs by clients or customers. The accounting organization is responsible for preparing documents that contain instructions for a variety of tasks, such as payment of customer bills or preparing employee payrolls. It also must prepare documents that serve what might be called private information purposes, such as the employees' own records of their salaries and wages. Many of these documents also serve other accounting purposes, but they would have to be prepared even if no information reports were necessary. Measured by the number of people involved and the amount of time required, document preparation is one of accounting's biggest jobs. Accounting systems must provide means of reducing the chance of losses of assets due to carelessness or dishonesty on the part of employees, suppliers, and customers. Asset protection devices are often very simple; for example, many restaurants use numbered meal checks so that waiters will not be able to submit one check to the customer and another, with a lower total, to the cashier. Other devices entail a partial duplication of effort or a division of tasks between two individuals to reduce the opportunity for unobserved thefts.
These are all part of the company's system of internal controls. Another important element in the internal control system is internal auditing. The task of internal auditors is to see whether prescribed data handling and asset protection procedures are being followed. To accomplish this, they usually observe some of the work as it is being performed and examine a sample of past transactions for accuracy and fidelity to the system. They may insert a set of fictitious data into the system to see whether the resulting output meets a predetermined standard. This technique is particularly useful in testing the validity of the programs that are used to process data through electronic computers. The accounting system must also provide data for use in the completion of the company's tax returns. This function is the concern of tax accounting. In some countries financial accounting must obey rules laid down for tax accounting by national tax laws and regulations, but no such requirement is imposed in the United States, and tabulations prepared for tax purposes often diverge from those submitted to shareholders and others. "Taxable income" is a legal concept rather than an accounting concept. Tax laws include incentives to encourage companies to do certain things and discourage them from doing others. Accordingly, what is "income" or "capital" to a tax agency may be far different from the accountant's measures of these same concepts. Finally, accounting systems in some companies must provide cost data in the forms required for submission to customers who have agreed to reimburse the companies for the costs they have incurred on the customers' behalf.
Banks and Banking
The principal types of banking in the modern industrial world are commercial banking and central banking. A commercial banker is a dealer in money and in substitutes for money, such as checks or bills of exchange. The banker also provides a variety of financial services. The basis of the banking business is borrowing from individuals, firms, and occasionally governments--i.e., receiving "deposits" from them. With these resources and also with the bank's own capital, the banker makes loans or extends credit and also invests in securities. The banker makes profit by borrowing at one rate of interest and lending at a higher rate and by charging commissions for services rendered. A bank must always have cash balances on hand in order to pay its depositors upon demand or when the amounts credited to them become due. It must also keep a proportion of its assets in forms that can readily be converted into cash. Only in this way can confidence in the banking system be maintained. Provided it honours its promises (e.g., to provide cash in exchange for deposit balances), a bank can create credit for use by its customers by issuing additional notes or by making new loans, which in their turn become new deposits. The amount of credit it extends may considerably exceed the sums available to it in cash. But a bank is able to do this only as long as the public believes the bank can and will honour its obligations, which are then accepted at face value and circulate as money. So long as they remain outstanding, these promises or obligations constitute claims against that bank and can be transferred by means of checks or other negotiable instruments from one party to another. These are the essentials of deposit banking as practiced throughout the world today, with the partial exception of socialist-type institutions. Another type of banking is carried on by central banks, bankers to governments and "lenders of last resort" to commercial banks and other financial institutions. They are often responsible for formulating and implementing monetary and credit policies, usually in cooperation with the government. In some cases--e.g., the U.S. Federal Reserve System--they have been established specifically to lead or regulate the banking system; in other cases--e.g., the Bank of England--they have come to perform these functions through a process of evolution. Some institutions often called banks, such as finance companies, savings banks, investment banks, trust companies, and home-loan banks, do not perform the banking functions described above and are best classified as financial intermediaries. Their economic function is that of channelling savings from private individuals into the hands of those who will use them, in the form of loans for building purposes or for the purchase of capital assets. These financial intermediaries cannot, however, create money (i.e., credit) as the commercial banks do; they can lend no more than savers place with them.
The development of banking systems
Banking is of ancient origin, though little is known about it prior to the 13th century. Many of the early "banks" dealt primarily in coin and bullion, much of their business being money changing and the supplying of foreign and domestic coin of the correct weight and fineness. Another important early group of banking institutions was the merchant bankers, who dealt both in goods and in bills of exchange, providing for the remittance of money and payment of accounts at a distance but without shipping actual coin. Their business arose from the fact that many of these merchants traded internationally and held assets at different points along trade routes. For a certain consideration, a merchant stood prepared to accept instructions to pay money to a named party through one of his agents elsewhere; the amount of the bill of exchange would be debited by his agent to the account of the merchant banker, who would also hope to make an additional profit from exchanging one currency against another. Because there was a possibility of loss, any profit or gain was not subject to the medieval ban on usury. There were, moreover, techniques for concealing a loan by making foreign exchange available at a distance but deferring payment for it so that the interest charge could be camouflaged as a fluctuation in the exchange rate. Another form of early banking activity was the acceptance of deposits. These might derive from the deposit of money or valuables for safekeeping or for purposes of transfer to another party; or, more straightforwardly, they might represent the deposit of money in a current account. A balance in a current account could also represent the proceeds of a loan that had been granted by the banker, perhaps based on an oral agreement between the parties (recorded in the banker's journal) whereby the customer would be allowed to overdraw his account. English bankers in particular had by the 17th century begun to develop a deposit banking business, and the techniques they evolved were to prove influential elsewhere. The London goldsmiths kept money and valuables in safe custody for their customers. In addition, they dealt in bullion and foreign exchange, acquiring and sorting coin for profit. As a means of attracting coin for sorting, they were prepared to pay a rate of interest, and it was largely in this way that they began to supplant as deposit bankers their great rivals, the "money scriveners." The latter were notaries who had come to specialize in bringing together borrowers and lenders; they also accepted deposits. It was found that when money was deposited by a number of people with a goldsmith or a scrivener a fund of deposits came to be maintained at a fairly steady level; over a period of time, deposits and withdrawals tended to balance. In any event, customers preferred to leave their surplus money with the goldsmith, keeping only enough for their everyday needs. The result was a fund of idle cash that could be lent out at interest to other parties. About the same time, a practice grew up whereby a customer could arrange for the transfer of part of his credit balance to another party by addressing an order to the banker. This was the origin of the modern check. It was only a short step from making a loan in specie or coin to allowing customers to borrow by check: the amount borrowed would be debited to a loan account and credited to a current account against which checks could be drawn; or the customer would be allowed to overdraw his account up to a specified limit. In the first case, interest was charged on the full amount of the debit, and in the second the customer paid interest only on the amount actually borrowed. A check was a claim against the bank, which had a corresponding claim against its customer. Another way in which a bank could create claims against itself was by issuing bank notes. The amount actually issued depended on the banker's judgment of the possible demand for specie, and this depended in large part on public confidence in the bank itself. In London, goldsmith bankers were probably developing the use of the bank note about the same time as that of the check. (The first bank notes issued in Europe were by the Bank of Stockholm in 1661.) Some commercial banks are still permitted to issue their own notes, but in most countries this has become a prerogative of the central bank. In Britain the check soon proved to be such a convenient means of payment that the public began to use checks for the larger part of their monetary transactions, reserving coin (and, later, notes) for small payments. As a result, banks began to grant their borrowers the right to draw checks much in excess of the amounts of cash actually held, in this way "creating money"--i.e., claims that were generally accepted as means of payment. Such money came to be known as "bank money" or "credit." Excluding bank notes, this money consisted of no more than figures in bank ledgers; it was acceptable because of the public's confidence in the ability of the bank to honour its liabilities when called upon to do so. When a check is drawn and passes into the hands of another party in payment for goods or services, it is usually paid into another bank account. Assuming that the overdraft technique is employed, if the check has been drawn by a borrower, the mere act of drawing and passing the check will create a loan as soon as the check is paid by the borrower's banker. Since every loan so made tends to return to the banking system as a deposit, deposits will tend to increase for the system as a whole to about the same extent as loans. On the other hand, if the money lent has been debited to a loan account and the amount of the loan has been credited to the customer's current account, a deposit will have been created immediately. One of the most important factors in the development of banking in England was the early legal recognition of the negotiability of credit instruments or bills of exchange. The check was expressly defined as a bill of exchange. In continental Europe, on the other hand, limitations on the negotiability of an order of payment prevented the extension of deposit banking based on the check. Continental countries developed their own system, known as giro payments, whereby transfers were effected on the basis of written instructions to debit the account of the payer and to credit that of the payee.
The business of banking
The business of banking consists of borrowing and lending. As in other businesses, operations must be based on capital, but banks employ comparatively little of their own capital in relation to the total volume of their transactions. The purpose of capital and reserve accounts is primarily to provide an ultimate cover against losses on loans and investments. In the United States capital accounts also have a legal significance, since the laws limit the proportion of its capital a bank may lend to a single borrower. Similar arrangements exist elsewhere.
FUNCTIONS OF COMMERCIAL BANKS
The essential characteristics of the banking business may be described within the framework of a simplified balance sheet. A bank's main liabilities are its capital (including reserves and, often, subordinated debt) and deposits. The latter may be from domestic or foreign sources (corporations and firms, private individuals, other banks, and even governments). They may be repayable on demand (sight deposits or current accounts) or repayable only after the lapse of a period of time (time, term, or fixed deposits and, occasionally, savings deposits). A bank's assets include cash (which may be held in the form of credit balances with other banks, usually with a central bank but also, in varying degrees, with correspondent banks); liquid assets (money at call and short notice, day-to-day money, short-term government paper such as treasury bills and notes, and commercial bills of exchange, all of which can be converted readily into cash without risk of substantial loss); investments or securities (substantially medium-term and longer term government securities--sometimes including those of local authorities such as states, provinces, or municipalities--and, in certain countries, participations and shares in industrial concerns); loans and advances made to customers of all kinds, though primarily to trade and industry (in an increasing number of countries, these include term loans and also mortgage loans); and, finally, the bank's premises, furniture, and fittings (written down, as a rule, to quite nominal figures). All bank balance sheets must include an item that relates to contingent liabilities (e.g., bills of exchange "accepted" or endorsed by the bank), exactly balanced by an item on the other side of the balance sheet representing the customer's obligation to indemnify the bank (which may also be supported by a form of security taken by the bank over its customer's assets). Most banks of any size stand prepared to provide acceptance credits (also called bankers' acceptances); when a bank accepts a bill, it lends its name and reputation to the transaction in question and, in this way, ensures that the paper will be more readily discounted.
Deposits.
The bulk of the resources employed by a modern bank consists of borrowed money (that is, deposits), which is lent out as profitably as is consistent with safety. Insofar as an increase in deposits provides a bank with additional cash (which is an asset), the increase in cash supplements its loanable resources and permits a more than proportionate increase in its loans. An increase in deposits may arise in two ways. (1) When a bank makes a loan, it may transfer the sum to a current account, thus directly creating a new deposit; or it may arrange a line of credit for the borrower upon which he will be permitted to draw checks, which, when deposited by third parties, likewise create new deposits. (2) An enlargement of government expenditure financed by the central bank may occasion a growth in deposits, since claims on the government that are equivalent to cash will be paid into the commercial banks as deposits. In the first instance, with the increase in bank deposits goes a related increase in the potential liability to pay out cash; in the second case, the increase in deposits with the commercial banks is accompanied by a corresponding increase in commercial bank holdings of money claims that are equivalent to cash. Taking one bank in isolation, an increase in its loans may result in a direct increase in deposits. This may occur either as a result of a transfer to a current account (as above) or a transfer to another customer of the same bank. Once again, there is an increase in the potential liability to pay out cash. On the other hand, if there has been an increase in loans by another bank (including an increase in central bank loans to the government), this may give rise to increased deposits with the first bank, matched by a corresponding claim to cash (or its equivalent). For these reasons a bank can generally expect that, if there is an increase in deposits, there will also be some net acquisition of cash or of claims for receipt of cash. It is in this way that an increase in deposits usually provides the basis for further bank lending. Except in countries where banks are small and insecure, banks as a whole can usually depend on their current account debits being largely offset by credits to current accounts, though from time to time an individual bank may experience marked fluctuations in its deposit totals, and all banks in a country may be subject to seasonal variations. Even when deposits are repayable on demand, there is usually a degree of inertia in the deposit structure that prevents sharp fluctuations; if money is accepted contractually for a fixed term or if notice must be given before its repayment, this inertia will be greater. On the other hand, if a significant proportion of total deposits derives from foreign sources, there is likely to be an element of volatility arising from international conditions. In banking, confidence on the part of the depositors is the true basis of stability. Confidence is steadier if there exists a central bank to act as a "lender of last resort." Another means of maintaining confidence employed in some countries is deposit insurance, which protects the small depositor against loss in the event of a bank failure. Such protection was the declared purpose of the "nationalization" of bank deposits in Argentina between 1946 and 1957; banks receiving deposits acted merely as agents of the government-owned and government-controlled central bank, all deposits being guaranteed by the state.
Reserves.
Since the banker undertakes to provide depositors with cash on demand or upon prior notice, it is necessary to hold a cash reserve and to maintain a "safe" ratio of cash to deposits. The safe ratio is determined largely through experience. It may be established by convention (as it was for many years in England) or by statute (as in the United States and elsewhere). If a minimum cash ratio is required by law, a portion of a bank's assets is in effect frozen and not available to meet sudden demands for cash from the bank's customers. In order to provide more flexibility, required ratios are frequently based on the average of cash holdings over a specified period, such as a week or a month. In addition to holding part of the bank's assets in cash, a banker will hold a proportion of the remainder in assets that can quickly be converted into cash without significant loss. No banker can safely ignore the necessity of maintaining adequate reserves of liquid assets; some prefer to limit the sum of loans and investments to a certain percentage of deposits, not allowing their loan-deposit ratio to run for any length of time at too high a level. Unless a bank held cash covering 100 percent of its demand deposits, it could not meet the claims of depositors if they were all to exercise in full and at the same time their rights to demand cash. If that were a common phenomenon, deposit banking could not long survive. For the most part, the public is prepared to leave its surplus funds on deposit with the banks, confident that they will be repaid if needed. But there may be times when unexpected demands for cash exceed what might reasonably have been anticipated; therefore, a bank must not only hold part of its assets in cash but also must keep a proportion of the remainder in assets that can be quickly converted into cash without significant loss. Indeed, in theory, even its less liquid assets should be self-liquidating within a reasonable time. A bank may mobilize its assets in several ways. It may demand repayment of loans, immediately or at short notice; it may sell securities; or it may borrow from the central bank, using paper representing investments or loans as security. Banks do not precipitately call in loans or sell marketable assets, because this would disrupt the delicate debtor-creditor relationships and increase any loss of confidence, probably resulting in a run on the banks. Ready cash may be obtainable in this way only at a very high price. Banks must either maintain their cash reserves and other liquid assets at a high level or have access to a "lender of last resort," such as a central bank, able and willing to provide cash against the security of eligible assets. In a number of countries, the commercial banks have at times been required to maintain a minimum liquid assets ratio. But central banks impose such requirements less as a means of maintaining appropriate levels of commercial bank liquidity than as a technique for influencing directly the lending potential of the banks. Among the assets of commercial banks, investments are less liquid than money-market assets such as call money and treasury bills. By maintaining an appropriate spread of maturities, however, it is possible to ensure that a proportion of a bank's investments is regularly approaching redemption, thereby producing a steady flow of liquidity and in that way constituting a secondary liquid assets reserve. Some banks, particularly in the United States and Canada, have at times favoured the "dumbbell" distribution of maturities, a significant proportion of the total portfolio being held in long-dated maturities with a high yield, a small proportion in the middle ranges, and another significant proportion in short-dated maturities. Following redemption, the banks usually reinvest all or most of the proceeds in longer-term maturities that in due course become increasingly short-term. Interest-rate expectations frequently modify the shape of a maturity distribution, and, in times of great uncertainty with regard to interest rates, banks will tend to hold the bulk of their securities at short term, and something like a T-distribution may then be preferred (mainly shorts, supported by small amounts of medium to longer dated paper). Investments and money-market assets merge into each other. The dividing line is arbitrary, but there is an essential difference: the liquidity of investments depends primarily on marketability (though sometimes it also depends on the readiness of the government or its agent to exchange its own securities for cash); the liquidity of money-market assets, on the other hand, depends partly on marketability but mainly on the willingness of the central bank to purchase them or accept them as collateral for a loan. This is why money-market assets are more liquid than investments.
INDUSTRIAL FINANCE
Long-term and medium-term lending.
Banks that do a great deal of long-term lending to industry must ensure their liquidity by maintaining relatively large capital funds and a relatively high proportion of long-term borrowings (e.g., time deposits, or issues of bonds or debentures), as well as valuing their investments very conservatively. Such banks, notably the French banques d'affaires and the German commercial banks, have developed special means of reducing their degree of risk. Every investment is preceded by a thorough technical and financial investigation. The initial advance may be an interim credit, later converted into a participation. Only when market conditions are favourable is the original investment converted into marketable securities, and an issue of shares to the public is arranged. One function of these banks is to nurse an investment along until the venture is well established. Even assuming its ultimate success, a bank may be obliged to hold such shares for long periods before being able to liquidate them. In addition, they often retain an interest in a firm as an ordinary investment as well as to ensure a degree of continuing control over it. The long-term provision of industrial finance in Britain and the Commonwealth countries is usually handled by specialist institutions, with the commercial banks providing only part of the necessary capital. In Japan the long-term financial needs of industry are met partly by special industrial banks (which also issue debentures as well as accepting deposits) and partly by the ordinary commercial banks. In Germany the commercial banks customarily handle long-term finance. Since World War II the commercial banks in the United States have developed the so-called term loan, especially for financing industrial capital requirements. The attempt to popularize the term loan began in the economic depression of the 1930s, when the banks tried to expand their business by offering finance for a period of years. Most term loans have an effective maturity of little more than five years, though some run for 10 years or more. They are usually arranged between the customer and a group of lending banks, sometimes in cooperation with other institutions such as insurance companies, and are normally subject to a formal term loan agreement. Banks in Britain, western Europe, the Commonwealth, and Japan began during the 1960s to give term loans both to industry and to agriculture.
Short-term lending.
Short-term loans are the core of the banking business even in countries where commercial banks make long-term loans to industry. Much short-term lending consists in the provision of working capital, but the banks also provide temporary finance for fixed capital development, aiding a customer until long-term finance can be found elsewhere. Much of this short-term lending is done by overdraft, particularly in the United Kingdom and a number of the Commonwealth countries, or by way of "current account lending" in many western European countries. The overdraft permits a depositor to overdraw an account up to an agreed limit. In theory, overdrafts are repayable on demand or after reasonable notice has been given, but often they are allowed to run on indefinitely, subject to a periodic review. An advance is reduced or repaid whenever the account is credited with deposits and recreated when new checks are drawn upon it, interest being paid only on the amount outstanding. An alternative method of short-term lending is to debit a loan account with the amount borrowed, crediting the proceeds to a current account; interest is usually payable on the whole amount of the loan, which normally is for a fixed period of time. (In Britain arrangements are sometimes more flexible, and the term of the loan may be set by oral agreement.) In a number of countries, including the United States, the United Kingdom, France, Germany, and Japan, short-term finance is often made available on the basis of discountable paper--commercial bills or promissory notes. Some of this paper is usually rediscountable at the central bank, thus becoming virtually a liquid asset, unlike a bank advance or loan. Credit may be offered with or without formal security, depending on the reputation and financial strength of the borrower. In many countries, a customer may use a number of banks, and these institutions usually freely exchange information about joint credit risks. In Britain and The Netherlands, however, most concerns tend to use a single banking institution for most of their needs.
Traditionally bankers took the view that the liabilities of a bank (in particular, its deposits) were more or less stable and concerned themselves primarily with the investment of these funds. Since the late 1950s and '60s, especially in North America and latterly in the United Kingdom, there has been a change in emphasis. Banks began to find it more difficult to obtain deposits. Interest rates rose to high levels, and banks were obliged to compete with each other and with other institutions for funds. At the same time, there was little point in paying a high rate of interest for money unless it could be employed profitably. Bankers began to relate the cost of borrowed money directly to the return on loans and investments. Previously the main limitation on a bank's expansion had been its ability to find profitable new business, but now the determining factor became the availability of funds to lend out. The essence of assets and liabilities management, as it came to be called, was deciding what kinds of new money to buy and what to pay for it. In the United States the liabilities side of bank balance sheets now included, inter alia, in much larger proportion than during the 1960s, repurchase agreements (under which securities are sold subject to an agreement to repurchase at a stated date), federal funds purchases (on the assets side, federal funds sales), excess balances of commercial banks and other depository institutions (regularly traded throughout the United States), negotiable certificates of deposit (which can be traded on a secondary market), and, for the larger banks, Eurocurrency borrowings, mostly Eurodollars (dollar balances held abroad). In the United Kingdom, "bought" money consisted of wholesale (i.e., large) deposits (on which money market rates were paid), negotiable certificates of deposit, interbank borrowings, and Eurocurrency purchases. This bought money could then be used to finance the loan demand, including term loans, long favoured in the United States but a more recent innovation in the United Kingdom and elsewhere, where they were developed considerably in the 1970s. Although much of the lending financed by bought money was by way of term loans, these could be "rolled over," with an interest rate adjustment, every three or six months, and there could therefore be a measure of interest-rate matching and also sometimes a matching of maturities. In less sophisticated environments than North America and the United Kingdom, there was again an increasing emphasis on bought money to meet any expansion in loan demands (much of which was now term lending), with an adjustment at the margin when more funds were needed--e.g., wholesale deposits, certificates of deposit, interbank borrowings, and purchases of Eurocurrencies.
The principles of central banking
The principles of central banking grew up in response to the recurrent British financial crises of the 19th century and were later adopted in other countries. Modern market economies are subject to frequent fluctuations in output and employment. Although the causes of these fluctuations are various, there is general agreement that the ability of banks to create new money may exacerbate them. Although an individual bank may be cautious enough in maintaining its own liquidity position, the expansion or contraction of the money supply to which it contributes may be excessive. This raises the need for a disinterested outside authority able to view economic and financial developments objectively and to exert some measure of control over the activities of the banks. A central bank should also be capable of acting to offset forces originating outside the economy, although this is much more difficult.
RESPONSIBILITIES OF CENTRAL BANKS
The first concern of a central bank is the maintenance of a soundly based commercial banking structure. While this concern has grown to comprehend the operations of all financial institutions, including the several groups of nonbank financial intermediaries, the commercial banks remain the core of the banking system. A central bank must also cooperate closely with the national government. Indeed, most governments and central banks have become intimately associated in the formulation of policy.
Relationships with commercial banks.
One source of economic instability is the supply of money. Even in relatively well-controlled banking systems, banks have sometimes expanded credit to such an extent that inflationary pressures developed. Such an overexpansion in bank lending would be followed almost inevitably by a period of undue caution in the making of loans. Frequently the turning point was associated with a financial crisis, and bank failures were not uncommon. Even today, failures occur from time to time. Such crises in the past often threatened the existence of financial institutions that were essentially sound, and the authorities sometimes intervened to prevent complete collapse. The willingness of a central bank to offer support to the commercial banks and other financial institutions in time of crisis was greatly encouraged by the gradual disappearance of weaker institutions and a general improvement in bank management. The dangers of excessive lending came to be more fully appreciated, and the banks also became more experienced in the evaluation of risks. In some cases, the central bank itself has gone out of its way to educate commercial banks in the canons of sound finance. In the United States the Federal Reserve System examines the books of the commercial banks and carries on a range of frankly educational activities. In other countries, such as India and Pakistan, central banks have also set up departments to maintain a regular scrutiny of commercial bank operations. The most obvious danger to the banks is a sudden and overwhelming run on their cash resources in consequence of their liability to depositors to pay on demand. In the ordinary course of business, the demand for cash is fairly constant or subject to seasonal fluctuations that can be foreseen. It has become the responsibility of the central bank to protect banks that have been honestly and competently managed from the consequences of a sudden and unexpected demand for cash. In other words, the central bank came to act as the "lender of last resort." To do this effectively, it was necessary that the central bank be permitted either to buy the assets of commercial banks or to make advances against them. It was also necessary that the central bank have the power to issue money acceptable to bank depositors. But if a central bank was to play this role with respect to commercial banks, it was only reasonable that it or some related authority be allowed to exercise a degree of control over the way in which the banks conducted their business. Most central banks now take a continuing day-to-day part in the operations of the banking system. The Bank of England, for example, has been increasingly in the market to ensure that the banks have a steady supply of cash, even during periods of credit restriction. It also lends regularly to the discount houses, supplementing their resources whenever the commercial banks feel the need to call back money they have on loan to them. In the United States the Federal Reserve System has operated in a similar way by buying and selling securities on the open market and by lending to dealers in government securities on the basis of repurchase agreements. The Federal Reserve may also discount paper submitted by the commercial banks through the Federal Reserve banks. The various techniques of credit control in use are discussed in greater detail below. The evolution of those working relations among banks implies a community of outlook that in some countries is relatively recent. The whole concept of a central bank as responsible for the stability of the banking system presupposes mutual confidence and cooperation. For this reason, contact between the central bank and the commercial banks must be close and continuous. The latter must be encouraged to feel that the central bank will give careful consideration to their views on matters of common concern. Once the central bank has formulated its policy after a full consideration of the facts and of the views expressed, however, the commercial banks must be prepared to accept its leadership. Otherwise, the whole basis of central banking would be undermined.
The central bank and the national economy.
Relationships with other countries.
Since no modern economy is self-contained, central banks must give considerable attention to trading and financial relationships with other countries. If goods are bought abroad, there is a demand for foreign currency to pay for them. Alternatively, if goods are sold abroad, foreign currency is acquired that the seller ordinarily wishes to convert into the home currency. These two sets of transactions usually pass through the banking system, but there is no necessary reason why, over the short period, they should balance. Sometimes there is a surplus of purchases and sometimes a surplus of sales. Short-period disequilibrium is not likely to matter very much, but it is rather important that there be a tendency to balance over a longer period, since it is difficult for a country to continue indefinitely as a permanent borrower or to continue building up a command over goods and services that it does not exercise. Short-period disequilibrium can be met very simply by diminishing or building up balances of foreign exchange. If a country has no balances to diminish, it may borrow, but normally it at least carries working balances. If the commercial banks find it unprofitable to hold such balances, the central bank is available to carry them; indeed, it may insist on concentrating the bulk of the country's foreign-exchange resources in its hands or in those of an associated agency. Long-period equilibrium is more difficult to achieve. It may be approached in three different ways: price movements, exchange revaluation (appreciation or depreciation of the currency), or exchange controls. Price levels may be influenced by expansion or contraction in the supply of bank credit. If the monetary authorities wish to stimulate imports, for example, they can induce a relative rise in home prices by encouraging an expansion of credit. If additional exports are necessary in order to achieve a more balanced position, the authorities can attempt to force down costs at home by operating to restrict credit. The objective may be achieved more directly by revaluing a country's exchange rate. Depending on the circumstances, the rate may be appreciated or depreciated, or it may be allowed to "float." Appreciation means that the home currency becomes more valuable in terms of the currencies of other countries and that exports consequently become more expensive for foreigners to buy. Depreciation involves a cheapening of the home currency, thus lowering the prices of export goods in the world's markets. In both cases, however, the effects are likely to be only temporary, and for this reason the authorities often prefer relative stability in exchange rates even at the cost of some fluctuation in internal prices.
Quite often governments have resorted to exchange controls (sometimes combined with import licensing) to allocate foreign exchange more or less directly in payment for specific imports. At times, a considerable apparatus has been assembled for this purpose, and, despite "leakages" of various kinds, the system has proved reasonably efficient in achieving balance on external payments account. Its chief disadvantage is that it interferes with normal market processes, thereby encouraging rigidities in the economy, reinforcing vested interests, and restricting the growth of world trade. Whatever method is chosen, the process of adjustment is generally supervised by some central authority--the central bank or some institution closely associated with it--that can assemble the information necessary to ensure that the proper responses are made to changing conditions.
Economic fluctuations.
As noted above, monetary influences may be an important contributory factor in economic fluctuations. An expansion in bank credit makes possible, if it does not cause, the relative overexpansion of investment activity characteristic of a boom. Insofar as monetary policy can assist in mitigating the worst excesses of the boom, it is the responsibility of the central bank to regulate the amount of lending by banks and perhaps by other financial institutions as well. The central bank may even wish to influence in some degree the direction of lending as well as the amount. An even greater responsibility of the central bank is that of taking measures to prevent or overcome a slump. Recessions, when they occur, are often in the nature of adjustments to eliminate the effects of previous overexpansion. Such adjustments are necessary to restore economic health, but at times they have tended to go too far; depressive factors have been reinforced by a general lack of confidence, and, once this has happened, it has proved extremely difficult to stimulate recovery. In these circumstances, prevention is likely to be far easier than cure. It has therefore become a recognized function of the central bank to take steps to preclude, if possible, any such general deterioration in economic activity.
For the central bank to be effective in regulating the volume and distribution of credit so that economic fluctuations may be damped, if not eliminated, it must at least be able to regulate commercial bank liquidity (the supply of cash and "near cash"), because this is the basis of bank lending. Monetary authorities in a number of countries have begun to resort increasingly to the management of monetary aggregates as a basic policy. This does not mean an uncritical acceptance of monetarist philosophy but rather what the U.S. economist and banker Paul A. Volcker has called "practical monetarism." In addition to the Federal Reserve in the United States, a growing number of western European countries have adopted the practice of setting growth targets for the money supply and sometimes other monetary targets as well (like domestic credit expansion), usually setting some range of allowable variation. Japan has had reservations and has preferred to indicate monetary projections or forecasts, partly because of the difficulty of changing a set target should it become necessary. Nor is there any great degree of consensus as to which target or aggregate to employ. In general terms, choice of a particular aggregate as a basis for reference would be linked to the theories--more or less explicit--on which the actions of a particular central bank are based and also on the state of the country's economy and its financial environment. Where there are publicly declared targets, these can have an important effect by the very fact of being announced. There is now little dispute about the broad objectives, though the techniques of control are various and depend to some extent on environmental factors. It would be incorrect to suppose, however, that the actions of the central bank can, unaided, achieve a high degree of stability. It can by wise guidance contribute to that end, but monetary action is in no sense a panacea; at all times, the degree to which it is likely to be effective depends on the provision of an appropriate fiscal environment
Banking services.
Another responsibility of the central bank is to ensure that banking services are adequately supplied to all members of the community that need them. Some areas of a country may be "under-banked" (e.g., the rural areas of India and the northern and more remote parts of Norway), and central banks have attempted, directly or indirectly, to meet such needs. In France, this need underlay the early extension of branches of the Bank of France to the départements. In India the authorities encouraged the opening of "pioneer" branches by the former Imperial Bank of India and its successor, the State Bank of India, latterly by all the nationalized banks, and particularly their extension to rural and semirural areas. In Pakistan, officials of the State Bank of Pakistan played an active part in the foundation of the semipublic National Bank of Pakistan with a similar objective in view. A different sort of problem arises when the business methods of existing banks are unsatisfactory. In such circumstances, a system of bank inspection and audit organized by the central banking authorities (as in India and Pakistan) or of bank "examinations" (as in the United States) may be the appropriate answer. Alternatively, the supervision of bank operations may be handed over to a separate authority, such as France's Banking Control Commission or South Africa's Registrar of Banks. In developing countries, central banks may encourage the establishment and growth of specialist institutions such as savings institutions and agricultural credit or industrial finance corporations. These serve to improve the mechanism for tapping existing liquid resources and to supplement the flow of funds for investment in specific fields.
Responsibilities to the government.
Central banks have over the years acquired a number of well-defined responsibilities to their respective national governments. Some, notably the Bank of England, developed into central banks after being, in origin, bankers to the government. More recently it has become a matter of course for a new central bank to accept responsibility for the financial affairs of its government. The reasons are self-evident. Government transactions have become of increasing importance in influencing the workings of the economy, and the institution that holds the government's account is in a strategic position to cushion the commercial banks against the impact of large movements of cash originating in this way. As banker to the government, furthermore, the central bank has an obvious responsibility to provide routine banking services, such as arranging loan flotations and supervising their service, renewal, and redemption. The central bank also usually issues the currency. Equally important are its responsibilities as an adviser on the probable monetary consequences of any proposed action. In this role the central bank should scrutinize the government's proposals with a certain amount of objectivity and state its point of view with vigour. One may cite a now-famous dictum of Montagu Norman as governor of the Bank of England:
I think it is of the utmost importance that the policy of the Bank and the policy of the Government should at all times be in harmony--in as complete harmony as possible. I look upon the Bank as having the unique right to offer advice and to press such advice even to the point of "nagging"; but always of course subject to the supreme authority of the Government.
Many central banks are now nationalized, reflecting the increasingly general recognition of the significance of the central bank's role as a servant, if not a creature, of the government. This development is also, in a way, a final recognition of the central bank as a responsible public institution whose major function is to serve the community as a whole, untrammelled by narrow dictates of profit and loss. Most central banks, nevertheless, make very handsome profits.
TECHNIQUES OF CREDIT CONTROL
Central banks have developed a variety of techniques for influencing, regulating, and controlling the activities of commercial banks. These may be divided into (1) the so-called classical, or indirect, techniques and (2) various direct controls. The classical techniques make use of open-market purchases or sales by the central bank of certain types of assets that are invariably associated with fluctuations in interest rates. Direct, or quantitative, credit controls are employed to influence the cash and liquidity bases of commercial bank lending by means of freezing or unfreezing their liquid resources; sometimes ceilings are imposed on bank loans.
Open-market operations.
The way in which open-market operations influence the cash reserves and, through them, the general liquidity of the commercial banks is essentially simple. If the central bank buys securities in the open market, the cash it offers in exchange adds to the reserves of the banks; if the central bank sells securities in the open market, the cash necessary to pay for them is either withdrawn from the banks' reserves or obtained by diminishing holdings of other assets (with the possibility of capital losses in consequence of these sales). It does not matter whether this buying and selling takes place between the central bank and the commercial banks directly or between the central bank and other financial sectors, including the public at large, since these are the customers of the commercial banks.
Open-market operations are invariably associated with related changes in one or more "strategic" rates of interest, the most influential of these rates being the minimum rate at which the central bank does business (the bank rate, or the discount rate), since other rates tend to move in sympathy with it. The central bank seeks to achieve an appropriate and consistent structure of interest rates. If a particular rate structure is desired (e.g., prior to a new issue of government securities or in order to change the emphasis of institutional investment between, say, long-term and short-term securities), it may be necessary to precondition the market by means of open-market operations. To achieve its purposes the central bank must possess (if it is selling) or be willing to absorb (if it is buying) the appropriate types of securities. In London the specialist banks known as discount houses effectively put to work the revolving fund of cash that circulates through the British banking system. If temporarily there is an inadequate supply of cash, the Bank of England either lends on a short-term basis or buys some of the assets held by the discount market. (From 1980 there was a shift in emphasis from lending to open-market operations, especially by dealing in bankers' acceptances.) Alternatively, the Bank of England may buy assets from the clearing banks (the large joint-stock banks), which then make the relevant moneys available to the market. On the other hand, if the discount market is oversupplied with funds, the Bank of England sells treasury bills, in this way mopping up the excess of cash. These transactions are known as smoothing-out operations. In addition, the Bank of England is also responsible for managing the national debt, and, whether the object is to influence the flows of money or not, such transactions in fact have monetary effects. In the United States the Federal Reserve System regulates the money supply. Within the Federal Reserve System, the Federal Open Market Committee is the most important single policy-making body. It is presided over by the chairman of the Board of Governors, with the president of the Federal Reserve Bank of New York as its permanent vice chairman. The main responsibility of the Open Market Committee is to decide upon the timing and amount of open-market purchases or sales of government securities. Since open-market operations must obviously be consistent with other aspects of monetary and credit policy, it is in the committee that broad agreement is reached on matters such as changes in discount rates or reserve requirements. One of the big differences between London and New York is that the central banking authorities in New York maintain direct relationships more or less continuously with the nonbank government securities dealers as well as with the commercial banks. The Federal Reserve Bank of New York may make temporary accommodation available to some 35 primary dealers (including certain banks) under a repurchase agreement, whereby securities are sold to the bank under an agreement that they be repurchased after a stipulated time. These agreements are made only for the purpose of supplying reserves to the banking system, but from the dealer's standpoint they are helpful in financing portfolios. Such repos, as they are called, may also be done with foreign official accounts. Since early 1966 the bank has also been prepared to mop up money by undertaking reverse repurchase agreements, in which the dealers act as intermediaries for large commercial banks with temporarily surplus money that they are prepared to place against bills, subject to the bank's repurchasing them a few days later; the commercial bank concerned lends the dealer the money to finance the holding of the bill. Similar arrangements are also made by the Federal Reserve directly with bank dealers. All member banks of the Federal Reserve System, and now also other depository institutions, have direct access to the discount service of their Federal Reserve Bank, of which there is one in each of 12 districts. This is a privilege, however, and not a right. In the early years of the system, the banks would sell discountable paper to the Federal Reserve, but now they usually borrow against a pledge of government securities held in safe custody with the Federal Reserve Bank in question. The Federal Reserve lends for a number of purposes but always at a time of general stress. It is assumed that, as the pressure abates, borrowing banks will repay their indebtedness as quickly as possible. Under ordinary conditions, the continuous use of Federal Reserve credit by a member bank over a considerable period is not regarded as appropriate.
Direct control of assets.
The so-called classical techniques of credit control--open-market operations and discount policy--can be employed only where there is a sufficiently developed complex of markets in which to buy and sell assets of the type that commercial banks ordinarily hold. Direct credit controls have a wider range of application. They may be used either as a substitute for the classical techniques or as a supplement to them. Direct controls are more likely to be resorted to when the money market is undeveloped, because then a central bank can only impose its authority by means of direct action. This is often the situation facing a newly established central bank. Rather than wait for the slow evolution of a money market, the authorities may provide the central bank from the start (as in Pakistan, the Philippines, Sri Lanka, and Malaysia) with very full powers to control the banking system. The aim in imposing a direct, quantitative regulation of credit is to curb inflationary pressures that may result from an expansion of commercial bank lending. This can be done in four main ways: (1) the commercial banks may be required to maintain stated minimum reserve ratios of cash to deposits, a stated liquid assets ratio, or some combination of both; (2) part of the cash resources of the commercial banks may be immobilized at the discretion of the central bank; (3) ceilings may be imposed on the amount of accommodation to be made available to the commercial banks at the central bank (sometimes referred to as "discount quotas"); and (4) a ceiling may be prescribed for commercial bank lending itself.
Minimum reserve requirements.
The variation of minimum cash reserve requirements as a direct means of quantitative credit control has become increasingly general in recent years. The practice has largely derived from experience in the United States. In its origin the U.S. insistence on stated minimum reserve requirements for commercial banks was simply a means of prescribing minimum standards of sound behaviour. Only later did such ratios come to be seen as a useful supplementary quantitative credit control. The power granted by the Banking Act of 1935 to the Federal Reserve System to determine the cash reserves of the commercial banks in the United States was employed for the first time during the boom of 1936-37, and periodic variation of minimum reserve requirements subsequently came to be recognized as an appropriate technique for controlling the money supply. The Federal Reserve Board's decisions were sometimes subject to considerable criticism, but, as it became more experienced in the use of this technique, variation in reserve requirements combined with other measures came to be regarded as a useful means of cushioning the economy against a recession. The variation of reserve requirements did not prove as effective in preventing inflation, largely because of the government's insistence that the Federal Reserve simultaneously support the prices of government bonds through open-market operations. This insistence was abandoned by the Treasury in March 1951. Since then, much greater emphasis has been placed on the use of open-market operations, which had become more effective, and the importance of varying minimum reserve requirements as a means of controlling the credit base has diminished in the United States. The technique is still widely used, however, in many countries. In some countries, the authorities require the maintenance of minimum liquid assets ratios. This is often combined with minimum requirements for cash reserves, as in India, Pakistan, and Germany, though not always (in France, for example, until 1967 there were no minimum cash reserve requirements). Where prescribed minima relate to liquid assets and not to cash as such, reserves are held in the form of earning assets--an important distinction from the point of view of the commercial banks. An important step toward a uniform and explicit minimum liquidity ratio for the London clearing banks was taken in 1951, when the governor of the Bank of England indicated to the banks that a liquidity ratio of from 32 to 28 percent would be regarded as normal and that it would be undesirable for the ratio to be allowed to fall below 25 percent. By 1957 a fairly rigid 30-percent minimum was in place (it was reduced to 28 percent in 1963). After 1946 the London clearing banks (but not the Scottish banks) also observed a more or less fixed cash ratio of 8 percent. A new element was introduced in 1960, when the Bank of England launched its system of "special deposits" as a means of reinforcing other methods of credit control. Calls were made from time to time on the London clearing banks to deposit with the Bank of England by a specified date some specified percentage of their gross deposits; similar arrangements applied to the Scottish banks, but the calls were smaller. This system lasted until 1971, when a new 12.5-percent minimum reserve ratio (excluding till cash) was introduced. This ratio related to "eligible liabilities" (primarily sterling deposits of up to two years maturity, including sterling certificates of deposit). The banks could also be required to place special deposits with the Bank of England. These arrangements were replaced in August 1981 by a voluntary holding of operational funds with the Bank of England by the London clearing banks ("for clearing purposes") and a uniform requirement of 0.5 percent of an institution's eligible liabilities that would be applied to all banks and licensed deposit-takers with eligible liabilities averaging more than 10,000,000. All banks that were eligible acceptors were also normally required to hold an average equivalent to 6 percent of their eligible liabilities either as secured money with discount houses or as secured call money with money brokers and gilt-edged jobbers, but the amount held in the form of secured money with a discount house was not normally to fall below 4 percent of eligible liabilities. This money became known as "club money." The use of variable minimum reserve requirements as a means of credit control can, if carried far enough, produce results, especially when the requirements include the holding of cash balances. It is more useful as an anti-inflationary weapon than as a means of countering recession, since it cannot overcome a possible unwillingness of the banks to lend or of their customers to borrow. It is a somewhat clumsy technique, however, and cannot make adequate allowance for the special needs of different institutions.
Immobilization of cash resources
A second group of direct quantitative credit controls involves keeping a portion of the cash resources of commercial banks immobilized at the discretion of the central bank. Two leading examples of this technique were the use of the Treasury Deposit Receipt (TDR) in the United Kingdom during and after World War II and the "special account procedure" adopted in Australia in 1941. Both were means of immobilizing the increased liquidity deriving from wartime government expenditure. The direct issue of Treasury Deposit Receipts at a nominal rate of interest to banks in the United Kingdom began in July 1940. They were not negotiable in the market or transferrable between banks, but they could be tendered in payment for government bonds (and tax certificates); hence, during the war years they had a limited degree of liquidity. The Bank of England communicated to the banks collectively the amount of the weekly call, which was divided among them in proportion to their deposits. After the war, TDR's were replaced by treasury bills; in order to reduce the consequent high liquidity of the banks, there was a "forced funding" of 1,000,000,000 of treasury bills in November 1951, which were required to be invested in Serial Funding Stocks. The special account procedure introduced in Australia in 1941 had a similar objective. The surplus investable funds of the Australian trading banks, defined as the amount by which each bank's total assets in Australia at any time exceeded the average of its total assets in Australia in August 1939, were required to be placed in special deposit accounts with the Commonwealth Bank (then the central bank) at a nominal rate of interest. A bank was not to withdraw any sum from its special account except with the consent of the Commonwealth Bank; during the war years, the bank generally directed the trading banks to lodge in their special accounts each month an amount equal to the increase in their total assets in Australia during the preceding month, although as a rule a lodgment was not required if it was known that a rise in assets would be followed by an early fall. Legislation in 1945 adopted the special account procedures as a means of general credit control (e.g., to curb inflation), but the provisions were made more flexible. In 1953 a more complicated formula was introduced, and in 1960 the system was abandoned in favour of minimum reserve ratios.
Direct control of loans.
Accommodation ceilings.
Some countries have tried limiting the amount of accommodation that the central bank may make available to the commercial banks. The difficulty in this type of quantitative credit control is to make it effective while also allowing for changes in the economy; its most obvious use is as a means of checking inflation, but, if the upward pressures on prices are strong, there is a temptation to increase the ceilings so that the restraint then becomes little more than a temporary check. Usually, it is only when a control begins to be felt and to affect bank profits that the banks become really sensitive to changes in credit policy and the implementation of the control becomes truly effective. The postwar experience of France is a case in point. Plafonds, or "ceilings," were first introduced in France in 1948. Rediscount ceilings (or discount quotas) were fixed for each bank, though some categories of paper were excluded. Ceilings could be increased or (after 1957) reduced. From the authorities' point of view, the chief difficulty in operating this control was the persistent building up of pressure against the ceilings. This was met partly by upward revisions in the ceilings themselves and partly by instituting a number of safety valves. The degree of elasticity required constituted the chief weakness of the ceiling technique. The central bank was constantly under pressure to adjust the ceilings upward. Some upward revisions were unavoidable, but the problem was to decide which claims were legitimate and which not. Much bilateral bargaining took place between the Bank of France and individual commercial banks, but the banks continued to complain that the strictness of the control was excessive and that the technique was lacking in flexibility. The inadequacies of the plafonds technique in its original form became apparent when prices began to rise rapidly during the Korean War boom, and even the built-in safety valves failed fully to accommodate the pressures on bank liquidity. The need to strengthen the mechanism was obvious, and this was attempted in 1951. Previously, rediscounts had frequently exceeded the ceilings during the month and were only brought within the plafonds by special action (e.g., through open-market purchases). The situation was brought under control by introducing a secondary ceiling to which a penalty rate of interest was applied. This was extended in 1958 to permit rediscounts even beyond the secondary ceiling, provided a further penalty was paid; each application, however, was scrutinized by the Bank of France. The system lasted until about the spring of 1964, though it did not finally disappear until 1968, when it was largely replaced by Bank of France operations in the open market. After early 1967, banks also were subject to minimum reserve requirements. Plafonds, or discount quotas, also are employed in Germany. They were introduced in West Germany in 1952 and strengthened in 1955. Quotas may be reduced periodically (after 1964 they were also used to discourage institutions from borrowing abroad). Again there were safety valves (although less generous than in France) and the possibility of extra accommodation (Lombard credits) at a higher rate. In some circumstances, supplementary quotas might be approved for up to six months. A bank might also raise funds through the money market, though likely at higher cost. Discount quotas are still an important tool of credit control in Germany. Other countries have employed this technique, including Sweden, where for a time the central bank imposed formal or informal ceilings on banks and sometimes on finance companies. If the banks failed to observe the ceiling, a penalty was applied based on the amount of the excess borrowing and its duration. In Finland, commercial banks have at times been able to borrow limited amounts from the Bank of Finland by way of traditional credit quotas. Beyond these quotas, funds could formerly be obtained as supra-quota credit at a higher rate, but banks now are forced into the official call-money market. Denmark, too, has permitted borrowing from the central bank in tranches, with higher (penalty) rates applying after the first tranche of the loan quota has been resorted to, a practice that can be expensive.
General ceilings on credit.
Attempts have been made to prescribe a general ceiling within which the quantity of commercial bank lending must be held. This is even more difficult to achieve. One example of such an attempt was the adoption of a "rising ceiling" by Chile in 1953. All banks were required not to expand the volume of their loans to businesses and individuals by more than 1.5 per-cent a month, using as their basis the average of a bank's advances on selected dates in 1953. Certain types of loans were forbidden, and bank resources were to be directed to productive and distributive activities that really contributed to the expansion of the national economy. Banks were also required to provide information on the destination of their loans. In succeeding years, adjustments were made on several occasions in the maximum permitted credit increase, expressed either as a percentage of advances or sometimes as a total for the banking system as a whole. In 1959 all quantitative credit restrictions were removed, and banks were permitted to advance funds up to their financial capacity, provided that they operated within the general banking law. There was no evidence the controls had been effective, but the major problem in Chile was budgetary rather than monetary. A temporary ceiling on loans was imposed by agreement in Canada (in 1951-52), The Netherlands (1957-58), and France (1958-59). The United Kingdom had considerable experience with this type of ceiling, introducing it as a temporary measure in 1955, when the banks were asked to bring their advances down by an average of 10 percent. Later an attempt was made to impose a true ceiling, requiring that bank advances not exceed the average of the period October 1956 to September 1957. This was continued until July 1958. Again, in 1961, the authorities indicated the banks must aim at checking the rate of rise in bank advances; this came to be interpreted as a request that the level of advances at the end of 1961 be no higher than in the previous June. The banks also were not to encourage an increase in the volume of commercial bills. The request was modified in May 1962 and largely withdrawn in October; but it was made again in May 1965, when the clearing banks were requested not to increase their advances to the private sector, at an annual rate of more than about 5 percent, in the 12 months to mid-March 1966 (likewise with commercial bills). Other financial institutions were requested to observe a comparable degree of restraint. For 12 months after March 1966, advances and discounts, allowing for seasonal factors, were not permitted to rise above levels set for March 1966. This represented an intensification of the credit squeeze because prices were rising. The credit restriction led to a falling off in business confidence, and, consequently, toward the end of 1966, bank lending was well below the official ceiling. In April 1967, authorities announced a change in techniques, with an emphasis on making calls to special deposits, but the ceilings returned again in November 1967. There was to be no increase in bank advances to the private sector (excluding exports and shipbuilding) except for seasonal reasons. In May 1968 a new ceiling was instituted for all such lending (including that for exports and shipbuilding); the clearing banks were asked to restrict the total of this lending, after seasonal adjustment, to 104 percent of the November 1967 figure, with priority to be given to finance for exports and for activities directly related to improving the balance of payments. The restrictions also extended to other types of credit. Credit became even tighter (in March 1969) when the ceiling was reduced to 98 percent of the November 1967 level. The banks had considerable difficulty in meeting this requirement and agreed merely to "do their best." Advances increased above the ceiling, and, as a penalty, the interest paid by the Bank of England on special deposits was halved. Not until late 1969 did it become clear that the authorities were prepared to abandon their long campaign to get bank loans down to the target figure. The ceiling was subsequently replaced by minimum reserve requirements. The system of quantitative credit control requires, for its successful implementation, the full cooperation of the banking community. In the United Kingdom, where banks base much of their lending on the overdraft technique, the system was very unpopular.
In France, however, the encadrement du crédit, as it is called, temporarily imposed in 1958-59, was revived during the first half of 1973. Subject to certain exclusions (e.g., certain investment credits, agricultural credits, export credits, the financing of energy savings and innovation, leasing transactions, and special medium-term construction loans), the mechanism chosen was to permit a certain percentage rate of growth in bank credits in relation to a particular month in the previous year, these limits being fixed quarterly and subject to variation from time to time. Subsequently, in early 1975, reference was made to a fixed base defined as equal to an index of 100, in relation to which the index might be increased (or decreased) and credit expanded (or contracted). The system was further refined to vary the rate of change of credits within different financial sectors, and it has been subject in the interests of flexibility to many amendments over the years. In effect, there has been a combination of quantitative and qualitative credit controls. In addition to regulating the quantity of credit, central banks have sometimes attempted to influence the directions in which the commercial banks lend. A loose system of control prevailed in the United Kingdom during World War II and afterward, based initially on directives from the Capital Issues Committee and later on requests from the Bank of England. A highly formalized technique was employed in Australia during the war and earlier postwar years; detailed and specific instructions were given to the trading banks, marginal cases being referred to the central bank. The system of Voluntary Credit Restraint in the United States in 1951 was similar. The more formal controls seemed to be no more effective than the looser system employed in the United Kingdom. Selective controls have been imposed on consumer installment finance in the United States and elsewhere (e.g., by stipulating the percentage of deposit that is required and the length of the term over which repayments may be made). Even when these are not varied in order to serve as a control over credit, there is a case for insisting on such requirements for prudential reasons. In the United States, under the Securities Exchange Act of 1934, the Federal Reserve can vary the margins that purchasers of securities must pay in cash, thereby limiting the credit available for this purpose.
The structure of modern banking systems
The banking systems of the world have many similarities, but they also differ, sometimes in quite material respects. The principal differences are in the details of organization and technique. The differences are gradually becoming less pronounced because of the growing efficiency of international communication and the tendency in each country to emulate practices that have been successful elsewhere. Banking systems may be classified in terms of their structure as unit banking, branch banking, or hybrids of the two. For example, unit banking prevails in large areas of the United States. In other countries it is more usual to find a small number of large commercial banks, each operating a highly developed network of branches. This is the system used in England and Wales, among others. Examples of hybrid systems include those of France, Germany, and India, where banks that are national in scope are supplemented by regional or local banks. Some of these hybrid systems are slowly changing their character, the banks becoming fewer in number and individually larger, with a larger number of branches.
UNIT BANKING: THE UNITED STATES
Bank organization in the United States during the years after World War II was still passing through a phase of structural development that many other countries had completed some decades earlier. Development in the United States has been subject to constraints not found elsewhere. The federal Constitution permits both the national and state governments to regulate banking. Some states prohibit branch banking, largely because of the political influence of small local bankers, thus encouraging the establishment and retention of a large number of unit banks. Even in its early years, the United States had an unusually large number of banks. As the frontiers of settlement were pushed rapidly westward, banks sprang up across the country. One reason for this was the demand for capital in the expanding frontier economy. There was also an obvious need for a large number of banks to serve the diverse and rapidly expanding demands of a growing and constantly migrating population. It must be remembered, too, that at this time communications between the frontiers of settlement and the established centres of commerce and finance were still inadequately developed.
As long as communications remained imperfect, the existence of large numbers of competing institutions is not difficult to explain. The subsequent failure of bank mergers or amalgamations to produce a concentration of financial resources in the hands of large banking units can be attributed in part to the character of the federal Constitution as noted above. Among the people, moreover, there was a widespread distrust of monopoly and a deep-rooted fear that a "money trust" might develop. This went hand in hand with a political philosophy that emphasized the virtues of individualism and free competition; restrictions on branching, merging, and on the formation of holding companies were a feature of both the state and the federal banking laws. Where permitted, however, bank branches are numerous in the United States (especially in California and in New York); in states in which branching is prohibited, one often finds local bank monopolies in small towns. Interstate banking is prohibited by federal law, but large banking organizations have provided financial services (e.g., through loan offices and offices of nonbank subsidiaries) for many years across state lines. A number of states have passed limited interstate or reciprocal banking laws, so that banks in other states with similar laws can acquire or merge with local banks. The banking system of the United States would not work without a network of correspondent bank relationships, which are more highly developed there than in any other country. From the 1970s there was an acceleration in the evolution of U.S. banking patterns. Unregulated financial institutions (and some nonfinancial institutions) moved into traditional banking activities; at the same time, depository institutions began offering a fuller range of financial services. Money-market mutual funds, for example, secured access to open-market interest rates for investors with relatively small amounts of money. Securities firms and insurance companies moved aggressively into providing a range of liquid financial instruments. Likewise, large manufacturing and retail firms moved into the commercial and retail lending businesses--e.g., by acquiring a savings and loan association, a securities brokerage house, an industrial loan company, a consumer banking business, or even a commercial bank. Meanwhile, depository institutions developed a number of new services, most notably the Negotiable Order of Withdrawal (NOW) account, an interest-bearing savings account with a near substitute for checks. These appeared first in 1972 in New England and after 1980 spread to the whole nation; they were offered both by commercial banks and by thrift institutions. Share drafts at credit unions also became a means of payment, and after 1978 the automatic transfer services of commercial banks permitted savings account funds to be transferred automatically to cover overdrafts in checking accounts. So-called Super-NOW accounts (with no interest rate ceilings and unlimited checking facilities with a minimum balance) were subsequently introduced, along with money-market deposit accounts, free of interest rate restrictions but with limited checking. Rapid changes in financial structure and the supply of financial services posed a host of questions for regulators, and, after much discussion, the Depository Institutions Deregulation and Monetary Control Act was passed in 1980. The object was to change some of the rules--many of them obsolete--under which U.S. financial institutions had operated for nearly half a century. The principal objectives were to improve monetary control and equalize more nearly its cost among depository institutions; to remove impediments to competition for funds by depository institutions, while allowing the small saver a market rate of return; and to expand the availability of financial services to the public and reduce competitive inequalities among financial institutions offering them. The major changes were: (1) Uniform Federal Reserve requirements were phased in on transaction accounts (demand deposits, NOW accounts, telephone transfers, automatic transfers, and share drafts) at all depository institutions--commercial banks (whether Federal Reserve members or not), savings and loan associations, mutual savings banks, and credit unions. (2) The Federal Reserve Board was authorized to collect all data necessary for the monitoring and control of money and credit aggregates. (3) Access to the discount window at Federal Reserve banks was widened to include any depository institution issuing transaction accounts or nonpersonal time deposits. (4) The Federal Reserve was to price its services, to which all depository institutions would now have access. (5) Regulation Q, which had long set interest-rate ceilings on deposits, was to be phased out over a six-year period. (6) An attempt was made to grasp the nettle of the state usury laws. (7) NOW accounts were authorized on a nationwide basis and could be offered by all depository institutions. Other services were extended. (8) The permissible activities of thrift institutions were broadened considerably. (9) Deposit insurance at commercial banks, savings banks, savings and loan associations, and credit unions was raised from $40,000 to $100,000. (10) The "truth in lending" disclosure and financial regulations were simplified to make it easier for creditors to comply.
BRANCH BANKING: THE UNITED KINGDOM
If the United States banks can be taken as representative of a unit banking system, the British system is the prototype of branch banking. Its development was linked to the growth of transportation and communications, for otherwise banks cannot clear checks drawn on other banks and effect remittances speedily and efficiently. The Scots favoured branch banking from the very beginning (the Bank of Scotland was founded in 1695), but at first they were not very successful--largely because of poor communications and the difficulty of supplying branches with adequate amounts of coin. Not until after the Napoleonic Wars, when the road system of Scotland had been greatly improved, did branch banking begin to develop vigorously there. As the Industrial Revolution progressed and as the size of businesses increased, the structure of English banking underwent a corresponding change. Greater resources were required for lending, and banks also needed more extensive interconnections in order to provide an increasing range of services. Where banks remained small, they were frequently unable to take the strain of the larger demand; they tended to become overextended and often failed.
The growth in size of banks was also greatly encouraged by legislation that encouraged joint-stock ownership, beginning in 1826. Joint-stock ownership, which reduced the risk to any individual, must be distinguished from limited liability, which did not become widely accepted until the failure of the City of Glasgow Bank in 1878 demonstrated the need for a legal device to protect the stockholder. The early joint-stock banks tended to remain localized in their business interests; it was only gradually (with the spread of limited liability and disclosure of accounts) that amalgamations began to convert the banking system in England and Wales into its highly concentrated modern form. The main movement was completed before World War I, though there was to be a further degree of concentration in the years after World War II. By these means, British banks were able to attract deposits from all parts of the country and to spread the banking risk over a wide range of industries and areas.
HYBRID SYSTEMS
A third group of banking systems differs from the unit banking system of the United States and also from the branch banking systems of countries that have followed the British model (such as Australia, Canada, New Zealand, and South Africa). This group is characterized by the existence of a small number of banks with branches throughout the country, holding a significant part of total deposits, along with a relatively large number of smaller banks that are regional or local in emphasis. Such systems exist in France, Germany, and India. Japan has a small number of large city banks with branch networks but a larger number of local banks.
France.
Banking institutions in France were classified after World War II into three main groups: deposit banks, banques d'affaires (or investment banks), and institutions that were either specialized or operated mainly outside France. New banking legislation in 1966 greatly reduced the importance of the distinction between deposit banks and banques d'affaires. There was also (1) a further concentration of banking resources, as a result of several large mergers and also of greater financial integration through share-exchange agreements and interlocking directorates, and (2) the conversion of a number of banques d'affaires into deposit banks, which hived off their investment interests into separate investment or holding companies. Further legislation in 1982 nationalized the remaining large and medium-sized banks (36 in all, plus two financial holding companies--those of Indosuez and Paribas); the largest deposit banks had already been nationalized after World War II. Another new law in 1984 abolished the old divisions between the several categories of banks, which were now defined simply as établissements de crédit, able to receive deposits from the public, undertake credit operations (including loans), and provide means of payment. The intention was to move cautiously toward a system of "universal banking." The new law was extended to cover the Caisse Nationale de Crédit Agricole, the banques populaires, the crédit mutuel, the central organizations of the cooperatives and the savings banks (and thereby institutions affiliated with them), and semipublic institutions like the Crédit Foncier and the Crédit National, but not the Caisse des Dépôts et Consignations nor the central banking institutions. All the regional banks and some local banks have branches. The balanced character of the regional economies often provides these banks with a good portfolio of risks; they serve not only a prosperous agriculture but also a number of local industries. Some of the local banks are also very sound institutions, despite their small size. The survival of a hybrid system in France, despite the long-run trend toward centralization, reflects certain characteristics of French society. These included, until recently, a strong emphasis on small business, together with a preference for individual and personal service. Particularism in some parts of France manifests itself in support for local institutions, and the local banker also often has the advantage of special knowledge of local industries and people, which makes possible the acceptance of risks that the big banks decline.
Germany.
An even more direct conflict between the forces favouring concentration and those working against it may be seen in Germany, where banking grew in the latter part of the 19th century along with industry. The banks were inclined to rely mainly on their own capital resources and did not at first try to attract deposits from the public. Not until 1874 did the Deutsche Bank A.G. begin to seek deposits through offices specially opened for the purpose. This was done to provide cheap finance for traders, the deposits being invested in mercantile bills that were regarded as both safe and liquid. In pursuit of deposits, the banks built up a widespread network of branch offices, which were also used to establish and maintain industrial contacts throughout the country. The unification of Germany in 1871 removed the political obstacles to a more integrated banking system, and the selection of Berlin as the capital made that city the country's financial centre. Four of the largest banks were already established there; the new Reichsbank was set up in 1876. In addition, the larger and more enterprising of the provincial banks were attracted to the capital. The Berlin stock exchange rapidly displaced that of Frankfurt am Main as the country's leading securities market. The Berlin banks extended their influence by developing correspondent relationships and subsequently by acquiring a financial interest in the provincial banks and being represented on their boards. Each of the big Berlin banks came to be associated with a group of provincial banks more or less under its control. At the same time, all of the banks, Berlin and provincial alike, expanded their business by opening branches. During World War I the degree of centralization increased; by 1918 the big Berlin banks held more than 65 percent of total deposits. In the early 1920s there were amalgamations, and branch systems became much larger. Bank failures and the financial crisis of 1931 resulted in further consolidation until the German banking system was dominated by three giants. But there were countervailing forces. Probably the most important of these was the establishment of publicly owned banking institutions, such as the communal savings banks and their central institutions, the Girozentralen, which became of increasing importance after World War II. German savings banks, which were permitted to have checks drawn on them from 1909 and which had giro clearing from the 1920s, now offer a wide range of services, especially to lower income groups and smaller businesses. The large commercial banks have concerned themselves more with big business and with wealthy individuals. The savings banks now compete in wholesale banking as well. A number of them, together with their Girozentralen, are to all intents and purposes "universal banks," like the Big Three and the larger regional banks. The Big Three (the Deutsche Bank, the Dresdner Bank, and the Commerzbank) remain unchallenged only in stock exchange and foreign banking business. Of the private bankers, only about a half-dozen are of any size. The bigger private banks are important in the fields of investment and wholesale banking, while the smaller ones flourish in the leading stock-exchange cities, such as Düsseldorf and Frankfurt am Main. Many of these private bankers, however, are not bankers in the true sense; they subsist mainly on stock-exchange transactions, investment services, portfolio management, and insurance and mortgage brokerage. There are also consumer finance institutions, mortgage and other specialist banks, and a large number of cooperatives. Regional and private banks are often within the sphere of influence of the Big Three. In some cases the latter have a financial interest in these banks, and in some cases they own them. The Big Three also have shares in certain of the private mortgage banks. There are also "cooperation agreements," and a number of mergers have taken place. In these several ways, much more integration exists than appears on the surface. While banking in Germany remains a hybrid system, a trend toward greater concentration is evident.
India.
Until the 1950s, banking in India was carried on by a large number of banks, many of them quite small. India is still primarily an agricultural country, with an economic and social structure based largely on the village. The integration of banking has been impeded by poor communications, by illiteracy, and by the barriers of language and caste. Banking and credit have remained largely in the hands of the so-called indigenous banker and the village moneylender. Although their influence has been greatly reduced in recent years, they still remain important in many an up-country area. The indigenous banker, who is also a merchant, offers genuine banking services: accepting deposits and remitting funds; making loans quickly and with a minimum of formality; and, by means of the hundi (a credit instrument in the form of a bill of exchange), financing a still significant, if declining, portion of India's internal trade and commerce. Efforts were made to eliminate the moneylender by developing a network of rural credit cooperatives. When progress proved to be slow, a more successful alternative was found in requiring banks to open "pioneer" branches in rural areas. The first branches were those of the semipublic Imperial Bank of India and its nationalized successor, the State Bank of India (and its subsidiaries). Many smaller banks began to disappear, sometimes by merger and sometimes as a result of failure. Between 1952 and 1967 the number of "reporting" banks fell from 517 to 90. Nationalized banks, including the State Bank of India and its seven subsidiaries, the 14 large commercial banks taken over in 1969, and the six additional banks nationalized in 1980, accounted for more than 90 percent of aggregate deposits in commercial banks. Banking services are also provided by chit funds, which accept and pay interest on monthly deposits against which it is possible to draw only by way of loan, and by Nidhis, mutual loan societies that have developed into semibanking institutions but deal only with their member shareholders. The main path of banking development in India is the expansion of bank branches into the under-banked areas. The authorities have sought to expand the number of branches but to avoid their concentration in the larger towns and cities and, in particular, to provide the rural areas with adequate facilities. The ultimate objective is to encourage the mobilization of deposits on a massive scale throughout the country, a formidable challenge in a country of 575,000 villages, and a stepping up of lending to weak sectors of the economy.
Japan.
Banking business in Japan is largely concentrated in the hands of the big banks (some of which are specialized), though a number of small banks still survive. The principal classes of banks are city banks and regional banks, but it should be noted that the distinction has no legal basis, though they are separately supervised. Both belong to the Federation of Bankers' Associations of Japan. The city banks service mainly manufacturing industry and commerce, particularly the big firms, while the regional banks are based on a prefecture, though some extend their operations into neighbouring prefectures, collecting deposits and lending to local businesses and smaller firms. The regional banks have city bank correspondents, not only to hold surplus balances but also for assistance in investing their funds, especially in the call-money market. In addition, a city bank may introduce certain of its large customers to a regional bank (e.g., a big company having a local factory). City correspondents in Japan do not, however, provide the wide range of ancillary services common in the United States. Since World War II there has been much stability in Japanese banking, but the city banks have suffered a relative decline in the importance of their business in competition with other institutions, especially the agricultural cooperatives, which attract the larger part of the Treasury's payments owing to government purchases of the rice crop. There has also been a relative increase in the importance of the life insurance companies and the trust funds, which have attracted sizable funds from the general public.
Insurance
Insurance is a method of coping with risk. Its primary function is to substitute certainty for uncertainty as regards the economic cost of loss-producing events. Insurance may be defined more formally as a system under which the insurer, for a consideration usually agreed upon in advance, promises to reimburse the insured or to render services to the insured in the event that certain accidental occurrences result in losses during a given period. Insurance relies heavily on the "law of large numbers." In large homogeneous populations it is possible to estimate the normal frequency of common events such as deaths and accidents. Losses can be predicted with reasonable accuracy, and this accuracy increases as the size of the group expands. From a theoretical standpoint, it is possible to eliminate all pure risk if an infinitely large group is selected. From the standpoint of the insurer, an insurable risk must meet the following requirements:
1. The objects to be insured must be numerous enough and homogeneous enough to allow a reasonably close calculation of the probable frequency and severity of losses.
2. The insured objects must not be subject to simultaneous destruction. For example, if all the buildings insured by one insurer are in an area subject to flood, and a flood occurs, the loss to the insurance underwriter may be catastrophic.
3. The possible loss must be accidental in nature, and beyond the control of the insured. If the insured could cause the loss, the element of randomness and predictability would be destroyed.
4. There must be some way to determine whether a loss has occurred and how great that loss is. This is why insurance contracts specify very definitely what events must take place, what constitutes loss, and how it is to be measured. From the viewpoint of the insured person, an insurable risk is one for which the probability of loss is not so high as to require excessive premiums. What is "excessive" depends on individual circumstances, including the insured's attitude toward risk. At the same time, the potential loss must be severe enough to cause financial hardship if it is not insured against. Insurable risks include losses to property resulting from fire, explosion, windstorm, etc.; losses of life or health; and the legal liability arising out of use of automobiles, occupancy of buildings, employment, or manufacture. Uninsurable risks include losses resulting from price changes and competitive conditions in the market. Political risks such as war or currency debasement are usually not insurable by private parties but may be insurable by governmental institutions. Very often contracts can be drawn in such a way that an "uninsurable risk" can be turned into an "insurable" one through restrictions on losses, redefinitions of perils, or other methods.
Insurance
Insurance is a method of coping with risk. Its primary function is to substitute certainty for uncertainty as regards the economic cost of loss-producing events. Insurance may be defined more formally as a system under which the insurer, for a consideration usually agreed upon in advance, promises to reimburse the insured or to render services to the insured in the event that certain accidental occurrences result in losses during a given period. Insurance relies heavily on the "law of large numbers." In large homogeneous populations it is possible to estimate the normal frequency of common events such as deaths and accidents. Losses can be predicted with reasonable accuracy, and this accuracy increases as the size of the group expands. From a theoretical standpoint, it is possible to eliminate all pure risk if an infinitely large group is selected. From the standpoint of the insurer, an insurable risk must meet the following requirements:
1. The objects to be insured must be numerous enough and homogeneous enough to allow a reasonably close calculation of the probable frequency and severity of losses.
2. The insured objects must not be subject to simultaneous destruction. For example, if all the buildings insured by one insurer are in an area subject to flood, and a flood occurs, the loss to the insurance underwriter may be catastrophic.
3. The possible loss must be accidental in nature, and beyond the control of the insured. If the insured could cause the loss, the element of randomness and predictability would be destroyed.
4. There must be some way to determine whether a loss has occurred and how great that loss is. This is why insurance contracts specify very definitely what events must take place, what constitutes loss, and how it is to be measured.
From the viewpoint of the insured person, an insurable risk is one for which the probability of loss is not so high as to require excessive premiums. What is "excessive" depends on individual circumstances, including the insured's attitude toward risk. At the same time, the potential loss must be severe enough to cause financial hardship if it is not insured against. Insurable risks include losses to property resulting from fire, explosion, windstorm, etc.; losses of life or health; and the legal liability arising out of use of automobiles, occupancy of buildings, employment, or manufacture. Uninsurable risks include losses resulting from price changes and competitive conditions in the market. Political risks such as war or currency debasement are usually not insurable by private parties but may be insurable by governmental institutions. Very often contracts can be drawn in such a way that an "uninsurable risk" can be turned into an "insurable" one through restrictions on losses, redefinitions of perils, or other methods.
Kinds of insurance
PROPERTY INSURANCE
Two main types of contracts--homeowner's and commercial--have been developed to insure against loss from accidental destruction of property. These contracts (or forms) typically are divided into three or four parts: insuring agreements, identification of covered property, conditions and stipulations, and exclusions.
Homeowner's insurance.
Homeowner's insurance covers individual, or nonbusiness, property. Introduced in 1958, it gradually replaced the older method of insuring individual property under the "standard fire policy."
Perils insured.
In homeowner's policies, of which there are several types, coverage can be "all risk" or "named peril." All-risk policies offer insurance on any peril except those later excluded in the policy. The advantage of these contracts is that if property is destroyed by a peril not specifically excluded the insurance is good. In named-peril policies, no coverage is provided unless the property is damaged by a peril specifically listed in the contract. In addition to protection against the loss from destruction of an owner's property by perils such as fire, lightning, theft, explosion, and windstorm, homeowner's policies typically insure against other types of risks faced by a homeowner such as legal liability to others for injuries, medical payments to others, and additional expenses incurred when the insured owner is required to vacate the premises after an insured peril occurs. Thus the homeowner's policy is multi-peril in nature, covering a wide variety of risks formerly written under separate contracts.
Property covered.
Homeowner's forms are written to cover damage to or loss of not only an owner's dwelling but also structures (such as garages and fences), trees and shrubs, personal property (excluding certain listed items), property away from the premises (such as boats), money and securities (subject to dollar limits), and losses due to forgery. They also cover removal of debris following a loss, expenditures to protect property from further loss, and loss of property removed from the premises for safety once an insured peril has occurred.
Limitations on amount recoverable.
Recovery under homeowner's forms is limited to loss due directly to the occurrence of an insured peril. Losses caused by some intervening source not insured by the policy are not covered. For example, if a flood or a landslide, which usually are excluded perils, severely damages a house that subsequently is destroyed by fire, the homeowner's recovery from the fire is limited to the value of the house already damaged by the flood or landslide.
Recovery under homeowner's forms may be on the basis of either full replacement cost or actual cash value (ACV). Under the former, the owner suffers no reduction in loss recovery due to depreciation of the property from its original value. This basis applies if the owner took out coverage that is at least equal to a named percentage--for example, 80 percent--of the replacement value of the property. If the insurance amount is less than 80 percent, a coinsurance clause is triggered, the operation of which reduces the recovery amount to the value of the loss times the ratio of the amount of insurance actually carried to the amount equal to 80 percent of the value of the property. However, the reduced recovery will not be less than the "actual cash value" of the property, defined as the full replacement cost minus an allowance for depreciation, up to the amount of the policy. For example, assume that a property is valued at $100,000 new, has depreciated 20 percent in value, insurance of $60,000 is taken, and a $10,000 loss occurs. The actual cash value of the loss is $8,000 ($10,000 minus 20 percent depreciation). The operation of the coinsurance clause would limit recovery to 6/8 of the loss, or $7,500. However, since the actual cash value of the loss is $8,000, this is the amount of the recovery. Recovery under homeowner's forms is also limited if more than one policy applies to the loss. For example, if two policies with equal limits are taken out, each contributes one-half of any insured loss. Loss payments also are limited to the amount of an insured person's insurable interest. Thus, if a homeowner has only a one-half interest in a building, the recovery is limited to one-half of the insured loss. The co-owners would need to have arranged insurance for their interest.
Excluded perils.
Among the excluded perils (or exclusions) of homeowner's policies are the following: loss due to freezing when the dwelling is vacant or unoccupied, unless stated precautions are taken; loss from weight of ice or snow to property such as fences, swimming pools, docks, or retaining walls; theft loss when the building is under construction; vandalism loss when the dwelling is vacant beyond 30 days; damage from gradual water leakage; termite damage; loss from rust, mold, dry rot, contamination, smog, and settling and cracking; loss from animals or insects; loss from earth movement, flood, war, or spoilage (e.g., chemical deterioration); loss from neglect of the insured to protect the property following a loss; and losses arising out of business pursuits. Special forms for business risks are available. Under named-peril forms, only losses from the perils named in the policy are covered. The named perils are sometimes defined narrowly; for example, theft claims are not paid if the property is merely lost and theft cannot be established. Earthquake and flood loss, while excluded from the basic homeowner's forms, may usually be covered by endorsement.
Conditions.
Homeowner's policies may include the following conditions: (1) Owners are required to give immediate written notice of loss to the insurer or the insurer's agent. (2) The insured must provide proof of the amount of loss. This suggests that owners should keep accurate records of the items in a building and of their original cost. (3) The insured must cooperate with the insurer in settling a loss. (4) The insured must pay the premium in advance. (5) The insurer has a right of subrogation (i.e., of pursuing liable third parties for any loss). This prevents an owner from collecting twice, once from the insurer and once from a liable third party. (6) A mortgagee's interest in a property can be protected. (7) The policy may be canceled by the insurer upon due notice, usually 10 days. If the insurer cancels, a pro rata refund of premium must be returned to the insured; if the insured cancels, a less-than-proportionate return of a premium may be recovered from the insurer. (8) Fraud by the insured, including misrepresentation or concealment of material facts concerning the risk, is ground for denial of benefits by the insurer. Also available is a form called renter's insurance, which provides personal property insurance for tenants.
Business property insurance.
Insurance for business property follows a pattern that is similar in many ways to the one for individual property. A commonly used form is the "building and personal property coverage form" (BPP). This form permits a business owner to cover in one policy the buildings, fixtures, machinery and equipment, and personal property used in business and the personal property of others for which the business owner is responsible. Coverage also can be extended to insure newly acquired property, property on newly acquired premises, valuable papers and records, property temporarily off the business premises, and outdoor property such as fences, signs, and antennas.
Direct losses.
Coverage on the BPP form can be written on a scheduled basis, whereby specific items of property are listed and insured, or on a blanket basis, whereby property at several locations can be insured for a single sum. Perils insured under the BPP are listed in the policy. All-risk coverage is also written, subject to specified exclusions. Losses may be settled on a replacement-cost coverage on the BPP by endorsement. Otherwise recovery is on an actual cash value basis that makes an adjustment for depreciation. Coverage for business personal property with constantly changing values is available on a reporting form. The business owner reports values monthly to the insurer and pays premiums based on the values reported. In this way, only the insurance actually needed is purchased.
Indirect losses.
An entirely different branch of the insurance business has been developed to insure losses that are indirectly the result of one of the specified perils. A prominent example of this type of insurance is business income insurance. The insurer undertakes to reimburse the insured for lost profits or for fixed charges incurred as a result of direct damage. For example, a retail store might have a fire and be completely shut down for one month and partially shut down for another month. If the fire had not occurred, sales would have been much higher, and therefore substantial revenues have been lost. In addition, fixed costs such as salaries, taxes, and maintenance must continue to be paid. A business income policy would respond to these losses. Forms of indirect insurance include the following: (1) contingent business income insurance, designed to cover the consequential losses if the plant of a supplier or a major customer is destroyed, resulting in either reduced orders or reduced deliveries that force a shutdown of the insured firm, (2) extra expense insurance, which pays the additional cost occasioned by having extra expenses to pay, such as rent on substitute facilities after a disaster, and (3) rent and rental value insurance, covering losses in rents that the owner of an apartment house may incur if the building is destroyed. Rental income insurance pays for rent lost when a peril destroys an owner's property that has been rented to others.
MARINE INSURANCE
Marine insurance is actually transportation insurance. After insurance coverage on ocean voyages had been developed, it was a natural step to offer insurance on inland trips. This branch of insurance became known as inland marine. In many policy forms, the distinction between inland and ocean marine has disappeared; it is common to cover goods from the time they leave the warehouse of the shipper, even if this warehouse is situated at a substantial distance from the nearest seaport, until they reach the warehouse of the buyer, which likewise may be located far inland.
Ocean marine insurance.
Ocean marine contracts are written to cover four major types of property interest: (1) the vessel or hull, (2) the cargo, (3) the freight revenue to be received by the ship owner, and (4) legal liability for negligence of the shipper or the carrier. Hull insurance covers losses to the vessel itself from specified perils. Usually there is a provision that the marine hull should be covered only within specified geographic limits. Cargo insurance is usually written on an open contract basis under which shipments, both incoming and outgoing, are automatically covered for the interests of the shipper, who reports periodically the values exposed and pays a premium based upon these values. By means of a negotiable open cargo certificate, which is attached to the bill of lading, insurance coverage is automatically transferred to whoever has legal title to the goods in the course of their movement from seller to buyer. Freight revenue may be insured in several different ways. If there is an obligation by the shipper to pay the carrier's freight bill regardless of whether the goods are delivered, the value of the freight is declared a part of the value of the cargo and is insured as part of this value. If the freight revenue is contingent upon safe delivery of the goods, the carrier insures the freight as a part of the regular hull coverage. Major clauses or provisions that are fairly standardized are (1) the perils clause, (2) the "running down" clause, or RDC, (3) the "free of particular average," or FPA, clause, (4) the general average clause, (5) the sue and labour clause, (6) the abandonment clause, (7) coinsurance, and (8) express and implied warranties. Each of these will be discussed in turn.
Perils clause.
Until 1978 the main insuring clause of modern ocean marine policies was preserved almost unchanged from the original 1779 Lloyd's of London form. The clause is as follows:
Touching the adventures and perils which we the assurers are contented to bear and do take upon us in this voyage: they are of the seas, men-of-war, fire, enemies, pirates, rovers, thieves, jettisons, letters of mart and countermart, surprisals, takings at sea, arrests, restraints, and detainments of all kings, princes, and people, of what nation, condition, or quality soever, barratry of the master and mariners, and of all other perils, losses, and misfortunes, that have or shall come to the hurt, detriment, or damage of the said goods and merchandises, and ship, etc., or any part thereof.
Although the clause reads as if it were an all-risk agreement, courts have interpreted it to cover only the perils mentioned. Essentially, the clause insures the voyage from perils "of" the sea. Perils on the sea, such as fire, are not covered unless specifically mentioned. Furthermore, although the perils clause indicates coverage from "enemies, pirates, rovers, thieves," the policy does not cover losses from war. (War risk insurance is offered in some nations through governmental agencies.) In 1978, at the request of the UN Conference on Trade and Development, the 1779 language was modernized and a revised insuring clause was proposed. The new form restricts coverage on losses from poor packing, places the burden of proof of seaworthiness on the shipper rather than on the carrier, and excludes losses resulting from insolvency of the common carrier, with the burden of proof placed on the shipper that the carrier is financially sound. The revised form has not been adopted by all insurers.
RDC clause.
The RDC, or "running down" clause, provides coverage for legal liability of either the shipper or the common carrier for claims arising out of collisions. (Collision loss to the vessel itself is part of the hull coverage.) The RDC clause covers negligence of the carrier or shipper that results in damage to the property of others. A companion clause, the protection and indemnity clause (P and I), covers the carrier or shipper for negligence that causes bodily injury to others.
FPA clause.
The FPA, or "free of particular average," clause excludes from coverage partial losses to the cargo or to the hull except those resulting from stranding, sinking, burning, or collision. Under its provisions, losses below a given percentage of value, say 10 percent, are excluded. In this way the insurer does not pay for relatively small losses to cargo. The percentage deductible varies according to the type of cargo and its susceptibility to loss.
General average clause.
The general average clause in ocean marine insurance obligates the insurers of various interests to share the cost of losses incurred voluntarily to save the voyage from complete destruction. Such sacrifices must be made voluntarily, must be necessary, and must be successful. For example, if a shipper's cargo is voluntarily jettisoned in a storm in order to save the vessel from total loss, the general average clause requires the insurers of the hull and of all other cargo interests to make a contribution to the loss of the shipper whose goods were sacrificed. Other types of losses may also be covered. It has been held, for example, that losses suffered from efforts to put out a fire on shipboard, which result in damage to specific goods, can be included in a general average claim. Similarly, losses from salvage efforts to free a stranded vessel may qualify under a general average claim to which all interests must contribute.
Sue and labour clause.
The sue and labour clause requires the ship owner to make every attempt to reduce or save the exposed interests from loss. Under the terms of the clause, the insurer pays for any necessary costs incurred in carrying out the requirements of the sue and labour clause. Thus, if a ship is stranded, under the sue and labour clause the hull owner would be required to hire salvors to attempt to save the ship. Such expenses are paid even if the salvage attempts fail.
Abandonment clause.
If salvaging or rehabilitating a ship or cargo following a marine loss costs more than the goods are worth, the loss is said to be constructively total. Under such conditions, the ocean marine policy permits the insured to abandon the damaged ship or cargo to the insurer and make a claim for the entire value. In this case, the salvage belongs to the insurer, who may dispose of it in any way. Abandonment is not permitted in other forms of property insurance.
Coinsurance.
Although there is no coinsurance clause as such in the ocean marine policy, losses are settled as though a 100 percent coinsurance clause existed. Thus, if an insured takes out coverage equal to 50 percent of the true replacement cost of the goods, only 50 percent of any partial loss may be recovered.
Warranties.
In the field of ocean marine insurance there are two general types of warranties that must be considered: express and implied. Express warranties are promises written into the contract. There are also three implied warranties, which do not appear in written form but bind the parties nevertheless. Examples of expressed warranties are the FC&S warranty and the strike, riot, and civil commotion warranty. The FC&S, or "free of capture and seizure," warranty excludes war as a cause of loss. The strike, riot, and civil commotion warranty states that the insurer will pay no losses resulting from strikes, walkouts, riots, or other labour disturbances. The three implied warranties relate to the following conditions: seaworthiness, deviation, and legality. Under the first, the shipper and the common carrier warrant that the ship will be seaworthy when it leaves port, in the sense that the hull will be sound, the captain and crew will be qualified, and supplies and other necessary equipment for the voyage will be on hand. Any losses stemming from lack of seaworthiness will be excluded from coverage. Under the deviation warranty, the ship may not deviate from its intended course except to save lives. Clauses may be attached to the ocean marine policy to eliminate the implied warranties of seaworthiness or deviation. The implied warranty of legality, however, may not be waived. Under this warranty, if the voyage itself is illegal under the laws of the country under whose flag the ship sails, the insurance is void.
Inland marine insurance.
Although there are no standard forms in inland marine insurance, most contracts follow a typical pattern. They are usually written on a named-peril basis covering such perils of transportation as collision, derailment, rising water, tornado, fire, lightning, and windstorm. The policies generally exclude losses resulting from pilferage, strike, riot, civil commotion, war, delay of shipments, loss of markets, illegal trade, or leakage and breakage. The scope of inland marine is greatly extended by means of "floater" policies. These are used to insure certain types of movable property whether or not the property is actually in transit. Business floater policies are purchased by jewelers, launderers, dry cleaners, tailors, upholsterers, and other persons who hold the property of others while performing services. Personal property floaters are used to cover, on a comprehensive basis, any item of personal property owned by a private individual. They may also cover the property of visitors, or the property of servants while on the premises of the insured. They exclude certain types of property for which other contracts have been designed, such as automobiles, aircraft, motorcycles, animals, or business and professional equipment.
LIABILITY INSURANCE
Liability insurance arises mainly from the operation of the law of negligence. Individuals who, in the eyes of the law, fail to act reasonably or to exercise due care may find themselves subject to large liability claims. Court judgments have been issued for sums so large as to require a lifetime to pay. There are at least four major types of liability insurance contracts: (1) liability arising out of the use of automobiles, (2) liability arising out of the conduct of a business, (3) liability arising from professional negligence (applicable to doctors, lawyers, etc.), and (4) personal liability, including the liability of a private individual operating a home, carrying on sporting activities, and so on. Practically all liability contracts falling in these four categories have some common elements. One is the insuring clause, in which the insurer agrees to pay on behalf of the insured all sums that the insured shall become legally obligated to pay as damages because of bodily injury, sickness or disease, wrongful death, or injury to another person's property. The liability policy covers only claims that an insured becomes legally obligated to pay; voluntary payments are not covered. It is often necessary to resort to legal or court action to determine the amount of these damages, although in a vast majority of cases the damages are settled out of court by negotiation between the parties.
All liability insurance contracts contain clauses that obligate the insurer to conduct a court defense and to pay any settlement, including premiums on bonds, interest on judgments pending appeal, medical and surgical expenses that are necessary at the time of the accident, and other costs. Liability insurance has sometimes been termed defense insurance because of this provision. The insurer agrees to defend a suit even though it is false or fraudulent, so long as it is a suit stemming from a peril insured against. The insured is required to cooperate with the insurer in all court actions by appearing in court, if necessary, to give testimony.
Limits of liability.
Practically all liability insurance policies contain limitations on the maximum amount of a judgment payable under the contract. Further, the cost of defense, supplementary payments, and punitive damages may or may not be paid in addition to the judgment limits. Separate limits often apply to claims for property damage and bodily injury. An annual aggregate limit may also be purchased, which puts a maximum on the amount an insurer must pay in any one policy period. Limits may apply on a per-occurrence or a claims-made basis. In the former, which gives the most comprehensive coverage, the policy in force in year one covers a negligent act that took place in year one, no matter when a claim is made. If the policy is made on a claims-made basis, the insurance in force when a claim is presented pays the loss. Under this policy, a claim can be made for losses that occur during the policy period but have their origins in events preceding its starting date; the period of time before this date for which claims can be made is, however, restricted. For an additional premium the discovery period can be extended beyond the end of the policy period. The claims-made basis for liability insurance is considered much more restrictive than a per-occurrence policy. Liability insurance contracts have in common the fact that the definition of "the insured" is broad. An automobile liability policy, for example, includes not only the owner but anyone else operating the car with permission. In business liability insurance, all partners, officers, directors, or proprietors are covered by the policy regardless of their direct responsibility for any act of negligence. Other parties may be included for an extra premium. Another element common to all liability insurance policies is certain exclusions. Policies covering business activities almost invariably exclude liability arising out of the personal activities of the insured. Each kind of liability contract tends to exclude the liability for which another contract has been devised: a personal liability coverage in the homeowner's contract, for example, excludes automobile liability because a special contract has been created for this particular type of liability. Another common element in liability policies is subrogation: the insurer retains the right to bring an action against a liable third party for any loss this third party has caused.
Business liability insurance.
Business liability contracts commonly written include the following: liability of a building owner, landlord, or tenant; liability of an employer for acts of negligence involving employees; liability of contractors or manufacturers; liability to members of the public resulting from faulty products or services; liability as a result of contractual agreements under which liability of others is assumed; and comprehensive liability. The latter contract is designed to be broad enough to encompass almost any type of business liability, including automobiles. There has been increasing use of coverage for liability stemming from defective products, because some court judgments have awarded huge compensations. Business liability contracts may be written to cover loss even if the act that produced the claim was not accidental. The only requirement is that the result of the act be accidental or unintended. Thus if a contractor is making an excavation that produces large amounts of dust and this dust causes loss to neighbouring property, the contractor's liability policy would respond to claims for loss, even though the act that produced the dust was a deliberate act.
Professional liability insurance.
Known as malpractice, or errors-and-omissions, insurance, professional liability contracts are distinguished from general business liability policies because of the specialized nature of the liability. Professional persons requiring liability contracts include physicians and surgeons, lawyers, accountants, engineers, and insurance agents. Important differences between professional and other liability contracts are the following:
1. No distinction is made between bodily injury or property damage liability, and there is no limit on the number of claims per accident but rather a limit of liability per claim. This recognizes the fact that one negligent act on the part of a professional person may involve more than one party, each of whom could bring a legal action against the professional person. Thus a doctor might administer the wrong medicine to a number of patients, each of whom could bring a legal action.
2. Claims against a professional person may have an adverse effect upon his or her reputation. The policy therefore permits the insured to carry any action to court, since an out-of-court settlement might conceivably imply guilt in the eyes of the professional's public or clientele.
3. In professional liability insurance there is an exclusion for any agreement guaranteeing the result of any treatment. Suits stemming from clients' dissatisfaction with the service performed are thus not covered.
Personal liability insurance.
The most common form of personal liability insurance is issued as part of the homeowner's liability insurance policy. It is an all-risk agreement and contains relatively few exclusions. The policy covers any act of negligence of the insured or residents of the home that results in legal liability. It may also include medical payments insurance covering accidental injury to guests and other nonresidents without regard to the question of negligence.
Automobile insurance.
Nearly half of all property-liability insurance written in the United States is in the area of automobile insurance. Set up as a comprehensive contract in most parts of the world, automobile insurance covers liability, collision loss of the vehicle, all other types of loss (called comprehensive loss), and medical expenses incurred by the driver, passengers, and other persons. Coverage usually applies to anyone driving the car with permission of the owner. Thus, drivers are insured whether driving their own or someone else's car. Automobile liability coverage is mandated by law in many countries up to specified monetary limits. The policy states what happens if the driver is covered by other automobile policies that may cover the loss. It also covers the liability of persons, such as parents, who have legal responsibility for actions of the driver. Coverage includes legal defense costs, usually in addition to the policy liability limits. Many policies exclude coverage for the time the automobile is driven in a foreign country.
Theft insurance.
Theft generally covers all acts of stealing. There are three major types of insurance contracts for burglary, robbery, and other theft. Burglary is defined to mean the unlawful taking of property within premises that have been closed and in which there are visible marks evidencing forcible entry. Such narrow definition is necessary to restrict burglary coverage to a particular class of criminal act. Robbery is defined as that type of unlawful taking of property in which another person is threatened by either force or violence. In the robbery peril, therefore, the element of personal contact is necessary. Perhaps the most common of all burglary coverages is on safes. Often the loss in the form of damage to the safe itself from the use of explosives and other devices is as great as the loss of the money, jewelry, or securities it contains. Accordingly, the policy covers both types of claims. Another common burglary policy applies to mercantile open stock. In this type of policy, there is usually a limit applicable on any article of jewelry or any article contained in a showcase where susceptibility to loss is high. In order to prevent underinsurance, the mercantile open stock policy is usually written with a coinsurance requirement or with some minimum amount of coverage. Another common theft policy for business firms is a comprehensive crime contract covering employee dishonesty as well as losses on money and securities both inside and outside the premises, loss from counterfeit money or money orders, and loss from forgery. This policy is designed to cover in one package most of the crime perils to which an average business is subject. A broad form of crime protection for individuals is offered both as a separate contract and as part of a "homeowner's policy." It covers all losses of personal property from theft and mysterious disappearance.
Aviation insurance.
Aviation insurance normally covers physical damage to the aircraft and legal liability arising out of its ownership and operation. Specific policies are also available to cover the legal liability of airport owners arising out of the operation of hangars or from the sale of various aviation products. These latter policies are similar to other types of liability contracts. Perhaps the major underwriting problem is the "catastrophic" exposure to loss. The largest passenger aircraft may incur losses of $300,000,000 or more, counting both liability and physical damage exposures. The number of aircraft of any particular type is not large enough for the accurate prediction of losses, and each type of aircraft has its special characteristics and equipment. Thus a great deal of independent individual underwriting is necessary. Rate making is complex and specialized. It is further complicated by rapid technological change and by the constant appearance of new hazards. Policies are written to cover liability of the owner or operator for bodily injury to passengers or to persons other than passengers and for property damage. Medical costs, including loss of income, are usually paid to passengers suffering permanent total disability without the requirement of proving negligence. This type of coverage has been called admitted liability insurance.
Workers' compensation insurance.
Workers' compensation insurance, sometimes called industrial injury insurance, compensates workers for losses suffered as a result of work-related injuries. Payments are made regardless of negligence. The schedule of benefits making up the compensation is determined by statute. The scope of employment injury laws, originally limited to persons in forms of employment recognized as hazardous, has, as the result of associating the right to compensation with the existence of a contract of service, been gradually extended to clerical employment. Nevertheless, the large exception of agricultural employees continues in some Third World countries, Canada, much of the United States, and the countries of eastern Europe. Other classes of exception are employees in very small undertakings and domestic servants. The exclusion of employees with middle-class salaries persists in parts of the former British Empire. In a few countries, working employers are permitted to insure themselves as well as their employees. The notion of employment injury was at first confined to injuries of accidental origin, but during the 20th century it was extended to include occupational diseases in increasing number. To entitle the worker to benefit, the accident must occur during employment, and many laws also require the accident to have been caused by the employment in some way; however, the trend seems to be toward accepting the former condition as sufficient. Following the German law of 1925, some 30 countries included accidents occurring on the way to and from work. Injuries due to the employee's willful misconduct are generally excluded. Occupational diseases are covered to some extent by virtually all national laws.
Classes of benefits.
Four classes of benefits are provided by compulsory insurance, and, except for certain diseases, a right to them is acquired without any qualifying period of previous employment. First is a medical benefit, which includes all necessary treatment and the supply of artificial limbs. If its duration is limited, the maximum is likely to be one year. Second is a temporary incapacity benefit, which lasts as long as the medical benefit except that a waiting period of a few days is frequently prescribed. The benefit varies from country to country, ranging from 50 percent of the employee's wage to 100 percent; the most common benefits are 66 2/3 percent and 75 percent. Third is a permanent incapacity benefit, which, unless the degree is very small, in which case a lump sum is paid, takes the form of a pension. If the incapacity is total, the pension is usually equal to the temporary incapacity benefit. If the incapacity is partial, the pension is proportionately smaller. In some 60 countries an additional pension is granted if the victim needs constant attendance. In cases of death, the pensions are distributed to the widow (or invalid widower) and minor children, and, if the maximum total has not then been attained, other dependents may receive small pensions. The maximum is the same as for total incapacity.
In a growing number of industrialized countries (Austria, France, Germany, Ireland, Israel, The Netherlands, and Switzerland) the fourth type of benefit--systematic arrangements for retraining and rehabilitation of seriously injured persons--is provided, and employers may even be required to provide employment to such persons.
Financing and administering employment
injury insurance.
Almost all systems of employment injury insurance are financed by employers' contributions exclusively, and in almost all these systems the contribution is proportional to the risk represented by the class of activity in which the employer is engaged. Usually the insurance institution adapts the contribution to the accident experience of the undertaking individually or to any special preventive measures it may have taken. On the other hand, mainly for simplicity, but partly perhaps in order to subsidize basic but dangerous industries, a uniform contribution rate for all classes of activity has been established in several countries. Social insurance against employment injury, as against other risks, is in most countries administered by institutions under the joint management of employers and employees and often of government representatives as well; in eastern Europe, however, the administration is entrusted to trade unions. Disputes are settled by arbitral organs without resort to the courts.
In the United States an employer may comply with the provisions of most workers' compensation laws in three ways: by purchasing a private workers' compensation and employer liability policy from a commercial insurer, by purchasing coverage through a state fund set up for this purpose, or by setting aside reserves sufficient to cover the risks involved. Most workers' compensation benefits are financed by the first two methods. State laws in the United States are not uniform with respect to the amount of the monetary compensation or length of time for which income payments are made. For example, only about half the states give lifetime income benefits for occupational injuries. In others there is a statutory limitation of between 400 and 500 weeks of payments. Again, most states provide liquidating damages for an injury that is permanent but does not totally incapacitate the worker, such as the loss of an arm or leg. The size of these liquidating damages varies greatly. Most state laws also provide complete medical benefits, including rehabilitation expenses, and survivors' benefits in the event of the worker's death.
Costs.
Following the publication in the early 1970s of about 40 studies revealing inadequacies in workers' compensation in the United States, most states passed laws increasing the number of workers covered, raising weekly benefits to equal or exceed 66 2/3 percent of the average weekly wage, and making other improvements. Compensable claims now include those involving back pain, stress, and heart conditions traceable to employment conditions. Many claims also involve court litigation, which greatly magnifies settlement costs. For employers, these and other factors have increased the average cost of benefits from less than 1 percent of wages before 1960 to 2.3 percent in 1992.
Credit insurance.
The use of credit in modern societies is so various and widespread that many types of insurance have grown up to cover some of the risks involved. Examples of these risks are the risk of bad debts from insolvency, death, and disability; the risk of loss of savings from bank failure; the risk attaching to home-loan debts when installments are not paid for various reasons, resulting in foreclosure with subsequent loss to the creditor; and the risk of loss from export credit because of war, currency restrictions, cancellation of import licenses, or other political causes.
Merchandise credit insurance.
Credit insurance for domestic buyers and sellers is available in the United States, Canada, Mexico, and most European countries. It is sold only to manufacturers, wholesalers, and certain service agencies, not to retailers. The insurance is designed to enable the seller to recover a certain percentage of losses from insolvency of the debtor, but the contracts list a number of conditions under which the creditor may initiate a claim regardless of the question of insolvency. The policy is designed primarily to meet the needs of those sellers whose business is concentrated on a few buyers, insolvency of any one of which would seriously jeopardize the financial stability of the seller.
Export credit insurance.
A special form of credit insurance is available to exporters against losses from both commercial and political risks. In the United States, for example, export credit insurance is written through a consortium of insurance companies organized by the Foreign Credit Insurance Association (FCIA). The Export-Import Bank of the United States assumes the ultimate liability for loss, while the FCIA serves as the underwriting agency. Coverage is usually limited to 90 or 95 percent of the account. Prior approval from the FCIA is usually required before export credit insurance is granted. In some cases, the exporter is required to purchase coverage on all credit sales in a given country as a device to reduce adverse selection. Export credit insurance is used more widely in some countries than in others. In the United Kingdom approximately one-quarter of all export sales are covered, compared with about 6 percent in the United States. Export sales are not eligible for insurance if they are made for cash or financed directly or indirectly through government-guaranteed loans.
Title insurance.
Title insurance is a contract guaranteeing the purchaser of real estate against loss from undiscovered defects in the title to property that has been purchased. Such loss may stem from unmarketability of the property because of defective title or from costs incurred to cure defects of the title.
The need for title insurance arises from the fact that real estate transactions are complex and technical. Any legal error, no matter how detailed or minute, may cause a defect in the title that impairs its marketability. Examples of such defects are forgeries, invalid or undiscovered wills, defective probate proceedings, or transfers of property by persons lacking full legal capacity to contract.
Miscellaneous insurance.
Special casualty forms are issued to cover the hazards of sudden explosions from equipment such as steam boilers, compressors, electric motors, flywheels, air tanks, furnaces, and engines. Boiler and machinery insurance has several distinctive features. A substantial portion of the premium collected is used for inspection services rather than loss protection. Second, the boiler policy provides that its coverage will be in excess of any other applicable insurance. In this sense, it may be looked upon as an "umbrella policy" to fill in gaps in the insured's program. Third, the policy lists the specific losses that will be paid, such as the loss of the boiler or machinery itself due to accident, expediting expenses, property damage liability, bodily injury liability, defense settlement and supplementary payments, business interruption, outage (interruption of service), power interruption, consequential loss due to spoilage of goods, and furnace explosion. The policy will satisfy each of these claims in the order in which they appear, up to the limit of the coverage. The extensive use of plate glass in modern architecture has produced a special comprehensive insurance that covers not only plate glass but glass signs, motion-picture screens, halftone screens and lenses, glass bricks, glass doors, and so forth. It may be written to cover loss from any source except fire or nuclear radiation. Increasing international business activity has caused greater use of policies generally termed difference-in-conditions insurance (DIC). The DIC policy insures property and liability losses not covered by basic insurance contracts. It can be written to insure almost any peril, including earthquake and flood, subject to deductibles and stated exclusions. It is often written on an all-risk basis. An international business firm may use the DIC to secure uniform coverage for all countries in which it operates and to obtain higher policy limits than those available from domestic insurers in the various foreign countries.
SURETYSHIP
Surety contracts are designed to protect businesses against the possible dishonesty of their employees. Surety and fidelity bonds fill the gap left by theft insurance, which always excludes losses from persons in a position of trust. A bond involves three contracting parties instead of two. The three parties are the principal, who is the person bonded; the obligee, the person who is protected; and the surety, the person or corporation agreeing to reimburse the obligee for any losses stemming from failures or dishonesty of the principal. The bond covers events within the control of the person bonded, whereas insurance in the strict sense covers loss from random events generally outside the direct control of the insured. In bonding, the surety always has the right to try to collect its losses from the person bonded, whereas in insurance the insurer may not attempt to recover losses from the insured. Of course, under property and liability policies the insurer may attempt to recover from liable third parties under the right of subrogation, but subrogation rights are often not possible to enforce in practice. Bonds are not usually cancelable by the insurer, whereas most insurance contracts, except life, are cancelable by the insurer upon due notice. Fidelity bonds are written to cover the obligee, usually an employer, against loss from dishonest acts of employees; surety bonds cover not only dishonesty but also incapacity to perform the work agreed upon. Surety bonds are normally written on principals who are acting in an independent or semi-independent capacity, such as building contractors or public officials, whereas fidelity bonds are written on employees acting under the guidance and supervision of their employer. Finally, surety bonds are often issued with the requirement of collateral, whereas fidelity bonds are not. The surety bond is an instrument through which the superior credit of the surety is substituted for the uncertain credit of the principal; hence, if the surety is asked to bond a principal of somewhat doubtful credit, the requirement of cash collateral is frequently imposed.
Major types of fidelity bonds.
Fidelity bonds differ according to whether specific persons are named as principals or whether all employees or persons are covered as a group. The latter are most frequently used by employers with a large number of employees, because they offer automatic coverage on given classes of workers, including new employees, and greater ease of administration, including simpler claims procedures. Fidelity bonds are usually written on a continuous basis--that is, they are effective until canceled and have no expiration date. The penalty of the bond (the maximum amount payable for any one loss) is unchanged from year to year and is not cumulative. The bonds specify a discovery period (usually two years) limiting the time for discovering losses after a bond is discontinued. When a new bond is put into effect, it can be written to cover losses that have occurred but are undiscovered before the effective issue date of the bond. A salvage clause also is included, stating the way in which any salvage recovered by the surety from the principal is to be divided between the surety and the obligee. This clause is significant, because the obligee may have losses in excess of the penalty of the bond. Some salvage clauses require that any salvage be paid to the obligee up to the full amount of all losses, and others provide that any salvage be divided between the surety and the obligee on a pro rata basis, in the proportion that each party has suffered loss.
Major types of surety bonds.
There are various classes of surety bonds. Contract construction bonds are written to guarantee the performance of contractors on building projects. Bonds are particularly important in this field because of the general practice of awarding commercial building contracts to the lowest bidder, who may promise more than can actually be performed. The surety who is experienced in this field is in a position to make sounder judgment about the liability of the various bidders than anyone else and backs up its judgment with a financial guarantee. Court bonds include several different types of surety bonds. Fiduciary bonds are required for court-appointed officials entrusted with managing the property of others; executors of estates and receivers in bankruptcy are frequently required to post fiduciary bonds. Other types of surety bonds include official bonds, lost instrument bonds, and license and permit bonds. Public official bonds guarantee that public officials will faithfully and honestly discharge their obligations to the state or to other public agencies. Lost instrument bonds guarantee that if a lost stock certificate, money order, warehouse receipt, or other financial instrument falls into unauthorized hands and causes a loss to the issuer of a substitute instrument, this loss will be reimbursed. License and permit bonds are issued on persons such as owners of small businesses to guarantee reimbursement for violations of the licenses or permits under which they operate.
LIFE AND HEALTH INSURANCE
Life insurance.
Life insurance may be defined as a plan under which large groups of individuals can equalize the burden of loss from death by distributing funds to the beneficiaries of those who die. From the individual standpoint life insurance is a means by which an estate may be created immediately for one's heirs and dependents. It has achieved its greatest acceptance in Canada, the United States, Belgium, South Korea, Australia, Ireland, New Zealand, The Netherlands, and Japan, countries in which the face value of life insurance policies in force generally exceeds the national income. In the United States in 1990 nearly $9.4 trillion of life insurance was in force. The assets of the more than 2,200 U.S. life insurance companies totaled nearly $1.4 trillion, making life insurance one of the largest savings institutions in the United States. Much the same is true of other wealthy countries, in which life insurance has become a major channel of saving and investment, with important consequences for the national economy. Life insurance is relatively little used in poor countries, although its acceptance has been increasing.
Types of contracts.
The major types of life insurance contracts are term, whole life, and universal life, but innumerable combinations of these basic types are sold. Term insurance contracts, issued for specified periods of years, are the simplest. Protection under these contracts expires at the end of the stated period, with no cash value remaining. Whole life contracts, on the other hand, run for the whole of the insured's life and gradually accumulate a cash value. The cash value, which is less than the face value of the policy, is paid to the policyholder when the contract matures or is surrendered. Universal life contracts, a relatively new form of coverage introduced in the United States in 1979, have become a major class of life insurance. They allow the owner to decide the timing and size of the premium and amount of death benefits of the policy. In this contract, the insurer makes a charge each month for general expenses and mortality costs and credits the amount of interest earned to the policyholder. There are two general types of universal life contracts, type A and type B. In type-A policies the death benefit is a set amount, while in type-B policies the death benefit is a set amount plus whatever cash value has been built up in the policy. Life insurance may also be classified, according to type of customer, as ordinary, group, industrial, and credit. The ordinary insurance market includes customers of whole life, term, and universal life contracts and is made up primarily of individual purchasers of annual-premium insurance. The group insurance market consists mainly of employers who arrange group contracts to cover their employees. The industrial insurance market consists of individual contracts sold in small amounts with premiums collected weekly or monthly at the policyholder's home. Credit life insurance is sold to individuals, usually as part of an installment purchase contract; under these contracts, if the insured dies before the installment payments are completed, the seller is protected for the balance of the unpaid debt.
Insurance may be issued with a premium that remains the same throughout the premium-paying period, or it may be issued with a premium that increases periodically according to the age of the insured. Practically all ordinary life insurance policies are issued on a level-premium basis, which makes it necessary to charge more than the true cost of the insurance in the earlier years of the contract in order to make up for much higher costs in the later years; the so-called overcharges in the earlier years are not really overcharges but are a necessary part of the total insurance plan, reflecting the fact that mortality rates increase with age. The insured is not overpaying for protection, because of the claim on the cash values that accumulate in the early years; the policyholder may borrow on this value or may recapture it completely by lapsing the policy. The insured does not, however, have a claim on all the earnings that accrue to the insurance company from investing the funds of its policyholders. By combining term and whole life insurance, an insurer can provide many different kinds of policies. Two examples of such "package" contracts are the family income policy and the mortgage protection policy. In each of these, a base policy, usually whole life insurance, is combined with term insurance calculated so that the amount of protection declines as the policy runs its course. In the case of the mortgage protection contract, for example, the amount of the decreasing term insurance is designed roughly to approximate the amount of the mortgage on a property. As the mortgage is paid off, the amount of insurance declines correspondingly. At the end of the mortgage period the decreasing term insurance expires, leaving the base policy still in force. Similarly, in a family income policy, the decreasing term insurance is arranged to provide a given income to the beneficiary over a period of years roughly corresponding to the period during which the children are young and dependent. Some whole life policies permit the insured to limit the period during which premiums are to be paid. Common examples of these are 20-year life, 30-year life, and life paid up at age 65. On these contracts, the insured pays a higher premium to compensate for the limited premium-paying period. At the end of the stated period, the policy is said to be "paid up," but it remains effective until death or surrender. Term insurance is most appropriate when the need for protection runs for only a limited period; whole life insurance is most appropriate when the protection need is permanent. The universal life plan, which earns interest at a rate roughly equal to that earned by the insurer (approximately the rate available in long-term bonds and mortgages), may be used as a convenient vehicle by which to save money. The owner can vary the amount of death protection as the need for it changes in the course of life. The policy offers flexibility and saves the owner commission expense by eliminating the need for dropping one policy and taking out another as protection requirements change.
Settlement options.
The death proceeds or cash values of insurance may be settled in various ways. The insured may take the cash value and lapse the policy. A beneficiary may take a lump sum settlement of the face amount upon the death of the insured. The beneficiary may, instead, elect to receive the proceeds over a given number of years or in some fixed amount, such as $100 a month, for as long as the proceeds last. The money may be left with the insurer temporarily to draw interest. Or the proceeds may be used to purchase a life annuity, which in effect is another insurance policy guaranteeing regular payments for the life of the insured.
Other provisions.
Life insurance policies contain various clauses that protect the rights of beneficiaries and the insured. Perhaps the best-known is the incontestable clause, which provides that if a policy has been in force for two years the insurer may not afterward refuse to pay the proceeds or cancel the contract for any reason except nonpayment of premiums. Thus, if the insured made a material misrepresentation when the policy was originally obtained, and this misrepresentation is not discovered until after the contestable period, beneficiaries may still receive the value of the policy so long as the premiums are maintained. Another protective clause is the suicide clause, which states that after a given period, usually two years, the insurer may not deny liability for subsequent suicide of the insured. If suicide occurs within the period, the insurer tenders to the beneficiary only the premiums that have been paid. If the age of the insured was misstated when the policy was taken out, the misstatement-of-age clause provides that the amount payable is the amount of insurance that would have been purchased for the premium had the correct age been stated. Many life insurance policies, known as participating policies, return dividends to the insured. The dividends, which may amount to 20 percent of the premiums, may be accumulated in cash left with the insurer at interest, used to buy additional life insurance, used to reduce premium payments, or used to pay up the contract sooner than would otherwise have been possible.
Special riders.
The insured may, at a nominal charge, attach to the contract a waiver-of-premium rider under which premium payments will be waived in the event of total and permanent disability before the age of 60. Under the disability income rider, should the insured become totally and permanently disabled, a monthly income will be paid. Under the double indemnity rider, if death occurs through accident, the insurance payable is double the face amount.
Private health insurance.
In many countries health insurance has become a governmental institution. In some, doctors and other professional staff are employed, directly or indirectly, by a government agency on a full-time or part-time salaried basis, and health facilities are owned or operated by the government. This has been the practice in Australia, Brazil, Canada, Chile, Greece, Ireland, Mexico, New Zealand, Sweden, Turkey, and the countries of eastern Europe. In other countries the government pays for medical care provided by private physicians; these countries include Austria, Denmark, The Netherlands, Norway, and Spain. In some countries private health insurance programs exist along with, or as part of, the government program. Various combinations of programs are possible, and it is difficult to summarize all the arrangements that actually exist. The United States provides government-run medical services in veterans' hospitals and mental hospitals, and it also has a governmental health insurance program for citizens age 65 and over (Medicare) under the Social Security Act amendments of 1965, but most health insurance in the United States still consists of private programs. Much private health insurance in the United States is operated on a group basis, generally through groups of employees whose payments may be subsidized by their employer.
Types of policies.
The major types of health insurance coverage are hospitalization, surgical, regular medical, major medical, disability income, dental, and long-term care. Health insurance contracts are not highly standardized. The policy provisions discussed below should be considered as typical, not universal or invariant. Hospitalization insurance indemnifies for room and board in the hospital, laboratory fees, use of special facilities, nursing care, and certain medicines and supplies. The contracts contain specific limitations on coverage, such as a maximum number of days in the hospital and maximum allowances for room and board. Surgical expense insurance covers the surgeon's charge for given operations or medical procedures, usually up to a maximum for each type of operation. Regular medical insurance contracts indemnify the insured for expenses such as physicians' home or office visits, medicines, and other medical expenses. Major medical contracts are distinguished from other health insurance policies by offering coverage without many specific limitations; usually there is only a maximum per person, a deductible amount, and a percentage deductible, called coinsurance, under which the insured usually pays 20 percent of each medical bill above the deductible amount. Disability income coverage provides periodic payments when the insured is unable to work as a result of accident or illness. There is normally a waiting period before the payments begin. Definitions of disability vary considerably. A strict definition of disability requires that one be unable to perform each and every duty of one's regular occupation for a given period, say two years, and thereafter be unable to perform the duties of any occupation for which one is reasonably fitted by training or experience. More liberal definitions of disability require only the inability to perform the duties of one's usual occupation. Dental insurance, usually sold on a group plan and sponsored by an employer, covers such dental services as fillings, crowns, extractions, bridgework, and dentures. Most policies contain relatively low annual limits of coverage, such as $2,500, as well as deductibles and coinsurance provisions. Some policies limit benefits to a percentage of the cost of services. Long-term care insurance (LTC) has been developed to cover expenses associated with old age, such as care in nursing homes and home care visits. LTC insurance, though relatively new, is already attracting strong interest because of the rapid growth of the elderly population in the United States. Policies specify a maximum limit per day plus an overall maximum benefit amount, with the result that the insurance typically covers the expenses of a maximum of four or five years in a nursing home. A common provision is a 20-day waiting period before benefits begin. Some policies exclude certain conditions such as Alzheimer's disease and do not cover custodial care. For an additional premium, some LTC policies offer an inflation provision, which increases the daily benefit by some percentage, such as 5 percent a year.
Renewability.
An important condition of health insurance is that of renewability. Some contracts are cancelable at any time upon short notice. Others are not cancelable during the year's term of coverage, but the insurer may refuse to renew coverage for a subsequent year or may renew only at higher rates or under restrictive conditions. Thus the insured may become ill with a chronic disease and discover that upon renewal the policy excludes all future coverage for this disease. Only policies that are both noncancelable and guaranteed renewable assure continuous coverage, but these are much more expensive.
Problems.
Private health insurance contracts are in general quite restricted in coverage, to the point that many consider them to be inadequate for modern conditions. They also lend themselves to abuses such as overutilization of coverage, multiple policies, and insuring for more than 100 percent of the expected loss. Health insurance, by its very existence, helps to escalate rising medical care costs; for example, insured medical losses tend to run higher than noninsured losses because physicians often charge according to "ability to pay," and insurance increases this ability. Through insurance it is also easier to pass on rising hospital costs to the patient. Finally, since there is a tendency for those most likely to have losses to take out health insurance, an element of adverse selection exists. Careful underwriting to screen out those who are trying to take advantage of the insurance mechanism to pay for known bills is considered essential, but this undoubtedly denies coverage to many who need protection.
Group insurance.
Groups have always been important in the insurance field, from the burial societies of the Romans and the insurance funds of the medieval guilds to the fraternal and religious insurance plans of modern times. In the 20th century private insurance companies have written increasingly large amounts of group insurance, particularly in life insurance, health insurance, and annuities. In 1990 more than 95 percent of the industrial labour force in the United States was covered by group life and health insurance plans established by employers. Much of the impetus for these employee benefit plans came from the labour unions, which pressed for such "fringe benefits" in bargaining with employers. Group insurance is widely used throughout the world, both in the form of private plans and as social insurance plans. Social security plans with group coverage exist in more than 140 nations. Private group plans are generally offered wherever private life and health insurance companies operate. Group life insurance is the most commonly offered plan; group health plans are government-operated in many nations. In many countries, group pension plans are common as a supplement to social insurance pension schemes. Group insurance has been especially popular in Japan, where many employees serve a company for life. All Japanese life insurance companies offer group life insurance. Health insurance is provided by the government. Funded group pensions became popular after a 1962 tax law made contributions tax-deductible for Japanese employers. In addition, virtually all Japanese employers provide lump-sum retirement allowances to their workers.
Group life insurance.
Under group life insurance an employer signs a master contract with the insurance company outlining the provisions of the plan. Each employee receives a certificate that gives evidence of participation in the plan. The amount of insurance depends on the employee's salary or job classification; usually the employer pays a portion of the premium and the employee pays the rest, but sometimes the employer pays the entire cost of the plan. A major advantage of group life insurance to an employee is that usually coverage may be obtained regardless of health. An employee who leaves the group may, without a medical examination, convert the group coverage to an individual policy. The premiums on group life insurance are considerably less than on comparable individual policies, mainly because the selling and administrative costs are minimal.
Group health insurance.
Major types of health insurance written on a group basis include insurance against the losses occasioned by hospitalization, surgical expense, and disability. Hospitalization insurance is designed to cover daily room and board and other expenses. Surgical expense insurance usually provides specified allowances for physicians' charges for various operations. Regular medical expense coverage is generally aimed at covering part of the costs of medicines and doctor calls. Major medical insurance offers the insured a large monetary coverage, designed to meet catastrophic costs of illness or accident with few restrictions as to the type of medical expense for which reimbursement is allowed. The insured must bear a percentage of any loss, usually 20 percent. Temporary disability income offers the insured a weekly indemnity for a period of up to six months if the insured is temporarily disabled and unable to work. Long-term disability extends the income for periods longer than six months. Accidental death and dismemberment insurance offers an insured or a beneficiary a lump sum; it is used widely as a form of travel accident insurance. Under the typical group health insurance contract, the insured person enjoys several elements of protection not obtainable in individual contracts. Cancellation of coverage is not permitted unless coverage for the entire group is canceled. The insured enjoys protection against rate increases unless the rate for all members of the class is increased. Typically the group protection may be converted to some kind of individual policy, or the insured may transfer to another group plan. The insurer tends to be liberal on claims settlement because the typical premium under a group plan is large enough for the insurer to be unwilling to jeopardize the good will of the clientele through miserly claims treatment. Most group insurance plans require that certain conditions be met. Sometimes there must be a minimum number of persons covered, such as 10 or 25. The group must also have some reason for existence other than to obtain insurance. The most usual types of groups are employees of a common employer, members of a labour organization, debtors of a common creditor, or members of a professional or trade association. Mention must also be made of nonprofit prepayment plans (e.g., the Blue Cross-Blue Shield plans and health maintenance organizations [HMOs] in the United States), which resemble the above plans in most respects but are not operated by insurance companies. These plans often indemnify the hospital or the physician, on the basis of services performed, rather than the patient. Health insurance plans may also be established independently by large employers, labour unions, communities, or cooperatives. Outside the United States this kind of health insurance has been taken over by government programs. In Sweden, before the enactment of the compulsory insurance program in 1955, 70 percent of the population was covered by private plans. In Great Britain, before the National Health Service was instituted in 1948, about half the population was privately covered. In The Netherlands about half the population was so covered before the government program began, and there were still many private funds run by various groups. In spite of the success of private group health insurance in the United States, it is estimated that in 1992 approximately 37 million people were without health insurance coverage. Many attempts over the years to establish universal national health insurance in the United States have failed.
Group annuities.
An annuity in the literal sense is a series of annual payments. More broadly it may be defined as a series of equal payments over equal intervals of time. A life annuity, a subclass of annuities in general, is one in which the payments are guaranteed for the lifetime of one or more individuals. A group annuity differs from an individual annuity in that the annuity payments are based upon the assumed length of lives of members of a given group. The size of the payments depends on several factors: the assumed interest rate, the life expectancy of the individual or of the individuals making up the group, the length of the period during which payments are guaranteed, the length of time elapsing before the payments begin, and the number of lives on which the payments are continued. For example, if payments to an annuitant aged 65 are to be guaranteed for 20 years, they will be substantially smaller than if they are guaranteed only for the remainder of the person's life.
The typical group life annuity is sponsored by an employer, who may pay all or part of the cost. Under the usual arrangement, every employee receives each year a credit with the life insurance company for an annuity purchased to begin at age 65. The final pension received is made up of the sum of the individual annuities purchased throughout the worker's life. As a rule, an irrevocable claim to these annuity rights is gained only after the person has worked with the employer for a given number of years or has reached a given age. The basic advantage of an annuity is that it provides an income for life that is larger than the amount that the holder would receive by putting money out at simple interest. It is the reverse of life insurance, in that the insurer pays premiums to the insured; it resembles insurance in that the payment is based on life expectancy. The problem of inflation has led to experimentation with variable annuities in order to protect annuitants against decreases in purchasing power. The major distinguishing characteristic of a variable annuity is that the payments vary according to underlying trends in the stock market. Funds paid in for the variable annuity are invested in common stock rather than in bonds, mortgages, or other fixed-interest investments as is true of regular annuities. In simplified terms, if the stock market rises 10 percent in one year, the annuitant may expect payments to go up by approximately 10 percent in the following year. Conversely, if the stock market drops 10 percent, the annuitant will suffer a 10 percent reduction in income. To the extent that the stock market reflects changes in the cost of living, the annuitant's income is automatically adjusted for these changes each year; and, if the stock market also reflects increases in productivity in the economy, then the annuitant may expect to receive a share in such increases in the productivity as the economy may gain. Some variable annuity plans are tied directly to a cost-of-living index. In order to finance the increased benefits, the employer invests a portion of the funds in equities such as common stock and real estate. An assumption is made that there will be a sufficient gain from this source to enable the employer to pay the increased cost of living, but the employee is not expected to suffer reductions in annuity payments. The problem of adjusting retirement benefits to changes in the economy has been of concern in many countries. Some governments have pegged the price of government bonds to the cost-of-living index. Retired individuals purchasing government bonds may then receive automatic increases in interest payments if the cost of living rises. Their interest will not fall below a specified amount. Social security legislation in most parts of the world is geared in various ways to changes in the cost of living. In some cases benefits are directly tied to a price index. In other cases the legislature from time to time must be asked to make adjustments in social security benefits.
Insurance practice
UNDERWRITING AND RATE MAKING
The two basic functions in insurance are underwriting and rating, which are closely related to each other. Underwriting deals with the selection of risks, and rating deals with the pricing system applicable to the risks accepted.
Underwriting principles.
Underwriting has to do with the selection of subjects for insurance in such a manner that general company objectives are met. The main objective of underwriting is to see that the risk accepted by the insurer corresponds to that assumed in the rating structure. There is often a tendency toward adverse selection, which the underwriter must try to prevent. Adverse selection occurs when those most likely to suffer loss are covered in greater proportion than others. The insurer must decide upon certain standards, terms, and conditions for applicants, project estimated losses and expenses through the anticipated period of coverage, and calculate reasonably accurate rates to cover these losses and expenses. Since many factors affect losses and expenses, the underwriting task is complex and uncertain. Bad underwriting has resulted in the failure of many insurers. In some types of insurance major underwriting decisions are made in the field, and in other types they are made at the home office. In the field of life insurance the agent's judgment is not accepted as final until the home-office underwriter can make a decision, for the life insurance contract is usually noncancelable, once written. In the field of property and liability insurance, on the other hand, the contract is cancelable if the home-office underwriter later finds the risk to be unacceptable. It is not uncommon for a property and liability insurer to accept large risks only to cancel them at a later time after the full facts are analyzed. The insurance underwriter must tread a thin line between undue strictness and undue laxity in the acceptance of risk. The underwriter's position is not unlike that of the credit manager in a business corporation, in which unreasonably strict credit standards discourage sales but overly weak credit standards invite losses. An important initial task of the underwriter is to try to prevent adverse selection by analyzing the hazards that surround the risk. Three basic types of hazards have been identified as moral, psychological, and physical. A moral hazard exists when the applicant may either want an outright loss to occur or may have a tendency to be less than careful with property. A psychological hazard exists when an individual unconsciously behaves in such a way as to engender losses. Physical hazards are conditions surrounding property or persons that increase the danger of loss.
An underwriter may suspect the existence of a moral hazard on applications submitted by persons with known records of dishonesty or when excessive coverage is sought or the replacement value of the property exceeds its value as a profit-making enterprise. Underwriters are aware that fire losses are more likely to occur during business depressions. The underwriter can detect moral hazard in various ways: An applicant's credit may be checked; courthouse and police records may reveal a criminal history or a history of bankruptcy; and other insurance companies can be queried for information when it is suspected that an individual is trying to obtain an excessive amount of coverage or has been turned down by other insurers. The psychological type of hazard can take a number of forms. Some persons are said to be "accident-prone" because they have far more than their share of accidents, suggesting that unconsciously they want them. It is well known that persons applying for annuities tend to have longer than average lives, and consequently a special mortality table is used for annuitants. Certain types of insanity have to be watched for--notably the impulse to set fires. Physical hazards include such things as wood-frame construction in buildings, particularly in areas where such properties are densely concentrated. Earthquake insurance rates tend to be high where geologic faults exist (as in San Francisco, which is built almost directly over such a fault). Each kind of insurance has its characteristic hazards. In fire insurance the physical hazards are analyzed according to four major factors: type of construction, the protection rating of the city in which the property is located, exposure to other structures that may spread a conflagration, and type of occupancy. In underwriting automobile insurance, the underwriter considers the following factors: the age, sex, and marital status of the driver and members of the driver's household; length of driving experience; occupation; stability of employment and residence; physical impairments; accident and conviction record; extent of use of alcohol and drugs; customary use of the vehicle; age, condition, and maintenance of the vehicle; and records of insurance cancellation or refusal. In some cases tests of emotional maturity are administered. Some underwriters even consider such factors as the school records of student drivers and whether or not driving courses have been taken.
The hazards considered in the underwriting of general liability insurance depend on the type of business and the record of the person applying for coverage. In the field of contracting, for example, the underwriter is interested in the type of equipment owned or rented by the applicant; the applicant's losses in the past, attitude toward safe practice, cooperation with building inspectors, and financial position and credit standing; the stability of supervisory employees; and the degree to which the applicant has been a successful contractor in the past.
Rate making.
Closely associated with underwriting is the rate-making function. If, for example, the underwriter decides that the most important factor in discriminating between different risk characteristics is age, the rates will be differentiated according to age.
The rate is the price per unit of exposure. In fire insurance, for example, the rate may be expressed as $1 per $100 of exposed property; if an insured has $1,000 of exposed property, the premium will thus be $10. The rate reflects three major elements: the loss cost per unit of exposure, the administrative expenses, or "loading," and the profit. In property insurance, approximately one-third of the premium covers expenses and profit, and two-thirds covers the expected cost of loss payments. These percentages vary somewhat according to the particular type of insurance.
Rates are calculated in the following way. A policy, for instance, may be written covering a class of automobiles with an expected loss frequency of 10 percent and an average collision loss of $400. The expenses of the insurer are to average 35 percent of the premium, and there must be a profit of 5 percent. The pure loss cost per unit is 10 percent of $400, or $40. The gross premium is calculated by the formula L/[1 - (E + P)], in which L equals the loss cost per unit, E equals the expense ratio, and P equals the profit ratio. In this case the gross premium would be $40/[1 - (.35 + .05)], or $66.67.
Four basic standards are used in rate making: (1) the structure of rates should allocate the burden of expenses and costs in a way that reflects as accurately as possible the differences in risk--in other words, rates should be fair; (2) a rate should produce a premium adequate to meet total losses but should not bring unreasonably large profits; (3) the rate should be revised often enough to reflect current costs; and (4) the rate structure should tend to encourage loss prevention among those who are insured.
Some examples will illustrate the nature and application of the criteria outlined above. In life insurance, the rate is generally more than adequate to meet all reasonably anticipated losses and expenses; in other words, the insured is charged an excessive premium, part of which is then returned as a dividend according to actual losses and expenses. The requirement that the rate reflect fairly the risk involved is much more difficult to achieve. In workers' compensation insurance, the rate is expressed as a percentage of the employer's payroll for each occupational class. This may seem fair enough, but an employer with relatively high-paid workers has fewer employees for a given amount of payroll than one whose workers are paid a lower wage. If the two employers fall into the same occupational class and have the same total payroll, they are charged the same premium even though one may have a larger number of workers than the other and hence greater exposure to loss. Fairness may be an elusive goal. Insurance rates are revised only slowly, and, since they are based upon past experience, they tend to remain out of date. In life insurance, for example, the mortality tables used are changed only every several years, and rate adjustments are reflected in dividends. In automobile insurance, rates are revised annually or even more often, but they still tend to be out of date. Two basic rate-making systems are in use: the manual, or class-rating, method and the individual, or merit-rating, method. Sometimes a combination of the two methods is used. A manual rate is one that applies uniformly to each exposure unit falling in some predetermined class or group, such as people of the same age, workers of one employer, drivers meeting certain characteristics, or all residences in a given area. Presumably the members of each class are so homogeneous as to be indistinguishable so far as risk characteristics are concerned. Merit rating is used to give recognition to individual characteristics. In commercial buildings, for example, fire insurance rates depend on such individual characteristics as the type of occupancy, the number and type of safety features, and the quality of housecleaning. In an attempt to reflect the true quality of the risk, a percentage charge or credit may be applied to the base rate for each of these features. Another example is found in employer group health insurance plans where the premium or the rate may be adjusted annually depending on the loss experience or on the amount of claims service provided. In order to obtain broader and statistically sounder rates, insurers often pool loss and claims experience by setting up rating bureaus to calculate rates based on industrywide experience. They may have an agreement that all member companies must use the rates thus developed. The rationale for such agreements is that they help insurers meet the criteria of adequacy and fairness. Rating bureaus are used extensively in fire, marine, workers' compensation, automobile, and crime insurance.
Underwriting cycle.
Profits in property and liability insurance have tended to rise and fall in fairly regular patterns lasting between five and seven years from peak to peak; this phenomenon is termed the underwriting cycle. Stages of the underwriting cycle may be described as follows: initially, when profits are relatively high, some insurers, wishing to expand sales, start to lower prices and become more lenient in underwriting. This leads to greater underwriting losses. Rising losses and falling prices cause profits to suffer. In the second stage of the cycle, insurers attempt to restore profits by increasing rates and restricting underwriting, offering coverage only to the safest risks. These restrictions may be so severe that insurance in some lines becomes unavailable in the marketplace. Insurers are able to offset a portion of their underwriting loses through earnings on investments. Eventually the increased rates and reduced underwriting losses restore profits. At this point, the underwriting cycle repeats itself. The general effect of the underwriting cycle on the public is to cause the price of property and liability insurance to rise and fall fairly regularly and to make it more difficult to purchase insurance in some years than in others. The competition among insurers caused by the underwriting cycle tends to create cost bargains in some years. This is especially evident when interest rates are high, because greater underwriting losses will, in part, be offset by greater investment earnings.
Reinsurance.
A significant insurance practice is that of reinsurance, whereby risk may be divided among several insurers, reducing the exposure to loss faced by each insurer. Reinsurance is effected through contracts called treaties, which specify how the premiums and losses will be shared by participating insurers. Two main types of treaties exist-- pro rata and excess-of-loss treaties. In the former, all premiums and losses may be divided according to stated percentages. In the latter, the originating insurer accepts the risk of loss up to a stated amount, and above this amount the reinsurers divide any losses. Reinsurance is also frequently arranged on an individual basis, called facultative reinsurance, under which an originating insurer contracts with another insurer to accept part or all of a specific risk. Reinsurance enlarges the ability of an originating insurer to accept risk, since unwanted portions of the risk can be passed on to others. Reinsurance stabilizes insurer profits, evens out loss ratios, reduces the capital needed to underwrite business, and offers a way for insurers to divest themselves of an entire segment of their risk portfolio.
LEGAL ASPECTS OF INSURANCE
Government regulation.
The insurance business is subject to extensive government regulation in all countries. In European countries insurance regulation is a mixture of central and local controls. In Germany central authority over insurance regulation is provided by the Federal Insurance Supervisory Authority (BAV), which exercises tight control of premiums, reserves, and investments of insurers. The BAV's regulation of life insurance, for example, allows no more than 20 percent of investments in equities. In the United Kingdom, regulation generally allows the managing agency fairly complete liberty of action and is concerned only with final business results. In this the United Kingdom differs from most other European countries, in which the purpose of insurance supervision is to regulate more closely the conditions in which insurers operate.
In the countries of the European Community (EC; under articles 59-60 of the Treaty of Rome) an attempt is being made to obtain greater uniformity among national insurance statutes. This is intended to facilitate the operations of insurers across national borders. Rate regulation, however, remains within the jurisdiction of individual countries.
Although 1992 was established as the goal year for completing the harmonization process for insurance in the EC, separate regulation in the various countries continues. Many legal and regulatory barriers to expansion of insurance operations in various countries in the world still exist. Examples include strict licensing requirements, prohibiting of unadmitted insurance, mandatory hiring of local nationals, requirements that insurers make local investments or enter into joint ventures with local insurers, prohibition of free exchange of currencies or repatriation of profits, and onerous taxation. An important legal force influencing insurance regulation in such countries as France, Belgium, Egypt, Greece, Italy, Lebanon, Spain, Turkey, and the former French African colonies is the Napoleonic Code. The influence of the code may be seen, for example, in the matter of third-party liability, in which the burden of proof may be upon the defendant rather than upon the plaintiff. In some countries not all classes of insurance are regulated. In The Netherlands only life insurance is regulated, and in Belgium only life, industrial injury, and thirdparty motor vehicle liability insurance. In some countries the scope of supervision may embrace many aspects of the insurance business, but in the United Kingdom and The Netherlands only financial matters are subject to regulation. In several European countries insurers may not write both life insurance and general insurance (property and liability insurance). Minimum capital requirements vary, depending on the type of business written, usually being highest for life insurance.
In most European countries policies are submitted to supervisory authorities for approval or for information. In some countries standard clauses or forms of contracts must be used; for instance, in Sweden insurers must use a standard compulsory motor vehicle third-party liability policy, and in Switzerland a standard contract for war risks and life insurance is required. Insurance is often compulsory. In general, laws frequently require individuals to carry third-party liability insurance and industrial injury insurance. Fire insurance is required on immovable property in Germany. A number of countries require aviation insurance (for accident and sickness) on airline passengers and crews. Although individuals generally have the freedom to select whichever insurer they wish, there are restrictions on buying insurance from foreign insurers. In some countries buyers must use domestic insurers for compulsory coverages but are free to take out insurance from foreign insurers when coverage is not available from domestic insurers. In other countries certain types of insurance may not be placed in foreign countries. About half the countries of the world prohibit "nonadmitted" insurance, defined as insurance written by an insurer not authorized to do business in that country. In the United States most regulation of insurance is in the hands of the individual states, although the federal government also has authority over insurers when it is deemed that state regulation fails to regulate effectively activities such as unfair trade practices, misleading advertising, boycotts, and monopolistic practices. States regulate four main aspects: rate making, minimum standards for financial solvency, investments, and marketing practices.In rate making, three basic requirements must be met: rates must be adequate to cover expected losses, must not be excessive, and must not be unfairly discriminatory among different classes of risk. In meeting minimum standards of financial solvency, state laws specify minimum capital requirements, accounting practices, minimum security deposits with state insurance commissioners, and procedures for liquidating insolvent insurers. In investments, states limit the types and quality of securities in which insurers may invest their assets. In marketing, states regulate advertising, licensing of agents, policy forms and wording, service and process procedures for handling claim disputes, expense allowances for acquiring new business, and other agency and insurer operations, including being admitted to do business in the state. Many states maintain a special division to register and handle consumer complaints.
Contract law.
In general, an insurance contract must meet four conditions in order to be legally valid: it must be for a legal purpose; the parties must have a legal capacity to contract; there must be evidence of a meeting of minds between the insurer and the insured; and there must be a payment or consideration. To meet the requirement of legal purpose, the insurance contract must be supported by an insurable interest (see further discussion below); it may not be issued in such a way as to encourage illegal ventures (as with marine insurance placed on a ship used to carry contraband).
The requirement of capacity to contract usually means that the individual obtaining insurance must be of a minimum age and must be legally competent; the contract will not hold if the insured is found to be insane or intoxicated or if the insured is a corporation operating outside the scope of its authority as defined in its charter, bylaws, or articles of incorporation. The requirement of meeting of minds is met when a valid offer is made by one party and accepted by another. The offer is generally made on a written application for insurance. In the field of property and liability insurance, the agent generally has the right to accept the insured's offer for coverage and bind the contract immediately. In the field of life insurance, the agent generally does not have this power, and the contract is not valid until the home office of the insurer has examined the application and has returned it to the insured through the agent.
The payment or consideration is generally made up of two parts--the premiums and the promise to adhere to all conditions stated in the contract. These may include, for example, a warranty that the insured will take certain loss-prevention measures in the care and preservation of the covered property.
Warranties.
In applying for insurance, the applicant makes certain representations or warranties. If the applicant makes a false representation, the insurer has the option of voiding the contract. Concealment of vital information may be considered misrepresentation. In general, the misrepresentation or concealment must concern a material fact--defined as a fact that would, if it were known, cause the insurer to change the terms of the contract or be unwilling to issue it in the first place. If the agent of the insurer asks the applicant a question the answer to which is a matter of opinion and if the answer turns out to be wrong, the insurer must demonstrate bad faith or fraudulent intent in order to void the contract. If, for example, in answer to an agent's question, the applicant reports no history of serious illness, in the mistaken belief that a past illness was minor, the court may find the statement to be an honest opinion and not a misrepresented fact.
A basic principle of property liability insurance contracts is the principle of subrogation, under which the insurer may be entitled to recovery from liable third parties. In fire insurance, for example, if a neighbour carelessly sets fire to the insured's house and the insurance company indemnifies the insured for the loss, the company may then bring a legal action in the name of the insured to recover the loss from the negligent neighbour. The principle of subrogation is complemented by another basic principle of insurance contract law, the principle of indemnity. Under the principle of indemnity a person may recover no more than the actual cash loss; one may not, for example, recover in full from two separate policies if the total amount exceeds the true value of the property insured.
Insurable interest.
Closely associated with the above legal principles is that of insurable interest. This requires that the insured be exposed to a personal loss if the peril insured against should occur. Otherwise it would be possible for a person to take out a fire insurance policy on the property of others and collect if the property burned. Any financial interest in property, or reasonable expectation of having a financial interest, is sufficient to establish insurable interest. A secured creditor such as a mortgagee has an insurable interest in the property on which money has been lent. In the field of personal insurance one is held to have an unlimited interest in one's own life. A corporation may take life insurance on the life of a key executive. A wife may insure the life of her husband, and a father may insure the life of a minor child, because there is a sufficient pecuniary relationship between them to establish an insurable interest.In life insurance the insurable interest must exist at the time of the contract. Continued insurable interest, however, need not be demonstrated. A divorced woman may continue life insurance on the life of her former husband and legitimately collect the proceeds upon his death even though she is no longer his wife. In the field of property insurance, on the other hand, the insurable interest must be demonstrated at the time of the loss. If an individual insures a home but later sells it, no recovery can be made if the house burns after the sale, because the insured has suffered no loss at the time of the fire.
Liability law.
In most countries, an individual may be held legally liable to another for acts or omissions and be required to pay damages. Liability insurance may be purchased to cover these contingencies. Legal liability exists when an individual commits a legal injury that wrongly encroaches on another person's rights. Such injuries include slander, assault, and negligent acts. A negligent act involves failure to behave in a manner expected when the results of this failure cause a financial loss to others. An act may be classed as negligent even if it is unintentional. Negligence may be imputed from one person to another. For example, a master is liable not only for his own acts but also for the negligent acts of servants or others legally representing him. It is not uncommon for a municipality to require that businesses using city property assume what would otherwise have been the city's negligence for the use of its property. Statutes may impute liability on individuals when no liability would exist otherwise; thus a parent may be legally liable for the acts of a minor child who is driving the family automobile. In common-law countries such as the United States and the United Kingdom, three defenses may be used in a negligence action. These are assumed risk, contributory negligence, and the fellow servant doctrine. Under the assumed risk rule, the defendant may argue that the plaintiff has assumed the risk of loss in entering into a given venture and understands the risks. Employers formerly used the assumed risk doctrine in suits by injured employees, arguing that the employee understood and assumed the risks of employment in accepting the job. The contributory negligence defense is frequently used to defeat negligence actions. If it can be shown that one party was partly to blame, then that party may not collect from any negligence of the other party. Some courts have applied a substitute doctrine known as comparative negligence. Under this, each party is held responsible for a portion of the loss corresponding to the degree of blame attached to that party; a person who is judged to be 20 percent to blame for an accident may be required to pay 20 percent of the injured person's losses. The fellow servant defense has been used at times by employers; an employer would argue in some cases that the injury to an employee was caused not by the employer's negligence but by the negligence of another employee. However, workers' compensation statutes in some countries have nullified such common law defenses in industrial injury cases. In many countries, the courts have tended to apply increasingly strict standards in adjudicating negligence. This has been termed the trend toward strict liability, under which the plaintiff may recover for almost any accidental injury, even if it can be shown that the defendant has used "due care" and thus is not negligent in the traditional sense. In the United States, manufacturers of polio vaccine that was found to have caused polio were required to pay large damage claims although it was demonstrated that they had taken all normal precautions and safeguards in the manufacture of the vaccine.
Historical development of insurance
Insurance in some form is as old as historical society. So-called bottomry contracts were known to merchants of Babylon as early as 4000-3000 BC. Bottomry was also practiced by the Hindus in 600 BC and was well understood in ancient Greece as early as the 4th century BC. Under a bottomry contract, loans were granted to merchants with the provision that if the shipment was lost at sea the loan did not have to be repaid. The interest on the loan covered the insurance risk. Ancient Roman law recognized the bottomry contract in which an article of agreement was drawn up and funds were deposited with a money changer. Marine insurance became highly developed in the 15th century. In Rome there were also burial societies that paid funeral costs of their members out of monthly dues.
The insurance contract also developed early. It was known in ancient Greece and among other maritime nations in commercial contact with Greece.
England.
Fire insurance arose much later, obtaining impetus from the Great Fire of London in 1666. A number of insurance companies were started in England after 1711, during the so-called bubble era. Many of them were fraudulent, get-rich-quick schemes concerned mainly with selling their securities to the public. Nevertheless, two important and successful English insurance companies were formed during this period -- the London Assurance Corporation and the Royal Exchange Assurance Corporation. Their operation marked the beginning of modern property and liability insurance. No discussion of the early development of insurance in Europe would be complete without reference to Lloyd's of London, the international insurance market. It began in the 17th century as a coffeehouse patronized by merchants, bankers, and insurance underwriters, gradually becoming recognized as the most likely place to find underwriters for marine insurance. Edward Lloyd supplied his customers with shipping information gathered from the docks and other sources; this eventually grew into the publication Lloyd's List, still in existence. Lloyd's was reorganized in 1769 as a formal group of underwriters accepting marine risks. (The word underwriter is said to have derived from the practice of having each risk taker write his name under the total amount of risk that he was willing to accept at a specified premium.) With the growth of British sea power, Lloyd's became the dominant insurer of marine risks, to which were later added fire and other property risks. Today Lloyd's is a major reinsurer as well as primary insurer, but it does not itself transact insurance business; this is done by the member underwriters, who accept insurance on their own account and bear the full risk in competition with each other.
United States.
The first American insurance company was organized by Benjamin Franklin in 1752 as the Philadelphia Contributionship. The first life insurance company in the American colonies was the Presbyterian Ministers' Fund, organized in 1759. By 1820 there were 17 stock life insurance companies in the state of New York alone. Many of the early property insurance companies failed from speculative investments, poor management, and inadequate distribution systems. Others failed after the Great Chicago Fire in 1871 and the San Francisco earthquake and fire of 1906. There was little effective regulation, and rate making was difficult in the absence of cooperative development of sound statistics. Many problems also beset the life insurance business. In the era following the U.S. Civil War, bad practices developed: dividends were declared that had not been earned, reserves were inadequate, advertising claims were exaggerated, and office buildings were erected that sometimes cost more than the total assets of the companies. Thirty-three life insurance companies failed between 1870 and 1872, and another 48 between 1873 and 1877.
After 1910 life insurance enjoyed a steady growth in the United States. The annual growth rate of insurance in force over the period 1910-90 was approximately 8.4 percent--amounting to a 626-fold increase for the 80-year period. Property-liability insurance had a somewhat smaller increase. By 1989 some 3,800 property-liability and 2,270 life insurance companies were in business, employing nearly two million workers. In 1987 U.S. insurers wrote about 37 percent of all premiums collected worldwide.
Japan.
Insurance in Japan is mainly in the hands of private enterprise, although government insurance agencies write crop, livestock, forest fire, fishery, export credit, accident and health, and installment sales credit insurance as well as social security. Private insurance companies are regulated under various statutes. Major classes of property insurance written include automobile and workers' compensation (which are compulsory), fire, and marine. Rates are controlled by voluntary rating bureaus under government supervision, and Japanese law requires rates to be "reasonable and nondiscriminatory." Policy forms generally resemble those of Western nations. Personal insurance lines are also well developed in Japan and include ordinary life, group life, and group pensions. Health insurance, however, is incorporated into Japanese social security.
Japan's rapid industrialization after World War II was accompanied by an impressive growth in the insurance business. Toward the end of the 20th century, Japan ranked number one in the world in life insurance in force. It accounted for about 25 percent of all insurance premiums collected in the world, ranking second behind the United States. The number of domestic insurers is relatively small; foreign insurers operate in Japan but account for less than 3 percent of total premiums collected.
Worldwide operations.
Because of the great expansion in world trade and the extent to which business firms make investments outside their home countries, the market for insurance on a worldwide scale has expanded rapidly in the 20th century. This development has required a worldwide network of offices to provide brokerage services, underwriting assistance, claims service, and so forth. The majority of the world's insurance businesses are concentrated in Europe and North America. These companies must service a large part of the insurance needs of the rest of the world. The legal and regulatory hurdles that must be overcome in order to do so are formidable.
In 1990 the 10 leading insurance markets in the world in terms of the percentage of total premiums collected were the United States (35.6 percent); Japan (20.5 percent); the United Kingdom (7.5 percent); Germany (6.8 percent); France (5.5 percent); the Soviet Union (2.6 percent); Canada (2.3 percent); Italy (2.2 percent); South Korea (2.0 percent); and Oceania (1.8 percent). Major world trends in insurance include a gradual movement away from nationalism of insurance, the development of worldwide insurance programs to cover the operations of multinational corporations, increasing use of reinsurance, increasing use by corporations of self-insurance programs administered by wholly owned insurance subsidiaries (captive companies), and increasing use of mergers among both insurers and brokerage firms.
Economic Theory
Introduction
Economic theory is the name commonly given to the more general and abstract parts of economics, the principles. These parts are no less practical than concrete-descriptive or applied economics but are less directly related to immediate problems. The mechanics of price relations or of markets afford a general explanation of the organization of production and distribution insofar as this is actually worked out and controlled through competitive buying and selling--which would largely be true even in a planned or socialistic economy that stopped short of complete military regimentation. This branch of the study bears somewhat the same relation to economic politics that pure physics bears to the engineering sciences. Hence the problems of value and distribution have continued to hold their place among the central concerns of economists. However, there has been a notable--one might say a revolutionary--change in the general character of the analysis. The older classical economists centered their attention on the long-run relations between value and costs and were generally content to dispose of short-run variations of price by merely invoking the formula of supply and demand. This was used without careful analysis of the short-run situation, particularly of the role of demand. Work directed toward filling in this gap had important effects in changing the whole conceptual picture. Enlarged theories of production, distribution, consumption, business fluctuations, and other economic elements
have been introduced and continually reconsidered from a variety of viewpoints.
Utility and value
One purpose of value theory in economics is to explain how the prices of goods and services are determined. This is only a step, however, in the analysis of a deeper problem. The modern industrial economy is characterized by a high degree of interdependence of its parts. The supplier of components or raw materials, for example, must deliver the desired quantities of his products at the right moment and in the desired specifications. In economies such as those of Western Europe, North America, and Japan, the coordination of these activities is done through the price system. The relative prices of the various inputs (e.g., labour, materials, and machinery) tend to determine the proportions in which they will be used. Prices also affect the relative outputs of the various final products, and they determine who will consume them. Value theory, therefore, studies the structure of these decisions, analyzes the influence of prices, and examines the efficiency of the resulting allocation of resources. Value theory is also applied by business firms and government agencies in their decisions that relate to pricing and the allocation of resources.
THEORIES OF VALUE
Cost-of-production analysis.
Modern value theory began with Adam Smith (1776), David Ricardo (1817), and a number of other writers, who are generally lumped together as the classical school. These writers sought to explain pricing primarily on the basis of cost of production. That is, if commodity A costs twice as much to produce as commodity B, the price of A will be pushed toward a level twice as high as that of B. If this were not the case--if, for example, A sold for three times the price of B--then the greater profitability of investment in A would cause its production to increase and drive down its price, while the production of B would decline, thus raising its price. Prices would finally be driven to the 2:1 ratio of the costs of production.
The classical economists were well aware of the oversimplification in this explanation, but, as with most theoretical analysis, its strength lay in the amount it was able to explain with a very simple model. (It is highly misleading to interpret the classical analysis literally, as a picture of its authors' views of the complex world of reality.) It was soon recognized, however, that the cost-of-production analysis considered only part of the relevant problem. Since cost depends on the quantity produced (e.g., costs per unit may decline as production of an item increases), the analysis must take into account the demand for the product. The analysis of demand was made possible by the theory of utility, developed by H.H. Gossen in Germany (1854), Karl Menger in Austria (1871), Léon Walras in France (1874-77), and W.S. Jevons in England (1871).
The role of utility analysis in value theory will be discussed later. It need only be added at this point that modern value theory, following the lead of the English economist Alfred Marshall ( Principles of Economics, 8th ed., 1920), considers prices to be determined simultaneously by cost and demand considerations. The analysis also recognizes the complex interdependencies in the system, with demands and supplies of various commodities affecting one another.
THEORIES OF UTILITY
There are two sides to the analysis of price and value: the supply side and the demand side. If cost can be said to underlie the supply relationship that determines price, the demand side must be taken to reflect consumer tastes and preferences. "Utility" is a concept that has been used to describe these tastes. As already indicated, the cost-of-production analysis of value given above is incomplete, because cost itself depends on the quantity produced. The cost analysis, moreover, applies only to commodities the production of which can be expanded and contracted. The price of a first-folio Shakespeare has no relation to cost of production; it must depend in some sense on its utility to purchasers as it affects their bids.
Marginal utility.
The classical economists suggested that this leads to a paradox. They argued that utility could not explain the relative price of fine jade and bread, because the latter was for many consumers essential to life, and hence its utility must surely be greater than that of jade. Yet the price of bread is far lower than that of jade. The theory of marginal utility that flowered toward the end of the 19th century supplied the key to the paradox and provided the basis for today's analysis of demand. Marginal utility was defined as the value to the consumer of an additional unit of some commodity. If, for example, the consumer is offered a choice between 22 and 23 slices of bread for his family, marginal utility measures how much more valuable 23 slices are than 22. It is clear that the magnitude of the marginal utility varies with the magnitude of, say, the smaller of the alternatives. That is, for a family of four, the difference between seven and eight slices of bread per day can be substantial, if the family will still be hungry in either case. But the difference in value between 31 and 32 slices may be negligible. If 31 slices offer enough for everyone to fill his stomach, a 32nd slice may be worth very little. Moreover, the difference in value between 122 and 123 slices may be negative--a 123rd slice may just add to the family's disposal problem. These observations lead directly to the plausible notion that marginal utility in some sense diminishes with the base from which one starts the calculation. With only seven or eight slices the marginal utility (incremental value) of an eighth slice is high. With 31 or 32 slices it is lower, and so on. The less scarce a commodity, the lower is its marginal utility, because its possessor in any case will have enough to satisfy his most pressing uses for it, and an increment in his holdings will only permit him to satisfy, in addition, desires of lower priority.
The consumer will be motivated to adjust his purchases so that the price of each and every good will be approximately equal to its marginal utility (that is, to the amount of money he is willing to pay for an additional unit). If the price of an item is P dollars, for example, and the consumer is considering buying, say, 10 units, at which point the marginal utility of the good to him is M (which is greater than P), the consumer will be better off if he purchases 11 rather than 10 units, since the additional unit costs him P dollars. He will keep revising his purchase plans upward until he reaches the point where the marginal utility of the item falls to P dollars. In sum, the consumer's self-interest will lead him (without conscious calculation) to purchase an amount such that the marginal utility is as close as possible to market price. So long as the consumer selects a bundle of purchases that gives him the most benefit (pleasure, utility) for his money, he must end up with quantities such that the marginal utility of each commodity in the bundle is approximately equal to its price.
It now becomes easy to explain the paradox underlying the relationship between the prices of jade and bread. Because a piece of fine jade is scarce, its marginal utility is high, and consumers are willing to pay comparatively high prices for it. The explanation is perfectly consistent with a utility analysis of demand, so long as one relates price to the marginal utility of the item rather than to its total utility. A family's bread may be very valuable to it, but, if it has enough, the marginal utility of the bread will be small, and this will be reflected in its low price.
Figure 1: Relationship between marginal utility and quantity
The relationship between price and marginal utility is important not because it explains issues like the jade-bread paradox but because it enables one to analyze the relationship between prices and quantities demanded. It also, as a practical matter, permits one to judge how well any portion of the price mechanism is working as a device to secure the efficient satisfaction of the wants of the public, within the limits set by available resources. The conclusion that at any price the consumer will purchase the quantity at which marginal utility is equal to price makes it possible to draw a demand curve showing--to a reasonable degree of approximation--how the amount demanded will vary with price. A curve based on the previous example of bread consumption is given in Figure 1. This shows that if the family gets 10 slices per day the marginal utility of bread will be nine cents (point A). One may reverse the question and ask how much the family would purchase at any particular price, say three cents. The graph indicates that at this price the quantity would be 30 slices, because only at that quantity is marginal utility equal to the three-cent price (point B). Thus the curve in Figure 1, to a reasonable degree of approximation, may be able to do double duty: it may serve as a marginal-utility curve relating marginal utility to quantity and, at the same time, as a demand curve relating quantity demanded to price.
Consumers' surplus.
Figure 1 leads to an important conclusion about the consumer's gains from his purchases. The diagram shows that the difference between 10 and 11 slices of bread is worth nine cents to the consumer (marginal utility = nine cents). Similarly, a 12th slice of bread is worth eight cents (see the shaded bars). Thus, the two slices of bread together are worth 17 cents, the area of the two rectangles together. Suppose the price of bread is actually three cents, and the consumer, therefore, purchases 30 slices per day. The total value of his purchases to him is the sum of the areas of all such rectangles for each of the 30 slices; i.e., it is (approximately) equal to all of the area under the demand curve; that is, the area defined by the points 0CBE. The amount the consumer pays, however, is less than this area. His total expenditure is given by the area of rectangle 0CBD--90 cents. The difference between these two areas, the quasi-triangular area DBE, represents how much more the consumer would be willing to spend on the bread over and above the 90 cents he actually pays for it, if he were forced to do so. It represents the absolute maximum that could be extracted from the consumer for the bread by an unscrupulous merchant who had cornered the market. Since, normally, the consumer only pays quantity 0CBD, the area DBE is a net gain derived by the consumer from the transaction. It is called consumers' surplus. Virtually every purchase yields such a surplus to the buyer.
The concept of consumers' surplus is important for public policy, because it offers at least a crude measure of the public benefits of various types of economic activity. In deciding whether a government agency should build a dam, for example, one may estimate the consumers' surplus from the electricity the dam would generate and seek to compare it with the surplus that could be yielded by alternative uses of the resources needed to construct and operate the dam.
Utility measurement and ordinal utility.
As originally conceived, utility was taken to be a subjective measure of strength of feeling. An item that might be described as worth "40 utils" was to be interpreted to yield "twice as much pleasure" as one valued at 20 utils. It was not long before the usefulness of this concept was questioned. It was criticized for its subjectivity and the difficulty (if not impossibility) of quantifying it. An alternative line of analysis developed that was able to accomplish most of the same purposes but without as many assumptions. First introduced by the economists F.Y. Edgeworth in England (1881) and Vilfredo Pareto in Italy (1896-97), it was brought to fruition by Eugen Slutsky in Russia (1915) and J.R. Hicks and R.D.G. Allen in Great Britain (1934). The idea was that to analyze consumer choice between, say, two bundles of commodities, A and B, given their costs, one need know only that one is preferred to another. This may at first seem a trivial observation, but it is not as simple as it sounds.
Figure 2: Commodities X and Y
In the following discussion, it is assumed for simplicity that there are only two commodities in the world. Figure 2 is a graph in which the axes measure the quantities of two commodities, X and Y. Thus, point A represents a bundle composed of seven units of commodity X and five units of commodity Y. The assumption is made that the consumer prefers to own more of either or both commodities. That means he must prefer bundle C to bundle A, because C lies directly to the right of A and hence contains more of X and no less of Y. Similarly, B must be preferred to A. But one cannot say, in general, whether A is preferred to D or vice versa, since one offers more of X and the other more of Y.
Figure 3: Indifference curves
The consumer may in fact not care whether he receives A or D--that is, he may be indifferent (see Figure 3). Assuming that there is some continuity in his preferences, there will be a locus connecting A and D, any point on which (E or A or D) represents bundles of commodities of equal interest to this consumer. This locus (I-I' in Figure 3) is called an indifference curve. It represents the consumer's subjective trade off between the two commodities--how much more of one he will have to get to make up for the loss of a given amount of another. That is, one may treat the choice between bundle D and bundle E as involving the comparison of the gain of quantity FD of X with the loss of FE of Y. If the consumer is indifferent between D and E, the gain and loss just offset one another; hence, they indicate the proportion in which he is willing to exchange the two commodities. In mathematical terms, FE divided by FD represents the average slope of the indifference curve over arc ED; it is called the marginal rate of substitution between X and Y.
Figure 3 also contains other indifference curves, some representing combinations preferred to A (curves lying above and to the right of A) and some representing combinations to which A is preferred. These are like contour lines on a map, each such line being a locus of combinations that the consumer considers equally desirable. Conceptually, through every point in the diagram there is an indifference curve. Figure 3, with its family of indifference curves, is called an indifference map. This map obviously does no more than rank the available possibilities; it indicates whether one point is preferred to another but not by how much it is preferred.
It is easy to show that at any point such as E the slope of the indifference curve, roughly FE divided by ED, equals the ratio of the marginal utility of X to the marginal utility of Y for the corresponding quantities. For in moving from E to D the consumer gives up FE of Y, a loss valued, by definition, at approximately FE multiplied by the marginal utility of Y, and he gains FD of X, a gain worth FD multiplied by the marginal utility of X. Relative marginal utilities can be measured in this way because their ratio does not measure subjective quantities--rather, it represents a rate of exchange of two commodities. The marginal utility of X measured in money terms tells one how much of the commodity used as money the consumer is willing to give for more of the commodity X but not what psychic pleasure the consumer gains.
PRICES AND INCOMES
One other type of information is needed to complete the analysis of consumer choice: the prices of X and Y and the amount the consumer has available to spend. In what follows, it will be assumed that the consumer spends all his money on the available commodities (savings bonds being among the commodities). If PX and PY are the prices of commodities X and Y, respectively, and M represents the amount of money available for spending, the condition that all of the money is spent yields the equation
or, solving for Y in terms of X,
(2)This is obviously the equation of a straight line with slope and with y-intercept.
The line, called the budget line, or price line, represents all the combinations of X and Y that the consumer can afford to buy with income M at the given prices.
Equilibrium of the consumer.
Figure 4: Indifference curves and a price line
Figure 4 combines this price line and the indifference curves, permitting direct analysis of the consumer purchase decision. Line PP' is the price line corresponding to equation (2) above. Any point R on that line represents a combination of X and Y that a given consumer can afford to purchase; however, R is not an optimal choice. This can be seen by comparing R with S on the same price line. Since S lies on a higher indifference curve than R, the former is the preferred position, and, since S costs no more than R (they are on the same price line, so each costs M dollars), S gives the consumer more for his money. It is at T, however, the point of tangency between the price line and an indifference curve, that the consumer reaches his highest indifference curve; this is, therefore, the optimal point for him, given his pattern of tastes as shown by the shapes of his indifference curves. This is the solution of the choice problem-it explains, in principle, the consumer's purchase decision on the basis of his given preferences, with no assumptions as to degrees of measurable utility.
The tangency at the solution point has a significant interpretation. It was noted above that the slope of the indifference curve is the ratio of the marginal utilities of the two commodities. It follows that, at the optimal point T, a dollar of expenditure must offer the same utility whether spent on X or on Y. If this is not so--as at point R in Figure 4, where the consumer gets more for his money by spending a dollar on Y rather than on X--it will pay him to reallocate his expenditures between the two commodities accordingly, moving toward S from R.
Changes in prices and incomes.
Figure 5: (A) Positive and (B) negative income-consumption curves
The diagram becomes more illuminating when one investigates how the consumer's decision is affected by a change in his income or in the price of a commodity. Equation (2) indicates that a change in income, M, does not affect the slope of the price line, only its intercept. Thus, as the person's income increases, the price line undergoes a sequence of parallel shifts (Figure 5). For each such line there will be a point of tangency, T, with an indifference curve, showing the consumer's optimal bundle of purchases with the corresponding income. The locus of these points (T1, T2, T3 . . .) may be called the income-consumption curve; it shows how the consumer's purchases vary with his income. Normally the curve will have a positive slope, as EE' does in Figure 5A, meaning that as a person grows wealthier he will buy more of each commodity. But the slope can be negative for some stretches (GG' in Figure 5B). In that case, X is said to be an inferior good of which the consumer buys less as his income rises.
Figure 6: Price-consumption curve
The diagram can also be used to show what happens as the price of X varies. From equation (2) it can be seen that the Y-intercept is not affected by an increase in the price of X but that the slope of the price line grows. Thus, as PX rises, the price line shifts from PP' to PR' in Figure 6. This means that, as PX rises, M dollars will buy as much of good Y as before (the position of point P at which all M dollars are spent on commodity Y does not change), but that M dollars will now buy less of good X, so that the position of point P' must move toward the left. Once again, by following the points of tangency between indifference curves and the price lines for various values of PX, one contains a locus UU', the price-consumption curve, showing how the consumer's purchases vary with PX.
Income and substitution effects.
Figure 7: Income effect and substitution effect
It is useful to divide the effects of the price change conceptually into two parts. An increase in the price of X obviously affects the relative cost of X and Y. But it also decreases the consumer's overall purchasing power. The effect on purchases of this reduction of purchasing power is called the income effect of the price change. Its effect via the relative price change is called the substitution effect. The division can be carried out graphically as follows: let the price of X increase so that the price line in Figure 7 moves from PP' to PR', and assume an imaginary intermediate price line, LL', with the slope of PR' but tangent to the indifference curve that was attained with the old price line PP'. The imaginary price line has the following properties: (1) it involves the same real income as PP' (tangency points T and S are the same indifference curve), and (2) it involves the same relative prices as the new price line since their slopes are the same. The rise in price has, in the figure, caused the demand for X to fall from C to A (the quantities of X corresponding to tangency points T and U). It has been possible to divide the total effect, CA, into two parts, the income effect, BA, and the substitution effect, CB. This breakdown is important, because a number of interesting and important theorems can be proved about the substitution effect. Two of these theorems will illustrate the point.
Under the normal assumptions of demand theory it can be proved that a rise in the price of X must, via the substitution effect, work to reduce the demand for X; the second theorem states the surprising result that, considering only substitution effects, a dollar rise in the price of X must change the demand for Y by precisely the same amount as a dollar rise in the price of Y changes the demand for X. Similar relationships have been shown to hold when there are more than two commodities involved.
Price
The price system, as it exists in western Europe and the Americas, is a means of organizing economic activity. It does this primarily by coordinating the decisions of consumers, producers, and owners of productive resources. Millions of economic agents who have no direct communication with each other are led by the price system to supply each other's wants. In a modern economy the price system enables a consumer to buy a product he has never previously purchased, produced by a firm of whose existence he is unaware, which is operating with funds partially obtained from his own savings.
Prices are an expression of the consensus on the values of different things, and every society that permits exchanges among men has prices. Because prices are expressed in terms of a widely acceptable commodity, they permit a ready comparison of the comparative values of various commodities--if shoes are $15 per pair and bread 30 cents per loaf, a pair of shoes is worth 50 loaves of bread. The price of anything is its value in exchange for a commodity of wide acceptability (money): the price of an automobile may be some 50 ounces of gold or 25 pieces of paper bearing the picture of an eminent statesman.
A system of prices exists because individual prices are related to each other. If, for example, copper rods cost 40 cents a pound and the process of drawing a rod into wire costs 25 cents a pound, then, if the price of wire exceeds 65 cents, it will be profitable to produce wire; and if the price of wire falls below 65 cents, it will be ruinous to produce wire. Competition, therefore, will hold the price of wire about 25 cents per pound above that of rods. A variety of such economic forces ties the entire structure of prices together.
The system of prices can be arranged to reward or penalize any kind of activity. Society discourages the production of electric shoestring-tying machines by the simple expedient of making such a machine's attainable selling price less than the prices of the resources necessary to produce it. Society stimulates people of large athletic promise to learn golf (rather than polo or cricket) by the immense prizes (= prices) that are given to tournament winners. The air in many cities is dirty because no one is charged a price for dirtying it and no one can pay a price for having it cleaned.
THE BASIC FUNCTIONS OF ECONOMIC SYSTEMS
Every economic system has three functions. In a decentralized (usually private enterprise) economic system, the price mechanism is the instrument by which these functions are performed.
Product and quantity.
One function is to determine what is to be produced and in what quantity. Even a primitive economy must choose between food and shelter, weapons and tools, priests and hunters. In a modern economy the potential variety of goods and services that may be produced is immense. Consider simply the 10,000 new book titles that are published each year or the hundreds of colours of paint or the thousands of styles of clothing that are produced--each of these actual collections being much smaller than modern technology permits.
A price system weighs the desires of consumers in terms of the prices they are willing to pay for various quantities of each commodity or service. The payment of $1,000 for the services of a skilled surgeon (a price much influenced by the number of surgeons) reflects the great importance of his services to the buyer-patient, whereas the offer of 75 cents for a month's use of an additional telephone outlet reflects the minor convenience it provides. Of course the offers of consumers are influenced by their wealth as well as their desires, but for any one consumer relative desires are proportional to price offers.
Universal laws are most uncommon in social life. Economists nonetheless place immense confidence in the proposition that the consumer will buy less of any commodity when its price rises. This law of demand is by no means a necessary fact of life; rather it is an empirical rule to which there are no known, reliable exceptions. Bread, caviar, education, narcotics--a man will buy more of each when its price falls. These demand prices are the guides to producers that in effect tell them which commodities to produce and in what quantities.
Production.
The second function an economy must perform is to decide how the desired goods are to be produced. There is more than one way not only to skin a cat but also to grow wheat, train lawyers, refine petroleum, and transport baggage. The efficient production of goods requires that certain obvious rules be followed: no resource should be used in producing one thing when it could be producing something more valuable elsewhere; and each product should be made with the smallest possible amount of resources.
A functioning price system steers resources into their most important use by appealing to the desires of their owners for large incomes. For example, the person capable of being a surgeon is drawn to this occupation from, say, that of a high school teacher by the promise of annual earnings (= price of labour) much more than those of the high school teacher. Capital is drawn from a faltering trade to a booming new industry in which it receives a higher return.
This same price system seeks to achieve production efficiency through the sanction of competition. If one firm, for instance, can produce shoes with fewer resources than its rivals, it will make larger profits; so it is stirred to discover more efficient combinations of inputs and location of plant, to devise wage systems to stimulate its workers, to use computers to reduce inventories, and so forth without end.
Distribution.
The third function of an economy is to determine who gets the product. Family A gets $5,000 worth of goods this year, family B five times as much--how is the division to be decided? The incomes of individuals are determined by the quantities of resources (labour skills, capital in all its forms) they own and the prices they receive for the use of these resources. Workers are incited by the price system to acquire new skills and to exercise them diligently, and families are encouraged to savings (capital accumulation) by the payment of interest or dividends. The inheritance of both personal ability and wealth also enter into the distribution of income.
If the price system is working reasonably well (some of the common failures will be noted later), it performs all of these economic functions with remarkable subtlety and precision. Society desires not only the correct amount of wheat but also that it be consumed more or less evenly over the crop year, with a surplus to carry over in case of a partial failure of the next year's crop. The price system provides a seasonal price pattern that encourages the holding of inventories rather than early splurging and richly rewards speculators who correctly anticipate a crop failure and hold grain that will alleviate it. In the same way, the desires of every sizable group of consumers (or resource owners) are registered through the price system; entrepreneurs are incited by price offers to provide opera and musical comedy, kosher food, and Persian delicacies. One might almost say that the price system is devoted to minority rule, since the only pressure toward uniformity is in the possibility of lowering costs of production by standardizing goods.
High prices in a properly functioning price system thus serve as incentives to produce more and consume less, and lower prices serve as corresponding deterrents. In addition the price system is a method of communicating information. Herbert Spencer once stated, rather ponderously, that only by constant iteration can alien truths be impressed upon reluctant minds: the price system, with its capacity for infinite repetition, is well suited to this sometimes unpleasant task. A higher price of steel scrap, for example, tells thousands of owners and collectors of scrap that more scrap is wanted and that more exhaustive search for abandoned rails, boilers, radiators, and machines is worth undertaking. A higher price of gasoline tells thousands of automobile drivers that gasoline should be used more sparingly, and the message is repeated each time each driver purchases more gasoline.
THE WORKINGS OF THE PRICE SYSTEM
The complexity and variety of tasks performed by the price system will be illuminated by an examination of three specific economic problems.
The choice of occupation.
Individuals must be distributed among occupations in such a way as to serve two basic purposes. First, the labourer must be placed where he is most productive--making certain that Enrico Fermi becomes a physicist rather than a chef and that there are not too many plumbers and too few electricians. Second, the individual worker should be given an occupation that is congenial to him: since he will spend a large part of his life at work, it will be a better life if he can choose the type he prefers.
The price of labour is the instrument by which workers are distributed among occupations: wages in rapidly growing occupations and rapidly growing parts of the nation are higher than in corresponding employment in declining occupations and areas. The choice of occupation involves, however, much more than simply a comparison of wage rates. The following are a few of the complications: (1) The wages of an occupation must as a rule be sufficient to compensate the costs of training. (2) The wages of an occupation must be sufficient to compensate special disadvantages (such as a large chance of unemployment). (3) Wages must be higher in large cities than in small because living costs are higher in large cities. (4) Wages must compensate workers for their additional skill as they acquire experience (they usually reach a peak of earnings between ages 40 and 55) and thereafter decline as the worker's efficiency declines. (5) Wages will reflect differences in taxation, fringe benefits (pensions, vacations), etc. Accordingly the wage structure even for a single occupation in a single city is elaborate. When a single wage (price) is imposed upon an occupation, labourers are no longer properly distributed by wages; for example, a city school system that pays all teachers of given experience the same wage finds it difficult to staff its less attractive schools.
The preferences of the individual worker cannot be given full play, or each person would become president of the corporation at a sumptuous salary. Yet the labourer may choose to live in California rather than Maine; then the price system will incite employers to move their operations to California, where they can hire this labourer more cheaply. The labourer may prefer to work long hours or short hours, and employers are induced by wage offers to cater to the labourer's diverse preferences. In fact it is equally appropriate to speak of the worker buying conditions of work and of the employer buying the services of the worker.
The conservation of resources.
A society has some resources that can be replaced by investment: timber is now largely grown as a commercial crop. Farmland is a more ancient example: the fertility of soil can be increased by prudent cultivation. Other resources are not replaceable, such as coal and petroleum. How does the price system conserve these exhaustible resources?
The method of using a resource is independent of the pattern over time of income and expenditures that the owner of the resource desires. Suppose that a farm will have a value of $100,000 if it is maintained at a constant level of fertility and yields a yearly income of $10,000 forever but that it can be cultivated ("mined") intensively to yield $12,000 a year for five years at the cost of a much reduced yield thereafter, with a value of $90,000. Even if the farmer is in urgent need of immediate funds and does not expect to live more than five years, he will still cultivate the farm at the uniform rate. Only then is it worth its maximum value to him, and only then (by sale or mortgage) can he obtain the largest possible funds even in the near future. In short, one need not adapt his expenditure pattern to his income pattern so long as he can borrow or lend.
If the growth of consumption or the decline of reserves threaten the exhaustion of supplies of a resource, then the price of that resource will rise and promise to rise more in the future, and this rise will serve to reduce current consumption and to reward the owner of the resource for holding back much of the supply for the future. This rise in price will therefore also stimulate buyers to find more economical ways of using the commodity (for example, burning the fuel more efficiently) and stimulate producers to find new supplies or substitute products. The price system will, therefore, ensure that the supply of the resource will be stretched out so that the resource will be available in both the present and the future.
LIMITATIONS AND FAILURES OF THE PRICE SYSTEM
The price system is an extraordinarily powerful instrument in organizing an economic system, but it is subject to three broad classes of limitations.
Private and public price control.
Sometimes prices are not permitted to do their work. Monopolies are able to exert control over prices; and they use it, sensibly enough, to raise their profits above the level allowed by competition. The monopolist (or group of colluding enterprises) sets prices at a level such that prices are above costs or, to use words of identical significance, such that resources earn more in the monopolized industry than they can earn elsewhere. The basis of the monopoly is its ability to prevent outsiders from entering the industry to share in the unusual profits and, by the act of producing, actually serve to eliminate them.
The fixing of prices by monopolists reduces the income of society. This is, in fact, the only well-established criticism (on grounds of efficiency) to be levied against monopolies: there is no reason to assume that they will make products less suited to consumer tastes or innovate more slowly or pay lower wages or otherwise misallocate resources. But the basic inefficiency led, first in the United States in 1890 and then increasingly in European nations, to governmental policies to maintain or restore competition.
Public price control has two aspects. A large part of public regulation is intended to correct monopolistic pricing (or other failures of the price system); this includes most public-utility regulation in the United States (transportation, electricity, and gas, etc.). Whatever the success of these endeavours--and on the whole there has been a substantial decline in confidence in the regulatory bodies--they are usually instructed to achieve the goals of an efficient price system.
Other public price controls are designed to serve ends outside the reach of the price system. Prices of farm products are regulated (raised) in most nations with the intention of improving farmers' incomes, and the fixing of interest rates paid by banks is undertaken to improve bank earnings. Such policies are invariably defended on various economic and ethical grounds but reflect primarily the political strength of large and well organized producer groups.
Externalities and the price system.
A second class of limitations consists of things that should be done but are not performable by a price system. Even when prices are freely established by competition, there is a class of economic relationships called "externalities" not efficiently controlled by prices. These may be illustrated by the air pollution caused by automobiles. Since no single automobile makes a significant contribution to air pollution, the owner has no incentive to bear the cost of installing antipollution devices even though all drivers would be better off if each did so. Yet if there are many automobiles in a region, it would be prohibitively expensive for drivers to contract with one another to have each install devices in his automobile to reduce pollution. The external effects of any one automobile's exhaust fumes are so diffuse and affect any one person so triflingly that they cannot be regulated by the price system.
The class of "externalities" is as broad as the class of actions that have effects upon people who are not parties to the contracts governing the actions. An attractive garden pleases passers-by, but they cannot be charged a portion of its cost. A new piece of scientific knowledge will prove useful to unknown persons. These two examples indicate that some externalities are economically trivial and some are highly important.
When the price system cannot deal with diffused effects, other social controls often take its place. The state invokes a whole arsenal of policies to deal with externalities, of which the following are only examples: (1) The state may subsidize activities that do not end in a product that can be sold. Thus basic scientific research that does not lead to patentable processes is subsidized. (2) Individuals may be compelled to act uniformly in areas where contracts would be too expensive; traffic laws, zoning laws, and compulsory vaccination are examples. (3) The state may itself undertake an activity that cannot be financed by sale of services, the most obvious example being national defense.
An interesting type of externality is the problem of highway congestion. Any one person's presence on a highway at a time and place of peak density has only a negligible effect upon others, so that, except on toll roads, private contracts have not been feasible. The state itself has not been able to deal effectively with highway congestion. More highways can be built until no highway is ever crowded, but this would be intolerably expensive. The state has lacked a method of inducing drivers to shift to less crowded hours and routes by charging fees to those drivers who impose high congestion costs by driving at peak times. Recent developments in technology may make it feasible to use the price system to reduce congestion. For example, cameras at appropriate points could photograph automobile licenses and a computer could accumulate the charges based on route and time for each automobile. Then only a person for whom travel at peak times was worth, for example, 25 cents per mile would impose (and pay for) the congestion he created.
Imperfect knowledge and tastes.
A third class of limitations to which the price system is subject has to do with the control of knowledge and tastes. To the extent that an economic actor, whether a consumer, a labourer, or an investor, is poorly informed, he is likely to make decisions whose consequences are much different from those he desired and expected. What follows relates only to consumer decisions, but parallel issues arise in labour markets, securities markets, etc.
A consumer can satisfy his desires only if he makes intelligent purchases--that is, only if the goods he buys are what he believes them to be. How can the consumer know whether the meat is free of disease or whether the washing machine will function well and long or whether the fabric of the garment is one synthetic fibre or another? To ascertain these facts personally, the consumer would have to be a versatile scientist equipped with a superb laboratory--and then he would need to spend so much time testing goods that he would have little time to enjoy them.
In some measure the consumer does experiment in his buying: whenever he buys a thing repeatedly, experience tells him much concerning its properties. Direct experience is a sufficient guide in buying celery or hiring domestic servants, but usually the purchase of information takes a less direct form. The city's premier department store can sell at prices somewhat higher than less well-known retailers; and the difference represents the payment of a price for reliability, responsibility, and the guarantee of quality. In parallel fashion the consumer buys the washing machine of a company that made his excellent refrigerator. Occasionally, information is bought directly: the advice of a lawyer, the knowledge of an appraiser, the taste of an interior decorator.
The most important and controversial method of informing consumers is by advertising. Many critics are outraged by the self-serving statements of sellers, some of whom indubitably provide irrelevance and deception rather than information. Yet the informational content of advertising may not be as deficient as its critics believe: advertising itself meets two market tests. In the first place, the direct sale of information by consumer advisory services has never become important, although there are no obstacles to entering this business. In the second place, there has been a general, sustained improvement in the quality of consumer goods over time: the automobile tire goes many more miles than formerly; the airplane flies more safely.
Nevertheless, recent public policy has paid great attention to increasing the safety of products and to raising the accuracy of advertising claims.
Knowledge is sometimes difficult to distinguish from taste: does the consumer who persists in smoking cigarettes have inadequate knowledge or simply different comparative values for the pleasures and risks of smoking? Censorship, in any event, is fairly common in every economic system: no society allows young children or incompetents full freedom of action or allows the unlimited sale of narcotics. Since the price system never forbids an effective demand (a demand backed by a willingness to pay the supply price), some form of restriction of prices is, therefore, necessary if certain tastes are to be forbidden or restricted. Compulsory school attendance can be viewed as, in effect, a form of censorship; and so are the controls on sale of firearms and the taxes on tobacco and liquor.
NONCAPITALIST PRICE SYSTEMS
The foregoing discussion has been confined to the price system as it exists in capitalist economies. The Communist countries have prices, but not autonomous price systems; in those countries the direction of economic activity is largely in the hands of the central authorities, and prices are used mainly as a marketing device. None of the three allocative functions of an economy--determination of what will be produced, of how it will be produced, and of who will get the product--is performed by the price mechanism in the socialist economies.
The relative scarcities that money prices measure exist, of course, in all countries and would exist in a world where no money or exchanges were allowed. Robinson Crusoe had a problem of allocating his time between sleep, garnering food, building shelter, etc.; and he confronted implicit costs of extending any one activity, for more food meant less of other things. The economist calls these implicit exchange ratios "shadow prices," and they appear in all areas of life in which deliberate choices are made.
Price systems are therefore the result of scarcity. The basic proposition of economics, that scarcities are essentially ubiquitous, is often phrased as "there is no such thing as a free lunch"; and it reminds one that the price of the lunch may be future patronage, a reciprocal lunch, or a boring monologue. The task of economic organization is the task of devising price systems that allow a society to achieve its basic goals.
Market structure: competition, oligopoly, monopoly
When economists use such words as "competition" and "monopoly" they have in mind certain complex relations among firms in an industry. An industry, as economists define it, is a group of sellers of close-substitute products who supply a common group of buyers. For the economy as a whole an industry would include all sellers having this relation. Thus one can recognize a cigarette or automobile or aluminum industry--in all, hundreds of industries.
TYPES OF MARKET STRUCTURES
Different industries have different market structures--that is, different market characteristics that determine the relations of sellers to one another, of sellers to buyers, and so forth. Probably the most important aspects of market structure are (1) the degree of concentration of sellers in an industry, (2) the degree of product differentiation, and (3) the ease or difficulty with which new sellers can enter the industry.
Concentration of sellers.
Seller concentration refers to the number of sellers in an industry together with their comparative shares of industry sales. When the number of sellers is quite large, and each seller's share of the market is so small that in practice he cannot, by changing his selling price or output, perceptibly influence the market share or income of any competing seller, economists speak of atomistic competition. A more common situation is that of oligopoly, in which the number of sellers is so few that the market share of each is large enough for even a modest change in price or output by one seller to have a perceptible effect on the market shares or incomes of rival sellers, and to cause them to react to the change. In a broader sense, oligopoly exists in any industry in which at least some sellers have large shares of the market, even though there may be an additional number of small sellers. When a single seller supplies the entire output of an industry, and thus can determine his selling price and output without concern for the reactions of rival sellers, a single-firm monopoly exists.
Product differentiation.
The structure of a market is also affected by the extent to which those who buy from it prefer some products to others. In some industries the products are regarded as identical by their buyers--as, for example, basic farm crops. In others the products are differentiated in some way so that various buyers prefer various products. Notably, the criterion is a subjective one; the buyers' preferences may have little to do with tangible differences in the products but are related to advertising, brand names, and distinctive designs. The degree of product differentiation as registered in the strength of buyer preferences ranges from slight to fairly large, tending to be greatest among infrequently purchased consumer goods and "prestige goods," particularly those purchased as gifts.
Ease of entry.
Industries vary in the ease with which new sellers can enter them. The barriers to entry consist of the advantages that sellers already established in an industry have over the potential entrant. Such a barrier is generally measurable by the extent to which established sellers can persistently elevate their selling prices above minimal average costs without attracting new sellers. The barriers may exist because costs for established sellers are lower than they would be for new entrants, or because the established sellers can command higher prices from buyers who prefer their products to those of potential entrants. The economics of the industry also may be such that new entrants would have to be able to command a substantial share of the market before they could operate profitably.
The effective height of these barriers varies. One may distinguish three rough degrees of difficulty in entering an industry: blockaded entry, which allows established sellers to set monopolistic prices, if they wish, without attracting entry; impeded entry, which allows established sellers to raise their selling prices above minimal average costs without attracting new sellers, but not as high as a monopolist's price; and easy entry, which does not permit established sellers to raise their prices at all above minimal average costs without attracting new entrants.
Classification of industries.
This discussion of market characteristics suggests a general way of classifying industries according to their market structures:
Under atomistic competition, in which entry is generally easy, there are no barriers to entry. By the same token, product differentiation among sellers is obviously inconsistent with single-firm monopoly.
The comparative importance of these types of market structure differs among various sectors of the economy. In the manufacturing sector in the United States, which includes about 400 industries, single-firm monopolies are almost completely absent. But in more than half of the manufacturing industries there is enough seller concentration for them to qualify as oligopolies. The remaining industries are more or less atomistic in their market structure. An appreciable degree of product differentiation is found in about half of the oligopolistic industries and in about half of the atomistic industries. Very strong product differentiation is usually found among oligopolistic industries. Easy entry is typical of atomistic industries, impeded entry of oligopolies. Entry is probably blockaded in a minor fraction of the latter, generally those with very high seller concentration.
The proportions of oligopolistic and atomistic manufacturing industries are about the same in the United Kingdom as in the United States. The incidence of oligopolies is slightly higher in Japan and progressively higher in France, Italy, Canada, and Sweden. Single-firm monopolies in manufacturing are found in a few industries in some of these countries, but they are typically under government ownership.
In the public-utility sector in the United States, single-firm monopolies are typically found in industries supplying gas, electricity, and telephone and telegraph service. Oligopoly, frequently highly concentrated, is typical in the radio and television and transportation industries; entry into these industries is usually very difficult or blockaded. The significance of such structural conditions is lessened, however, by the fact that these industries are subject to various degrees of public regulation. The situation is much the same in other Western countries, except that public utilities are frequently under government ownership.
In the distributive trades (wholesaling and retailing), a number of United States industries are fairly atomistic, while a somewhat larger number are relatively unconcentrated oligopolies in which a few large sellers supply about half the industry's output and a very large number of small sellers supply the remainder. Product differentiation is important. Entry is relatively easy. The service-trade industries in the United States display a similar range of characteristics. In the distributive- and service-trade sectors in other Western countries, oligopoly is less frequent and atomistic industries are proportionally more important. The residential-construction industries in the U.S. and elsewhere are relatively atomistic in structure, have significant product differentiation, and are easy to enter. Industries in the agricultural sectors of Western countries generally are typically atomistic in structure, with easy entry. But the significance of these structural conditions is lessened by governmental interference designed to modify the working of market forces.
MARKET CONDUCT AND PERFORMANCE
How do sellers behave in determining their selling prices, outputs, advertising costs, and so forth; and in what ways does this market behaviour differ among industries with different types of market structure? An educated layman might ask, for example, whether sellers cut their selling prices in order to take customers away from each other until some rock-bottom market price is reached just high enough to allow them minimal interest returns on their investments or whether, on the other hand, they agree with each other to set a uniform higher price well above their production costs, sharing the market and reaping excessive profits.
It is helpful to distinguish the related ideas of market conduct and market performance. Market conduct refers to the price and other market policies pursued by sellers, in terms both of their aims and of the way in which they coordinate their decisions and make them mutually compatible. Market performance refers to the end results of these policies--the relationship of selling price to costs, the size of output, the efficiency of production, progressiveness in techniques and products, and so forth.
Pure competition.
Market conduct and performance in atomistic industries provide good standards against which to measure behaviour in other types of industry. The atomistic category includes both pure competition and monopolistic competition. In pure competition, a large number of small sellers supply a homogeneous product to a common buying market. In this situation no individual seller can perceptibly influence the market price at which he sells but must accept a market price that is impersonally determined by the total supply of the product offered by all sellers and the total demand for the product of all buyers. The large number of sellers precludes the possibility of a common agreement among them, and each must therefore act independently. At any going market price, each seller tends to adjust his output to that quantity that will yield him the largest aggregate profit, assuming that the market price will not change as a result. But the collective effect of such adjustments by all sellers will cause the total supply in the market to change significantly so that the market price falls or rises. Theoretically, the process will go on until a market price is reached at which the total output that sellers wish to produce is equal to the total output that all buyers wish to purchase. This way of reaching a provisional equilibrium price is what Adam Smith was referring to when he wrote of prices being determined by "the invisible hand" of the market
If the provisional equilibrium price is high enough to allow the established sellers profits in excess of a normal interest return on investment, then added sellers will be drawn to enter the industry, and supply will increase until a final equilibrium price is reached that is equal to the minimal average cost of production (including an interest return) of all sellers. Conversely, if the provisional equilibrium price is so low that established sellers incur losses, some will tend to withdraw from the industry, and supply will decline until the same sort of long-run equilibrium price is reached.
The long-run performance of a purely competitive industry therefore embodies these features: (1) industry output is at a feasible maximum and industry selling price at a feasible minimum; (2) all production is undertaken at minimum attainable average costs, since competition forces them down; and (3) income distribution is not influenced by the receipt of any excess profits by sellers.
This performance has often been applauded as ideal from the standpoint of general economic welfare. But the applause, for several reasons, should not be unqualified. Pure competition is truly ideal only if all or most industries in the economy are purely competitive and if in addition there is free and easy mobility of productive factors among industries. Otherwise, the relative outputs of different industries will not be such as to maximize consumer satisfaction. There is also some question whether producers in purely competitive industries will generally earn enough to plow back some of their earnings into improved equipment and thus maintain a satisfactory rate of technological progress. Finally, some purely competitive industries have been afflicted with "destructive competition"--the coal industry and the basic agricultural industries, for example. For some historical reason such an industry accumulates excess capacity to the point where sellers suffer chronic losses, and the situation is not corrected by the exit of people and resources from the industry. The invisible hand of the market works too slowly for society to accept. In some cases, notably in agriculture, government has intervened to restrict supply or raise prices. Leaving these qualifications aside, however, the market performance of pure competition furnishes some sort of a standard to which the performance of industries of different structure may be compared.
Monopolistic competition.
In the more complex situation of monopolistic competition (atomistic structure with product differentiation) market conduct and performance may be said to follow roughly the tendencies attributed to pure competition. The principal differences are the following. First, individual sellers, because of the differentiation of their products, are able to raise or lower their individual selling prices slightly; they cannot do so by very much, however, because they remain strongly subject to the impersonal forces of the market operating through the general level of prices. Second, rivalry among sellers is likely to involve sales promotion costs as well as the expense of altering products to appeal to buyers. This is a competitive game that all will play but that nobody, on the average, will win, and the long-run equilibrium price will reflect the added costs involved. In return, however, buyers will get more variety. Third, since not every seller is likely to be equally successful in his sales-promotion and product policies, some will receive profits in excess of a basic interest return on their investment; such profits will come from their success in winning buyers. Monopolistic competition may, like pure competition, include industries that are afflicted with what has been called above destructive competition. This may result not only from a failure to get rid of excess capacity but also from the entry of too many new firms despite the danger of losses.
Monopoly.
While single-firm monopolies are rare, except for those subject to public regulation, it is useful to examine the monopolist's market conduct and performance to establish a standard at the other pole from pure competition. As the sole supplier of a distinctive product, the monopolist can set any selling price provided he accepts the sales that correspond to that price. Since the market demand will generally be less the higher the price he sets, the monopolist presumably will set that price that produces the greatest profits, given the relationship of production costs to output. By restricting output he can raise his selling price significantly--an option not opens to sellers in atomistic industries.
The monopolist will generally charge prices well in excess of production costs and reap profits well above a normal interest return on investment. His output will be substantially smaller, and his price higher, than if he had to meet established market prices as in pure competition. The monopolist may or may not produce at minimal average cost, depending on his cost-output relationship; if he does not, there are no market pressures to force him to do so.
If the monopolist is subject to no threat of entry by a competitor, he will presumably set a selling price that maximizes profits for the industry he monopolizes. If he faces only impeded entry, he may elect to charge a price sufficiently low to discourage entry but above a competitive price--if this will maximize his long-run profits.
Oligopoly.
Market conduct and performance in oligopolistic industries generally combine monopolistic and competitive tendencies, with the relative strength of the two tendencies depending roughly on the detailed market structure of the oligopoly.
Rivalry among sellers.
In the simplest form of oligopolistic industry, sellers are few and every seller supplies a sufficiently large share of the market so that any feasible and modest change in his policies will appreciably affect the market shares of all his rival sellers and induce them to react or respond. For example, if seller A reduces his selling price below the general level of prices being charged by all sellers sufficiently to permit him to capture significant numbers of customers from his rivals if they hold their selling prices unchanged, they may react by reducing their prices by a similar amount, so that none gains at the expense of others and the group has probably reduced its combined profits. Or seller A's rivals may retaliate by reducing their selling prices more than he did, thus forcing a further reaction from him. Conversely, if seller A increases his selling price above the general level being charged by all sellers (thus tending to lose at least some of his customers to his rivals), they may react by holding their prices unchanged, in which event seller A will probably retract his increase and bring his price back to the previous level. But his rivals may also react by raising their prices as much as seller A raised his, in which case the general level of prices in the industry rises and the combined profits of all sellers are probably increased.
Any seller A in an oligopoly will therefore determine whether or not to alter his price or other market policy in the light of his conjectures about the reactions of his rivals. Correspondingly, his rivals will determine their reactions in the light of their conjectures about what seller A will do in response. The process is not likely to bring the industry price level down to minimal average cost (as in atomistic competition). Many different "equilibrium" levels between the competitive and monopolistic limits are possible, depending on further circumstances.
Thus in an oligopoly viable collusive agreements among rival sellers are quite possible. They may be express agreements established by contract or tacit understandings that develop as a pattern of reactions among sellers to changes in each others' prices or market policies becomes customary. In the United States, express collusive agreements are forbidden by law, but tacit agreements or "gentlemen's understandings" are common in oligopolies. In numerous other Western countries, formal collusive agreements (often called cartels if comprehensive in scope) are legal. Whether tacit or explicit, legal or illegal, one may say that oligopolistic prices tend to be "administered" by sellers, in the senses mentioned above, as distinct from being determined by impersonal market forces.
Sellers' dual aims.
The varying market performance of oligopolies results from the fact that individual sellers intrinsically have two conflicting aims. One common desire is to establish among themselves a monopolistic level of price (and of selling costs, etc.), which will maximize their combined profits, giving them the largest "profit pie" to divide. But each seller also has a fundamental antagonism toward rival sellers and wants to maximize his own profits even at the expense of theirs. The relative strengths of these conflicting aims--the maximizing of combined profits and the maximizing of individual profits--will likely depend on how concentrated the oligopoly is, because when sellers are fewer and their individual market shares larger, their rivals' reactions are stronger deterrents to independent actions.
This is why various sorts of market performance are to be expected in oligopolistic industries. When the entry of other sellers is blockaded, collusive or interdependent behaviour may lead to a full monopoly price. If entry is only impeded, the resulting price may be far enough below the full monopoly level to discourage further entry. But prices are not always what they seem. An announced price that is well above cost may be undercut by clandestine price reductions to individual buyers, bringing the average of actual selling prices down somewhat.
If an oligopolistic industry is made up of a "core" of a few large interdependent sellers plus a "competitive fringe" of several or numerous quite small sellers, the competition of the small sellers may induce the large ones to limit the extent to which they raise their prices.
Price behaviour approaching full monopoly pricing seems to be found mainly in oligopolies having very high seller concentration and blockaded entry. Where these characteristics are less pronounced, prices and profits tend to be lower, though they are likely to be somewhat above the competitive level. A few economists maintain that oligopolistic prices in general do not significantly differ from atomistically competitive prices, but the bulk of statistical evidence does not support them.
In oligopolies in which product differentiation is important, sales-promotion costs and the costs of product improvement or development will display roughly the same variety of tendencies found in pricing. Where there are a few large interdependent sellers, these costs may be restricted to about the same level as those of a single-firm monopolist; on the other hand, rivalry in sales promotion and product development may be sufficient to raise them higher. Oligopolists may also arrive collusively at relatively high uniform selling prices but simultaneously engage in independent nonprice competition (perhaps more so where seller concentration is lower).
WORKABLE COMPETITION
Definition and attributes.
Since the character of market performance varies among industries along with their market characteristics, efforts have been made to devise some practical standard for identifying the sorts of market structure that engender socially satisfactory performance in a given industry. The term workable competition was coined to denote competition that may be considered as leading to a reasonable or socially acceptable approximation to ideal performance in the circumstances of a particular industry. The limits of such an approximation are of course debatable, and so the idea of workable competition must remain elusive because it is basically subjective.
Without entering into a complex theoretical discussion of the relationship of individual-industry performance to overall welfare, it is plausible to suggest the following principal attributes of workable performance in an industry: (1) In the long term, selling price on the average should be equal to or not significantly above average costs of production, so that profits do not appreciably exceed a normal interest return on investment. Prices should be responsive to basic reductions in costs. (2) In so far as average costs of production are affected by the scales or capacities of plants and firms, the preponderance of industry output should be from plants and firms of the most efficient scale or with closely comparable technical efficiency. (3) The industry should not have chronic excess capacity--i.e., significant plant capacity that is persistently unused even in periods of high general economic activity. (4) The industry's sales-promotion costs should not be substantially greater than needed to keep buyers informed of the availability, characteristics, and prices of products. (5) The industry should be adequately progressive in introducing more economical production techniques and improved products--balancing the costs of progress with the gains.
While the first three of these attributes are easier to appraise than the others, certain generalizations are possible concerning the workability of different market structures: (1) Unregulated single-firm monopolies tend to generate unworkable market performance, mainly in the form of output restriction, prices well above costs, and consequent excess profits. They have undesirable effects on the uses to which resources are put and on income distribution. (2) Oligopolies with high seller concentration and also very high barriers to entry tend toward unworkable performance, like that of single-firm monopoly. In general, however, they do not show significant degrees of technical inefficiency resulting from inefficient plant scales or excess capacity. (3) Oligopolies with fairly high seller concentration but only moderate barriers to entry are also prone to unworkable performance of the sort just mentioned, but not to as high a degree. (4) Oligopolies with only moderate seller concentration and moderate-to-low barriers to entry tend toward workable performance both in price-cost relations and in technical efficiency, except that some of them may have recurrent chronic excess capacity due to periodic overentry. (If cartels are legalized and their provisions are not rigorously controlled by government, the last two categories of oligopoly may have the same sort of unworkable performance as do very highly concentrated oligopolies.) (5) Industries of atomistic structure tend generally toward workable performance unless they suffer from destructive competition as described above.
Product differentiation and promotion.
In industries with significant differentiation of products among sellers--and especially in oligopolies of this sort--there is a tendency for minor but significant fractions of income to be devoted to persuasive (as distinct from informational) advertising and other sales promotion and also to more or less idle variations of product design, with the result that resources are in a sense "wasted" and costs increased.
By the criteria of workable competition, a purely rational society would presumably favour industries with moderate to low seller concentration, moderate to low barriers to entry, and without extreme product differentiation--all this from the standpoint of enhancing overall material welfare. The argument that oligopolistic and atomistic industries generally need legal protection from destructive competition may be discarded on the basis of evidence. Price and other market warfare in such industries has been extremely rare in industrial countries in the last 50 years.
Production: the output of the factors of production
In economics, the theory of production is an effort to explain the principles by which a business firm decides how much of each commodity that it sells (its "outputs" or "products") it will produce, and how much of each kind of labour, raw material, fixed capital good, etc., that it employs (its "inputs" or "factors of production") it will use. The theory involves some of the most fundamental principles of economics. These include the relationship between the prices of commodities and the prices (or wages or rents) of the productive factors used to produce them and also the relationships between the prices of commodities and productive factors, on the one hand, and the quantities of these commodities and productive factors that are produced or used, on the other.
The various decisions a business enterprise makes about its productive activities can be classified into three layers of increasing complexity. The first layer includes decisions about methods of producing a given quantity of the output in a plant of given size and equipment. It involves the problem of what is called short-run cost minimization. The second layer, including the determination of the most profitable quantities of products to produce in any given plant, deals with what is called short-run profit maximization. The third layer, concerning the determination of the most profitable size and equipment of plant, relates to what is called long-run profit maximization.
MINIMIZATION OF SHORT-RUN COSTS
The production function.
However much of a commodity a business firm produces, it endeavours to produce it as cheaply as possible. Taking the quality of the product and the prices of the productive factors as given, which is the usual situation, the firm's task is to determine the cheapest combination of factors of production that can produce the desired output. This task is best understood in terms of what is called the production function, i.e., an equation that expresses the relationship between the quantities of factors employed and the amount of product obtained. It states the amount of product that can be obtained from each and every combination of factors. This relationship can be written mathematically as y = f (x1, x2, . . . , xn; k1, k2, . . . , km). Here, y denotes the quantity of output. The firm is presumed to use n variable factors of production; that is, factors like hourly paid production workers and raw materials, the quantities of which can be increased or decreased. In the formula the quantity of the first variable factor is denoted by x1 and so on. The firm is also presumed to use m fixed factors, or factors like fixed machinery, salaried staff, etc., the quantities of which cannot be varied readily or habitually. The available quantity of the first fixed factor is indicated in the formal by k1 and so on. The entire formula expresses the amount of output that results when specified quantities of factors are employed. It must be noted that though the quantities of the factors determine the quantity of output, the reverse is not true, and as a general rule there will be many combinations of productive factors that could be used to produce the same output. Finding the cheapest of these is the problem of cost minimization.
The cost of production is simply the sum of the costs of all of the various factors. It can be written:
in which p1 denotes the price of a unit of the first variable factor, r1 denotes the annual cost of owning and maintaining the first fixed factor, and so on. Here again one group of terms, the first, covers variable cost (roughly" direct costs" in accounting terminology), which can be changed readily; another group, the second, covers fixed cost (accountants' "overhead costs"), which includes items not easily varied. The discussion will deal first with variable cost.
Figure 8: Isoquant diagram of hours of labour and feet of gold wire used per month.
The principles involved in selecting the cheapest combination of variable factors can be seen in terms of a simple example. If a firm manufactures gold necklace chains in such a way that there are only two variable factors, labour (specifically, goldsmith-hours) and gold wire, the production function for such a firm will be y = f (x1, x2; k), in which the symbol k is included simply as a reminder that the number of chains producible by x1 feet of gold wire and x2 goldsmith-hours depends on the amount of machinery and other fixed capital available. Since there are only two variable factors, this production function can be portrayed graphically in a figure known as an isoquant diagram (Figure 8). In the graph, goldsmith-hours per month are plotted horizontally and the number of feet of gold wire used per month vertically. Each of the curved lines, called an isoquant, will then represent a certain number of necklace chains produced. The data displayed show that 100 goldsmith-hours plus 900 feet of gold wire can produce 200 necklace chains. But there are other combinations of variable inputs that could also produce 200 necklace chains per month. If the goldsmiths work more carefully and slowly, they can produce 200 chains from 850 feet of wire; but to produce so many chains more goldsmith-hours will be required, perhaps 130. The isoquant labelled "200" shows all the combinations of the variable inputs that will just suffice to produce 200 chains. The other two isoquants shown are interpreted similarly. It is obvious that many more isoquants, in principle an infinite number, could also be drawn. This diagram is a graphic display of the relationships expressed in the production function.
Substitution of factors.
The isoquants also illustrate an important economic phenomenon: that of factor substitution. This means that one variable factor can be substituted for others; as a general rule a more lavish use of one variable factor will permit an unchanged amount of output to be produced with fewer units of some or all of the others. In the example above, labour was literally as good as gold and could be substituted for it. If it were not for factor substitution there would be no room for further decision after y, the number of chains to be produced, had been established.
The shape of the isoquants shown, for which there is a good deal of empirical support, is very important. In moving along any one isoquant, the more of one factor that is employed, the less of the other will be needed to maintain the stated output; this is the graphic representation of factor substitutability. But there is a corollary: the more of one factor that is employed, the less it will be possible to reduce the use of the other by using more of the first. This is the property known as "diminishing marginal rates of substitution." The marginal rate of substitution of factor 1 for factor 2 is the number of units by which x1 can be reduced per unit increase in x, output remaining unchanged. In the diagram, if feet of gold wire are indicated by x1 and goldsmith-hours by x2, then the marginal rate of substitution is shown by the steepness (the negative of the slope) of the isoquant; and it will be seen that it diminishes steadily as x2 increases because it becomes harder and harder to economize on the use of gold simply by taking more care. The remainder of the analysis rests heavily on the assumption that diminishing marginal rates of substitution are characteristic of the production process generally.
Figure 9: Isoquant diagram for two factors of production, x1 and x2
The cost data and the technological data can now be brought together. The variable cost of using x1, x2 units of the factors of production is written p1x1 + p2x2, and this information can be added to the isoquant diagram (Figure 9). The straight line labelled v2, called the v2-isocost line, shows all the combinations of input that can be purchased for a specified variable cost, v2. The other two isocost lines shown are interpreted similarly. The general formula for an isocost line is p1x1 + p2x2 = v, in which v is some particular variable cost. The slope of an isocost line is found by dividing p2 by p1 and depends only on the ratio of the prices of the two factors.
Three isocost lines are shown, corresponding to variable costs amounting to v1, v2, and v3. If 200 units are to be produced, expenditure of v1 on variable factors will not suffice since the v1- in socost line never reaches the isoquant for 200 units. An expenditure of v3 is more than sufficient; and v2 is the lowest variable cost for which 200 units can be produced. Thus v2 is found to be the minimum variable cost of producing 200 units (as v3 is of 300 units) and the coordinates of the point where the v2 isocost line touches the 200-unit isoquant are the quantities of the two factors that will be used when 200 units are to be produced and the prices of the two factors are in the ratio p2/p1. It may be noted that the cheapest combination for the production of any quantity will be found at the point at which the relevant isoquant is tangent to an isocost line. Thus, since the slope of an isoquant is given by the marginal rate of substitution, any firm trying to produce as cheaply as possible will always purchase or hire factors in quantities such that the marginal rate of substitution will equal the ratio of their prices.
The isoquant-isocost diagram (or the corresponding solution by the alternative means of the calculus) solves the short-run cost minimization problem by determining the least-cost combination of variable factors that can produce a given output in a given plant. The variable cost incurred when the least-cost combination of inputs is used in conjunction with a given outfit of fixed equipment is called the variable cost of that quantity of output and denoted VC(y). The total cost incurred, variable plus fixed, is the short-run cost of that output, denoted SRC(y). Clearly SRC(y) = VC(y) + R(K), in which the second term symbolizes the sum of the annual costs of the fixed factors available.
Marginal cost.
Two other concepts now become important. The average variable cost, written AVC(y), is the variable cost per unit of output. Algebraically, AVC(y) = VC(y)/y. The marginal variable cost, or simply marginal cost [MC(y)] is, roughly, the increase in variable cost incurred when output is increased by one unit; i.e., MC(y) = VC(y + 1) - VC(y). Though for theoretical purposes a more precise definition can be obtained by regarding VC(y) as a continuous function of output, this is not necessary in the present case.
Figure 10: Average variable costs (AVC) and marginal variable costs (MC) in relation to output.
The usual behaviour of average and marginal variable costs in response to changes in the level of output from a given fixed plant is shown in Figure 10. In this figure costs (in dollars per unit) are measured vertically and output (in units per year) is shown horizontally. The figure is drawn for some particular fixed plant, and it can be seen that average costs are fairly high for very low levels of output relative to the size of the plant, largely because there is not enough work to keep a well-balanced work force fully occupied. People are either idle much of the time or shifting, expensively, from job to job. As output increases from a low level, average costs decline to a low plateau. But as the capacity of the plant is approached, the inefficiencies incident on plant congestion force average costs up quite rapidly. Overtime may be incurred, outmoded equipment and inexperienced hands may be called into use, there may not be time to take machinery off the line for routine maintenance; or minor breakdowns and delays may disrupt schedules seriously because of inadequate slack and reserves. Thus the AVC curve has the flat-bottomed U-shape shown. The MC curve, as might be expected, falls faster and rises more rapidly than the AVC curve.
MAXIMIZATION OF SHORT-RUN PROFITS
The average and marginal cost curves just deduced are the keys to the solution of the second-level problem, the determination of the most profitable level of output to produce in a given plant. The only additional datum needed is the price of the product, say p0.
The most profitable amount of output may be found by using these data. If the marginal cost of any given output (y) is less than the price, sales revenues will increase more than costs if output is increased by one unit (or even a few more); and profits will rise. Contrariwise, if the marginal cost is greater than the price, profits will be increased by cutting back output by at least one unit. It then follows that the output that maximizes profits is the one for which MC(y) = p0. This is the second basic finding: in response to any price the profit-maximizing firm will produce and offer the quantity for which the marginal cost equals that price
Such a conclusion is shown in Figure 10. In response to the price, p0, shown, the firm will offer the quantity y* given by the value of y for which the ordinate of the MC curve equals the price. If a denotes the corresponding average variable cost, net revenue per unit will be equal to p0 - a, and the total excess of revenues over variable costs will be y*(p0 - a), which is represented graphically by the shaded rectangle in the figure.
Marginal cost and price.
The conclusion that marginal cost tends to equal price is important in that it shows how the quantity of output produced by a firm is influenced by the market price. If the market price is lower than the lowest point on the average variable cost curve, the firm will "cut its losses" by not producing anything. At any higher market price, the firm will produce the quantity for which marginal cost equals that price. Thus the quantity that the firm will produce in response to any price can be found in Figure 10 by reading the marginal cost curve, and for this reason the marginal cost curve is said to be the short-run supply curve for the firm.
The short-run supply curve for a product--that is, the total amount that all the firms producing it will produce in response to any market price--follows immediately, and is seen to be the sum of the short-run supply curves (or marginal cost curves, except when the price is below the bottoms of the average variable cost curves for some firms) of all the firms in the industry. This curve is of fundamental importance for economic analysis, for together with the demand curve for the product it determines the market price of the commodity and the amount that will be produced and purchased.
One pitfall must, however, be noted. In the demonstration of the supply curves for the firms, and hence of the industry, it was assumed that factor prices were fixed. Though this is fair enough for a single firm, the fact is that if all firms together attempt to increase their outputs in response to an increase in the price of the product, they are likely to bid up the prices of some or all of the factors of production that they use. In that event the product supply curve as calculated will overstate the increase in output that will be elicited by an increase in price. A more sophisticated type of supply curve, incorporating induced changes in factor prices, is therefore necessary. Such curves are discussed in the standard literature of this subject.
Marginal product.
It is now possible to derive the relationship between product prices and factor prices, which is the basis of the theory of income distribution. To this end, the marginal product of a factor is defined as the amount that output would be increased if one more unit of the factor were employed, all other circumstances remaining the same. Algebraically, it may be expressed as the difference between the product of a given amount of the factor and the product when that factor is increased by an additional unit. Thus if MP1(x1) denotes the marginal product of factor 1 when x1 units are employed, then MP1(x1) = f(x1 + 1, x2, . . . ,xn;k) - f(x1, x2 . . . ,xn; k). The marginal products are closely related to the marginal rates of substitution previously defined. If an additional unit of factor 1 will increase output by f1 units, for example, then one more unit of output can be obtained by employing 1/f1 more units of factor 1. Similarly, if the marginal product of factor 2 is f2, then output will fall by one unit if the use of factor 2 is reduced by 1/f2 units. Thus output will remain unchanged, to a good approximation, if 1/f1 units of factor 1 are used to replace 1/f2 units of factor 2. The marginal rate of substitution is therefore f2/f1, or the ratio of the marginal products of the two factors. It has already been shown that the marginal rate of substitution also equals the ratio of the prices of the factors, and it therefore follows that the prices (or wages) of the factors are proportional to their marginal products.
This is one of the most significant theoretical findings in economics. To restate it briefly: factors of production are paid in proportion to their marginal products. This is not a question of social equity but merely a consequence of the efforts of businessmen to produce as cheaply as possible.
Further, the marginal products of the factors are closely related to marginal costs and, therefore, to product prices. For if one more unit of factor 1 is employed, output will be increased by MP1(x1) units and variable cost by p1; so the marginal cost of additional units produced will be p1/MP1(x1). Similarly, if additional output is obtained by employing an additional unit of factor 2, the marginal cost will be p2/MP2(x2). But, as shown above, these two numbers are the same; whichever factor i is used to increase output, the marginal cost will be pi/MPi(xi) and, furthermore, the firm will choose its output level so that the marginal cost will be equal to the price, p0.
Therefore it has been established that p1 = p0MP1(x1), p2 = p0MP2(x2), . . . , or the price of each factor is the price of the product multiplied by its marginal product, which is the value of its marginal product. This, also, is a fundamental theorem of income distribution and one of the most significant theorems in economics. Its logic can be perceived directly. If the equality is violated for any factor, the businessman can increase his profits either by hiring units of the factor or by laying them off until the equality is satisfied, and presumably the businessman will do so.
The theory of production decisions in the short run, as just outlined, leads to two conclusions (of fundamental importance throughout the field of economics) about the responses of business firms to the market prices of the commodities they produce and the factors of production they buy or hire: (1) the firm will produce the quantity of its product for which the marginal cost is equal to the market price and (2) it will purchase or hire factors of production in such quantities that the price of the commodity produced multiplied by the marginal product of the factor will be equal to the cost of a unit of the factor. The first explains the supply curves of the commodities produced in an economy. Though the conclusions were deduced within the context of a firm that uses two factors of production, they are clearly applicable in general.
MAXIMIZATION OF LONG-RUN PROFITS
Relationship between the short run and the long run.
The theory of long-run profit-maximizing behaviour rests on the short-run theory that has just been presented but is considerably more complex because of two features: (1) long-run cost curves, to be defined below, are more varied in shape than the corresponding short-run cost curves, and (2) the long-run behaviour of an industry cannot be deduced simply from the long-run behaviour of the firms in it because the roster of firms is subject to change. It is of the essence of long-run adjustments that they take place by the addition or dismantling of fixed productive capacity by both established firms and new or recently created firms.
At any one time an established firm with an existing plant will make its short-run decisions by comparing the ruling price of its commodity with cost curves corresponding to that plant. If the price is so high that the firm is operating on the rising leg of its short-run cost curve, its marginal costs will be high--higher than its average costs--and it will be enjoying operating profits, as shown in Figure 10. The firm will then consider whether it could increase its profits by enlarging its plant. The effect of plant enlargement is to reduce the variable cost of producing high levels of output by reducing the strain on limited production facilities, at the expense of increasing the level of fixed costs.
In response to any level of output that it expects to continue for some time, the firm will desire and eventually acquire the fixed plant for which the short-run costs of that level of output are as low as possible. This leads to the concept of the long-run cost curve: the long-run costs of any level of output are the short-run costs of producing that output in the plant that makes those short-run costs as low as possible. These result from balancing the fixed costs entailed by any plant against the short-run costs of producing in that plant. The long-run costs of producing y are denoted by LRC(y). The average long-run cost of y is the long-run cost per unit of y [algebraically LAC(y) = LRC(y)/y]. The marginal long-run cost is the increase in long-run cost resulting from an increase of one unit in the level of output. It represents a combination of short-run and long-run adjustments to a slight increase in the rate of output. It can be shown that the long-run marginal cost equals the marginal cost as previously defined when the cost-minimizing fixed plant is used.
Long run cost curves.
Cost curves appropriate for long-run analysis are more varied in shape than short-run cost curves and fall into three broad classes. In constant-cost industries, average cost is about the same at all levels of output except the very lowest. Constant costs prevail in manufacturing industries in which capacity is expanded by replicating facilities without changing the technique of production, as a cotton mill expands by increasing the number of spindles. In decreasing-cost industries, average cost declines as the rate of output grows, at least until the plant is large enough to supply an appreciable fraction of its market. Decreasing costs are characteristic of manufacturing in which heavy, automated machinery is economical for large volumes of output. Automobile and steel manufacturing are leading examples. Decreasing costs are inconsistent with competitive conditions, since they permit a few large firms to drive all smaller competitors out of business. Finally, in increasing-cost industries average costs rise with the volume of output generally because the firm cannot obtain additional fixed capacity that is as efficient as the plant it already has. The most important examples are agriculture and extractive industries.
CRITICISMS OF THE THEORY
The theory of production has been subject to much criticism. One objection is that the concept of the production function is not derived from observation or practice. Even the most sophisticated firms do not know the direct functional relationship between their basic raw inputs and their ultimate outputs. This objection can be got around by applying the recently developed techniques of linear programming, which employ observable data without recourse to the production function and lead to practically the same conclusions.
On another level the theory has been charged with excessive simplification. It assumes that there are no changes in the rest of the economy while individual firms and industries are making the adjustments described in the theory; it neglects changes in the technique of production; and it pays no attention to the risks and uncertainties that becloud all business decisions. These criticisms are especially damaging to the theory of long-run profit maximization. On still another level, critics of the theory maintain that businessmen are not always concerned with maximizing profits or minimizing costs.
Though all of the criticisms have merit, the simplified theory of production does nevertheless indicate some basic forces and tendencies operating in the economy. The theorems should be understood as conditions that the economy tends toward, rather than conditions that are always and instantaneously achieved. It is rare for them to be attained exactly, but it is just as rare for substantial violations of the theorems to endure.
Only the simplest aspects of the theory were described above. Without much difficulty it could be extended to cover firms that produce more than one product, as almost all firms do. With more difficulty it could be applied to firms whose decisions affect the prices at which they sell and buy (monopoly, monopolistic competition, monopsony). The behaviour of other firms that recognize the possibility that their competitors may retaliate (oligopoly) is still a theory of production subject to controversy and research.
Distribution: the shares of the factors of production
The factors of production, as suggested earlier, are the economic resources, both human and other, which, if properly utilized, will bring about a flow or output of goods and services. The factors are commonly classified into three groups: capital, labour, and land. The first, in the simplest sense, refers to all the "produced" instruments of production--the factories, their equipment, their stocks of raw materials and finished goods, houses, trade facilities, and so on; the owners of capital receive their income in various possible forms, profits and interest being the usual ones. The factor of labour represents all those productive resources that can be applied only at the cost of human effort; the wage (or salary) is the form of payment for use of this factor. The factor of land represents resources whose supply is low in relation to demand and cannot be increased as the result of production; the income derived from the ownership of this factor is known as economic rent.
Distribution, in economics, generally refers to (1) explanations of how prices for the services of the different factors of production are determined; (2) explanations of how the total product of the economy is divided among the various factors, and (3) descriptions of the ways in which the income is divided among various income classes or groups of persons.
CAPITAL AND INTEREST
Capital in economics is a word of many meanings. They all imply that capital is a "stock" by contrast with income, which is a "flow." In its broadest possible sense, capital includes the human population; nonmaterial elements such as skills, abilities, and education; land, buildings, machines, equipment of all kinds; and all stocks of goods--finished or unfinished--in the hands of both firms and households.
In the business world the word capital usually refers to an item in the balance sheet representing that part of the net worth of an enterprise that has not been produced through the operations of the enterprise. In economics the word capital is generally confined to "real" as opposed to merely "financial" assets. Different as the two concepts may seem, they are not unrelated. If all balance sheets were consolidated in a closed economic system, all debts would be cancelled out because every debt is an asset in one balance sheet and a liability in another. What is left in the consolidated balance sheet, therefore, is a value of all the real assets of a society on one side and its total net worth on the other. This is the economist's concept of capital.
A distinction may be made between goods in the hands of firms and goods in the hands of households, and attempts have been made to confine the term capital structure to the former. There is also a distinction between goods that have been produced and goods that are gifts of nature; attempts have been made to confine the term capital to the former, though the distinction is hard to maintain in practice. Another important distinction is between the stock of human beings (and their abilities) and the stock of nonhuman elements. In a slave society human beings are counted as capital in the same way as livestock or machines. In a free society each man is his own slave--the value of his body and mind is not, therefore, an article of commerce and does not get into the accounting system. In strict logic persons should continue to be regarded as part of the capital of a society; but in practice the distinction between the part of the total stock that enters into the accounting system, and the part that does not, is so important that it is not surprising that many writers have excluded persons from the capital stock.
Another distinction that has some historical importance is that between circulating and fixed capital. Fixed capital is usually defined as that which does not change its form in the course of the process of production, such as land, buildings, and machines. Circulating capital consists of goods in process, raw materials, and stocks of finished goods waiting to be sold; these goods must either be transformed, as when wheat is ground into flour, or they must change ownership, as when a stock of goods is sold. This distinction, like many others, is not always easy to maintain. Nevertheless, it represents a rough approach to an important problem of the relative structure of capital; that is, of the proportions in which goods of various kinds are found. The stock of real capital exhibits strong complementarities. A machine is of no use without a skilled operator and without raw materials for it to work on.
The classical theory of capital.
Although ancient and medieval writers were interested in the ethics of interest and usury, the concept of capital as such did not rise to prominence in economic thought before the classical economists (Adam Smith, David Ricardo, Nassau Senior, and John Stuart Mill).
Adam Smith laid great stress on the role played by the accumulation of a stock of capital in facilitating the division of labour economics and in increasing the productivity of labour in general. He recognized clearly that accumulation proceeds from an excess of production over consumption. He distinguished between productive labour, which creates objects of capital, and unproductive labour (services), the fruits of which are enjoyed immediately. His thought was strongly coloured by observation of the annual agricultural cycle. The end of the harvest saw society with a given stock of grain. This stock was in the possession of the capitalists. A certain portion of it they reserved for their own consumption and for the consumption of their menial servants, the rest was used to feed "productive labourers" during the ensuing year. As a result, by the end of the next harvest the barns were full again and the stock had replaced itself, perhaps with something left over. The stock that the capitalists did not reserve for their own use was the "wages fund"--the more grain there was in the barn in October the sharper the competition of capitalists for workers, and the higher real wages would be in the year to come. The picture is a crude one, of course, and does not indicate the complexity of the relationship between stocks and flows in an industrial society. The last of the classical economists, John Stuart Mill, was forced to abandon the wages-fund theory. Nevertheless, the wages fund is a crude representation of some real but complex relationships, and the theory reappears in a more sophisticated form in later writers.
The classical economists distinguished three categories of income--wages, profit, and rent--and identified these with three factors of production--labour, capital, and land. David Ricardo especially made a sharp distinction between capital as "produced means of production," and land as the "original and indestructible powers of the soil." In modern economics this distinction has become blurred.
The Austrian school.
About 1870 a new school developed, sometimes called the Austrian school from the fact thatmany of its principal members taught in Vienna, but perhaps better called the Marginalist school. The movement itself was thoroughly international, and included such figures as William Stanley Jevons in England and Léon Walras in France. The so-called Austrian theory of capital is mainly based on the work of Eugen Böhm-Bawerk. His Positive Theory of Capital (1889) set off a controversy that has not yet subsided. In the Austrian view the economic process consisted of the embodiment of "original factors of production" in capital goods of greater or lesser length of life that then yielded value or utility as they were consumed. Between the original embodiment of the factor and the final fruition in consumption lay an interval of time known as the period of production. In an equilibrium population it can easily be shown that the total population (capital stock) equals the annual number of births or deaths (income) multiplied by the average length of life (period of production). The longer the period of production, therefore, the more capital goods there will be per unit of income. If the period of production is constant, income depends directly on the amount of capital previously accumulated. Here is the wages fund in a new form. Unfortunately, the usefulness of Böhm-Bawerk's theory is much impaired by the fact that it is confined to equilibrium states. The great problems of capital theory are dynamic in character, and comparative statics throws only a dim light on them.
Marginalist and Keynesian theories.
The Marginalist school culminated in the work of three men--P.H. Wickstead in England, Knut Wicksell in Sweden, and Irving Fisher in the United States. The last two especially gave the Austrian theory clear mathematical expression. Perhaps the greatest contribution of the Austrian theory was its recognition of the importance of the valuation problem in the relation of capital to interest. From the mere fact that physical capital produces an income stream, there is no explanation of the phenomenon of interest, for the question is why the value of a piece of physical capital should be less than the total of future values that are expected to accrue from it. The theory also makes a contribution to the problem of rational choice in situations involving waiting or maturing. The best example is that of slowly maturing goods such as wines or timber. There is a problem here of the best time to draw wine or to cut down a tree. According to the marginal theory this is at the time when the rate of net value growth of the item is just equal to the rate of interest, or the rate of return in alternative investments. Thus, if a tree or a wine is increasing in value at the rate of 7 percent per annum when the rate of interest is 6 percent it still pays to be patient and let it grow or mature. The longer it grows, however, the less the rate of value growth, and when the rate of value growth has fallen to the rate of interest, then is the time to reap the fruits of patience. (see also Index: profit maximization)
The contributions of John Maynard (Lord) Keynes to capital theory are incidental rather than fundamental. Nevertheless, the "Keynesian revolution" had an impact on this area of economic thought as on most others. It overthrew the traditional assumption of most economists that savings were automatically invested. The great contribution of Keynes, then, is the recognition that the attempt to save does not automatically result in the accumulation of capital. A decision to restrict consumption is only a decision to accumulate capital if the volume of production is constant. If abstention from consumption itself results in a diminution of production, then accumulation (production minus consumption) is correspondingly reduced.
Later thinking.
The theory of capital was not a matter of primary concern to economists in the late 20th century, though some revival of interest occurred in the late 1950s. Nevertheless, certain problems remain of perennial interest. They may be grouped as follows.
Heterogeneous goods.
First are the problems involved in measuring aggregates of goods. Real capital includes everything from screwdrivers to continuous strip-rolling mills. A single measure of total real capital can be achieved only if each item can be expressed in a common denominator such as a given monetary unit (e.g., dollars, sterling, francs, pesos, etc.). The problem becomes particularly complicated in periods of rapid technical change when there is change not only in the relative values of products but in the nature of the list itself. Only approximate solutions can be found to this problem, and no completely satisfactory measure is ever possible.
A related problem that has aroused considerable interest among accountants is how to value capital assets that have no fixed price. In the conventional balance sheet the value of some items is based on their cost at an earlier period than that of others. When the general level of prices is changing this means that different items are valued in monetary units of different purchasing power. The problem is particularly acute in the valuation of inventory. Under the more conventional "FIFO" ( First In, First Out) system, inventory is valued at the cost (purchase price) of the latest purchases. This leads to an inflation of inventory values, and therefore of accounting profits, in time of rising prices (and a corresponding deflation under falling prices), which may be an exaggeration of the long-run position of the firm. This may be partially avoided by a competing system of valuation known as LIFO ( Last In, First Out), in which inventory is valued at the purchase price of the earliest purchases. This avoids the fluctuations caused by short-run price-level changes, but it fails to record changes in real long-run values. There seems to be no completely satisfactory solution to this problem, and it is wise to recognize the fact that any single figure of capital value that purports to represent a complex, many-dimensional reality will need careful interpretation.
The accumulation process.
A second problem concerns the factors that determine the rate of accumulation of capital; that is, the rate of investment. It has been seen that investment in real terms is the difference between production and consumption. The classical economist laid great stress on frugality as the principal source of capital accumulation. If production is constant it is true that the only way to increase accumulation is by the reduction of consumption. Keynes shifted the emphasis from the reduction of consumption to the increase of production, and regarded the decision to produce investment goods as the principal factor in determining the rate of growth of capital. In modern theories of economic development great stress is laid on the problem of the structure of production--the relative proportions of different kinds of activity. The advocates of "balanced growth" emphasize the need for a developing country to invest in a wide range of related and cooperative enterprises, public as well as private. There is no point in building factories and machines, they say, if the educational system does not provide a labour force capable of using them. There is also, however, a case to be made for "unbalanced growth," in the sense that growth in one part of the economy frequently stimulates growth in other parts. A big investment in mining or in hydroelectric power, for example, creates strains on the whole society, which result in growth responses in the complementary sectors. The relation of inflation to economic growth and investment is an important though difficult problem. There seems to be little doubt that deflation, mainly because it shifts the distribution of income away from the profit maker toward the rentier and bondholder, has a deleterious effect on investment and the growth of capital. In 1932, for instance, real investment had practically ceased in the United States. It is less clear at what point inflation becomes harmful to investment. In countries where there has been long continuing inflation there seems to be some evidence that the structure of investment is distorted. Too much goes into apartment houses and factories and not enough into schools and communications.
Capital and time.
A third problem that exists in capital theory is that of the period of production and the time structure of the economic process. This cannot be solved by the simple formulas of the Austrian school. Nevertheless, the problem is a real one and there is still a need for more useful theoretical formulations of it. Decisions taken today have results extending far into the future. Similarly, the data of today's decisions are the result of decisions that were taken long in the past. The existing capital structure is the embodiment of past decisions and the raw material of present decisions. The incompatibility of decisions is frequently not discovered at the time they are made because of the lapse of time between the decision and its consequences. It is tempting to regard the cyclical structure of human history, whether the business cycle or the war cycle, as a process by which the consequences of bad decisions accumulate until some kind of crisis point is reached. The crisis (a war or a depression) redistributes power in the society and so leads to a new period of accumulating, but hidden, stress. In this process, distortion in the capital structure is of great importance.
Capital and income.
A fourth problem to be considered is the relationship that exists between the stocks and the flows of a society, or in a narrower sense the relation between capital and income. Income, like capital, is a concept that is capable of many definitions; a useful approach to the concept of income is to regard it as the gross addition to capital in a given period. For any economic unit, whether a firm or an individual, income may be measured by that hypothetical amount of consumption that would leave capital intact. In real terms this is practically identical with the concept of production. The total flow of income is closely related to both the quantity and the structure of capital; the total real income of a society depends on the size and the skills of its population, and on the nature and the extent of the equipment with which they have to work. The most important single measure of economic well-being is real income per person; this is closely related to the productivity of labour, and this in turn is closely related to capital per person, especially if the results of investment in human resources, skills, and education are included in the capital stock.
Interest.
Historically, the concept of capital has been so closely bound to the concept of interest that it seems wise to take these two topics together, even though in the modern view it is capital and income rather than capital and interest that are the related concepts.
Interest as a form of income may be defined as income that is received as a result of the possession of contractual obligations for payment on the part of another. Interest, in other words, is income that is received as a result of the ownership of a bond, a promissory note, or some other instrument that represents a promise on the part of some other party to pay sums in the future. The obligations may take many forms. In the case of the perpetuity, the undertaking is to pay a certain sum each year or other interval of time for the indefinite future. A bond with a date of maturity usually involves a promise to pay a certain sum each year for a given number of years, and then a larger sum on the terminal date. A promissory note frequently consists of a promise to pay a single sum at a date that is some time in the future.
If a1, a2, . . . an are the sums received by the bondholder in years 1, 2 . . . n, and if P0 is the present value in year 0, or the sum for which the bond is purchased, the rate of interest r in the whole transaction is given by the equation
There is no general solution for this equation, though in practice it can be solved easily by successive approximation, and in special cases the equation reduces to much simpler forms. In the case of a promissory note, for instance, the equation reduces to the form
where an is the single promised payment. In the case of a perpetuity with an annual payment of a, the formula reduces to
Thus if one had to pay $200 to purchase a perpetual annuity of $5 per annum, the rate of interest would be 2 1/2 percent.
It should be observed that the dimensions of the rate of interest are those of a rate of growth. The rate of interest is not a price or ratio of exchange; it is not itself determined in the market. What is determined in the market is the price of contractual obligations or "bonds." The higher the price of a given contractual obligation, the lower the rate of interest on it. Suppose, for instance, that one has a promissory note that is a promise to pay one $100 in one year's time. If I buy this for $100 now, the rate of interest is zero; if I buy it for $95 now the rate of interest is a little over 5 percent; if I buy it for $90 now, the rate of interest is about 11 percent. The rate of interest may be defined as the gross rate of growth of capital in a contractual obligation.
A distinction is usually made between interest and profit as forms of income. In ordinary speech, profit usually refers to income derived from the ownership of aggregates or assets of all kinds organized in an enterprise. This aggregate is described by a balance sheet. In the course of the operations of the enterprise, the net worth grows, and profit is the gross growth of net worth. Stocks, as opposed to bonds, usually imply a claim on the profits of some enterprise.
The development of interest theory.
In ancient and medieval times the main focus of inquiry into the theory of interest was ethical, and the principal question was the moral justification of interest. On the whole, the taking of interest was regarded unfavorably by both classical and medieval writers. Aristotle regarded money as "barren" and the medieval schoolmen were hostile to usury. Nevertheless, where interest fulfilled a useful social function elaborate rationalizations were developed for it. Among the classical economists, the focus of attention shifted away from ethical justification toward the problem of mechanical equilibrium. The question then became this: Is there any equilibrium rate of interest or rate of profit in the sense that where actual rates are above or below this, forces are brought into play, tending to change them toward the equilibrium? The classical economists did not provide any clear solution for this problem. They believed that the rate of interest simply followed the rate of profit, for people would not borrow or incur contractual obligations unless they could earn something more than the cost of the borrowing by investing the proceeds in enterprises or aggregates of real capital. They believed that the growth of capital itself would tend to reduce the rate of profit because of the competition of the capitalists. This doctrine is important in the Marxian dynamics in which the struggle of capital to avoid a falling rate of profit is seen as a critical factor leading, for instance, to unemployment, foreign investment, and imperialism.
In the framework of classical economics, the work of Nassau Senior deserves mention. He raised the question whether profit or interest were "paid for" anything; that is, whether there was any identifiable contribution to the general product of society that would not be forthcoming if this form of income were not paid. He identified such a function and called it abstinence. Karl Marx denied the existence of any such function and argued that the social product must be attributed entirely to acts of labour, capital being merely the embodied labour of the past. On this view, profit and interest are the result of pure exploitation in the sense that they consist of an income derived from the power position of the capitalist and not from the performance of any service. Non-Marxist economists have generally followed Senior in finding some function in society that corresponds to these forms of income.
The Marginalists generally held that profit and interest were related to the marginal productivity of the extension of the period of production. Böhm-Bawerk assumed that "roundabout" processes of production would generally be more productive than processes with shorter periods of production; he thought there was a productivity of "waiting" (to use the term of Alfred Marshall) and saw the rate of interest as an inducement to the capitalist to extend the period of productionA low rate of interest leads to concentration on longer, more roundabout processes, and a high rate of interest on shorter, less roundabout processes. There is a limit, however, on the period of production imposed by the existing stock of accumulated capital. If one embarks on a long process with insufficient capital, he will find that he has exhausted his resources before the end of the process and before the fruits can be gathered. It is the business of the rate of interest to prevent this, and to adjust the roundaboutness of the processes used to the capital resources available. The Marginalists' theory of interest reached its clearest expression in the work of Irving Fisher. He saw an equilibrium rate of interest as determined by the interaction of two sets of forces: the impatience of consumers on the one hand, and the returns from extending the period of production on the other.
John Maynard Keynes brought a new approach. His liquidity preference theory of interest is a short-run theory of the price of contractual obligations ("bonds"), and it is essentially an application of the general theory of market price. If people as a whole decide that they want to hold a larger proportion of their assets in the form of money, and if new money is not created to satisfy this desire, there will be a net desire to sell securities and the price of securities will fall. This is the same thing as a rise in the rate of interest. Conversely, if people want to get rid of money the price of securities will rise and the rate of interest will fall. This, then, is the theory of the "market" rate of interest, by contrast with the Marginalists' theory, which concerns itself with whether or not there is a long-run equilibrium rate of interest. The controversy, therefore, between the liquidity preference theory--which regards interest as a "bribe" to prevent people holding money rather than bonds--and the time preference theory--which regards interest as a bribe to persuade people to postpone enjoyments to the future--can be resolved by placing the former in the short run and the latter in the long run
Contemporary questions.
The middle of the 20th century saw a considerable shift in the focus of concern relating to the theory of interest. Economists seemed to lose interest in the equilibrium theory, and their main concern was with the effect of rates of interest as a part of monetary policy in the control of inflation. It was recognized that the monetary authority could control the rate of interest in the short run. The controversy lay mainly between the advocates of "monetary policy" and the advocates of " fiscal policy." If inflation is regarded as a symptom of a desire on the part of a society to consume and invest more in total than its resources permit, it is clear that the problem can be attacked either by diminishing investment or by diminishing consumption. On the whole, the attack of the advocates of monetary policy is on the side of diminishing investment, through raising rates of interest and making it harder to obtain loans, though the possibility that high rates of interest may restrict consumption is not overlooked. The alternative would seem to restrict consumption by raising taxes. This has the disadvantage of being politically unpopular. The mounting concern with economic growth, however, has raised considerable doubts about the use of high rates of interest as an instrument to control inflation. There is some doubt whether high interest rates in fact restrict investment; if they do not, they are ineffective, and if they do, they may be harmful to economic growth. This is a serious dilemma for the advocates of monetary policy. On the other hand, it must be admitted that the type of fiscal policy that might be most desirable theoretically has achieved very limited public support.
The ethics of interest.
The problem of the ethics of interest is still unresolved after many centuries of discussion; as long as the institution of private property is accepted, the usefulness of borrowing and lending can hardly be denied. In the long historic process of inheritance, widowhood, gain and loss, by which the distribution of the ownership of capital is determined, there is no reason to suppose that the actual ownership of capital falls into the hands of those best able to administer it. Much of the capital of an advanced society, in fact, tends to be owned by elderly widows, simply because of the greater longevity of the female. Society, therefore, needs some machinery for separating the control of capital from its ownership. Financial instruments and financial markets are the principal agency for performing this function. If all securities took the form of stocks or equities, it might be argued that contractual obligations (bonds), and therefore interest as a form of income, would not be necessary. The case for bonds and interest, however, is the case for specialization. There is a demand for many different degrees of ownership and responsibility, and interest-bearing obligations tap a market that would be hard to reach with equity securities; they are also peculiarly well adapted to the obligations of governments. The principal justification for interest and interest-bearing securities is that they provide an easy and convenient way for skilled administrators to control capital that they do not own and for the owners of capital to relinquish its control. The price society pays for this arrangement is interest.
There remains the problem of the socially optimum rate of interest. It could be argued that there is no point in paying any higher price than one needs to and that the rate of interest should be as low as is consistent with the performance of the function of the financial markets. This position, of course, would place all the burden of control of economic fluctuations on the fiscal system, and it is questionable whether this would be acceptable politically.
The ancient problem of "usury," in the form of the exploitation of the ignorant poor by moneylenders, is still important in many parts of the world. The remedy is the development of adequate financial institutions for the needs of all classes of people rather than the attempt to prohibit or even to limit the taking of interest. The complex structure of lending institutions in a developed society--banks, building societies, land banks, cooperative banks, credit unions, and so on--testifies to the reality of the service that the lender provides and that interest pays for. The democratization of credit--that is, the extension of the power of borrowing to all classes in society--is one of the important social movements of the 20th century.
Wages are income derived from human labour. Technically they cover all payments for the use of labour, mental or physical, but in ordinary usage the term excludes income of the self-employed and is restricted to compensation of employees. Occasionally fringe benefits are included, but generally they are not. The term is not fully synonymous with labour costs, which may include such items as cafeterias or meeting rooms maintained for the convenience of employees (such items are part of capital). Wages, in economic terms, however, do include remuneration in the form of extra benefits, such as paid vacations, holidays, and sick leave, as well as wage supplements in the form of pensions and health insurance paid for by the employer. A worker in covered industries also receives the protection of governmentally provided unemployment compensation, old-age pensions, and industrial accident compensation. Government services provided for workers are of even greater significance in European countries than in the United States and must be taken into account when comparisons of earnings are made
Classical theories.
Theories of wage determination and the share of labour in the gross national product have varied from time to time and have changed as the economic environment has changed. The body of thought referred to today as wage theories could not have emerged until the old feudal system had disappeared and the modern economy with its modern institutions had come into existence. Adam Smith, in The Wealth of Nations (1776), failed to propose a definitive theory of wages, but he anticipated several theories that were developed by others later. Smith thought that wages were determined in the marketplace through the law of supply and demand. Workers and employers would naturally follow their own self-interest; labour would be attracted to the jobs where labour was needed most, and the result would be the greatest overall benefit to the workers and to society. But Smith gave no precise analysis of the supply of and demand for labour; he discussed many elements that were involved but did not weave them into a consistent theoretical pattern.
Subsistence theory.
Subsistence theories emphasize the supply aspects and neglect the demand aspects of the labour market. They hold that change in the supply of workers is the basic force that drives real wages to the minimum required for subsistence. Elements of a subsistence theory appear in The Wealth of Nations, where Smith wrote that the wages paid to workers had to be enough to allow them to live and to reproduce themselves. Smith was more optimistic, however, than the British classical economists, such as David Ricardo and Thomas Malthus, who followed him, for he implied that--at least in an advancing nation--the wage level would have to be above subsistence to permit the population to grow enough to supply the additional workers needed. Ricardo maintained a more rigid view. He wrote that the "natural price" of labour was the price necessary to enable the labourers to subsist and to perpetuate the race without increase or diminution. Ricardo's statement was consistent with the Malthusian theory of population, which held that population adjusts to the means of supporting it. The market price of labour could not vary from the natural price for long: if wages rose above subsistence, the number of workers would increase and bring the wage rates down; if wages fell below subsistence, the number of workers would decrease and bring the wage rates up. At the time that these economists wrote, most workers were actually living near the subsistence level, and population appeared to be trying to outrun the means of subsistence. The subsistence theory seemed to fit the facts; and, although Ricardo said that the natural price of labour was not fixed and might be changed if custom and habit moderated population increases in relation to food supply and other items necessary to maintain labour, later writers tended to subscribe to the basic idea and not to admit exceptions. Their inflexible and inevitable conclusion earned the theory the name "iron law of wages."
Wages-fund theory.
Smith said that the demand for labour could not increase except in proportion to the increase of the funds destined for the payment of wages. Ricardo maintained that an increase in capital would result in an increase in demand for labour. Statements such as these foreshadowed the wages-fund theory, which held that a predetermined fund of wealth existed for the payment of wages. The size of the fund could be changed over periods of time, but at any given moment the amount was fixed, and the average wage could be determined simply by dividing the fund by the number of workers. Smith thought of the fund as surplus income of wealthy men--beyond the needs of their families and trade--which they would use to employ others. Ricardo thought of it in terms of capital--food, clothing, tools, raw materials, machinery, etc., necessary to give effect to labour. Regardless of the makeup of the fund, the obvious conclusion was that when the fund was large in relation to the number of workers, wages would be high. When it was relatively small, wages would be low. If population increased too rapidly in relation to food and other necessities (as outlined by Malthus), wages would be driven to the subsistence level. Therefore, it would be to the advantage of labour to help promote the accumulation of capital to enlarge the fund rather than to discourage it by forming labour organizations and making exorbitant demands. Also, it followed that legislation designed to raise wages would not be successful, for, with only a fixed fund to draw upon, increases gained by some workers could be maintained only at the expense of others.
This theory was generally accepted for 50 years by economists, including such well-known figures as Nassau William Senior and John Stuart Mill. W.T. Thornton, F.D. Longe, and Francis A. Walker were largely responsible for discrediting the theory during the decade following 1865. They pointed out that the demand for labour was not determined by a fund but was derived from the consumer demand for products. The proponents of the wages-fund doctrine had been unable to prove that there was a determinate wage fund, or any fund maintaining a predetermined relationship with capital or with the portion of the proceeds of labour's product paid out in wages. Actually the amount paid out depended upon a number of factors, including the bargaining power of labour. Yet, in spite of these telling criticisms, the wages-fund theory continued to exercise an important influence until the end of the 19th century.
Marxian surplus-value theory.
Karl Marx accepted Ricardo's labour theory of value, but he subscribed to a subsistence theory of wages for a different reason than that given by the classical economists. In Marx's mind, it was not the pressure of population that drove wages to the subsistence level but rather the existence of a large army of unemployed, which he blamed on the capitalists. He stated that the exchange value of any product was determined by the amount of labour time socially necessary to create it. He held that under the capitalistic system, labour was merely a commodity and could get only its subsistence. The capitalist, however, could force the worker to spend more time on his job than was necessary to earn his subsistence, and the excess product, or surplus value, thus created, was taken by the capitalist.
From the point of view of classical theory, Marx's argument appeared persuasive, although the term "labour time socially necessary" hid some serious objections. The fatal blow came when the labour theory of value and Marx's subsistence theory of wages were found to be invalid. Without them, the surplus-value theory collapsed.
Residual-claimant theory.
The residual-claimant theory holds that, after all other factors of production have received their share of the product, the amount left goes to the remaining factor. Adam Smith implied such a theory for wages, since he said that rent would be deducted first and profits next. Francis A. Walker in 1875 worked out a residual theory of wages in which the shares of the landlord, capitalist, and entrepreneur were determined independently and subtracted, thus leaving the remainder for labour in the form of wages. It should be noted, however, that any of the factors of production may be selected as the residual claimant, assuming that independent determinations may be made for the shares of the other factors. It is doubtful, therefore, that such a theory has much value as an explanation of wage phenomena.
Bargaining theory.
The bargaining theory of wages holds that wages, hours, and working conditions are determined by the relative bargaining strength of the parties to the agreement. Smith hinted at such a theory when he noted that employers had greater bargaining strength than employees, because it was easier for employers to combine in opposition to employees' demands and also because employers were financially able to withstand the loss of income for a longer period than the employees. This idea was developed to a considerable extent by John Davidson, who argued, in 1898, that the determination of wages is an extremely complicated process involving numerous influences that interact to establish the relative bargaining strength of the parties. There is no one factor or single combination of factors that determines wages, and there is no one rate that necessarily prevails. Because there are many possibilities, there is a range of rates within which any number of rates may exist simultaneously. The upper limit of the range is set by the rate beyond which the employer refuses to hire certain workers. This rate is influenced by such considerations as the productivity of the workers, the competitive situation, the size of the investment, and the employer's estimate of future business conditions. The lower limit of the range is set by the rate below which the workers will not offer their services to the employer. This rate is influenced by such considerations as minimum wage legislation, the workers' standard of living, their appraisal of the employment situation, and their knowledge of rates paid to others. Neither the upper nor the lower limit is fixed, and either may move upward or downward. The rate or rates within the range are determined by relative bargaining power.
The bargaining theory is very attractive to labour organizations, for, contrary to the subsistence and wages-fund theories, it provides a very cogent reason for the existence of unions. The bargaining strength of a union is much greater than that of the members acting as individuals. Also there are situations (bilateral monopoly, for instance) under which theoretical analysis arrives at a range of wage rates rather than a determinate rate. The actual rate must depend upon relative bargaining power. It should be observed, however, that historically labour was able to improve its situation before its bargaining power became more effective through organization. Factors other than the relative bargaining strength of the parties must have been at work. The bargaining theory often gives an excellent explanation of a short-run situation, such as the existence of certain wage differentials, but over the long run it fails to provide an adequate understanding of the changes that have taken place in the average level of wages.
Marginal-productivity theory and its critics.
Toward the end of the 19th century, marginal-productivity analysis was applied not only to labour but to other factors of production as well. It was not a new idea as an explanation of wage phenomena, for Smith had observed that a relationship existed between wage rates and the productivity of labour, and Johann Heinrich von Thünen, a German economist, had worked out a marginal-productivity type of analysis for wages in 1826. The Austrian economists made important contributions to the marginal idea after 1870; and, building on these grounds, a number of economists in the 1890s, including Philip Henry Wicksteed in England and John Bates Clark in the United States, elaborated the idea into the marginal-productivity theory of distribution. It is likely that the disturbing conclusions drawn by Marx from classical economic theory inspired this development. In the early 1930s refinements to the marginal-productivity analysis, particularly in the area of monopolistic competition, were made by Joan Robinson in England and Edward H. Chamberlin in the United States.
As applied to wages, the marginal-productivity theory holds that employers will tend to hire workers of a particular type until the addition made by the last (marginal) worker to the total value of the product is equal to the addition to total cost caused by the hiring of one more worker. The wage rate is established in the market through the demand for, and supply of, the type of labour, and the operation of competition assures the workers that they will receive a wage equal to the marginal product. Under the law of diminishing marginal productivity, the contribution of each additional worker is less than that of his predecessor, but workers of a particular type are assumed to be alike, making them interchangeable, and any one could be considered the marginal worker. All receive the same wage, and, therefore, by hiring to the margin, the employer maximizes his profits. As long as each additional worker contributes more to total value than he costs in wages, it pays the employer to continue hiring. Beyond the margin, additional workers would cost more than their contribution and would subtract from attainable profits.
The theory also provides an explanation of wage differentials. Wage differentials are caused by differences in marginal product. The wages of skilled workers are higher than those of unskilled workers because there are fewer skilled workers, and their marginal product, therefore, is higher.
The marginal-productivity theory of wages became the prevailing wage theory, and, although it has been attacked by many and discarded by some, no acceptable alternative has been devised. The chief basis for criticism of the theory is that it rests on unrealistic assumptions, such as the existence of homogenous groups of workers whose knowledge of the labour market is so complete that they will always move to the best job opportunities. Workers are, in fact, not homogenous; usually they have little knowledge of the labour market; and because of home ties, seniority, and other considerations, they do not often move quickly from one job to another. The assumption that employers are able to measure productivity accurately and compete freely in the labour market also is farfetched. Even the assumption that all employers attempt to maximize profits may be doubted. The profit motive does not affect charitable institutions or government agencies. For the theory to operate properly, labour and capital must be fully employed so that increased production can be secured only at increased cost; capital and labour must be easily substitutable for each other; and the situation must be completely competitive.
Obviously these assumptions do not fit the real world, and some critics feel that the results of the theory are so misleading that the theory should be abandoned. The proponents argue, however, that productivity gives a rough approximation of wages, and that although productivity may not provide the immediate explanation in a particular case, it certainly indicates long-run trends. The theory, therefore, has important uses, and if the difficulties are kept in mind, it can be a valuable tool.
In a modern economy, monopolistic or near monopolistic conditions exist in some important areas, particularly where there are only a few large producers (such as in the automobile industry) on one side of the bargaining table and powerful labour organizations on the other. Under such circumstances, the marginal productivity analysis cannot determine wages precisely; it can show only the positions that the union (as a monopolist of labour supply) and the employer (as a monopsonist, or single purchaser of labour services) will strive to reach, depending upon their current policies.
Purchasing-power theory.
The purchasing-power theory of wages involves the relation between wages and employment and the business cycle and is not, therefore, a theory of wage determination. It stresses the importance of spending through consumption and investment as an influence upon the activity of the economy. The theory gained prominence during the Great Depression of the 1930s, when it became apparent that lowering wages might not increase employment as previously had been assumed. John Maynard Keynes, the British economist, maintained in his General Theory of Employment, Interest and Money (1936), that (1) depressional unemployment could not be explained merely by frictions in the labour market that interrupted the smooth movement of the economy toward full employment equilibrium and (2) the assumption that "all other things remained equal" presented a special case that had no real applicability to the existing situation. Keynes related changes in employment to changes in consumption and investment, and he pointed out that stable equilibrium could exist with less than full employment.
Because wages make up such a large percentage of the national income, changes in wages usually have an important effect upon consumption. It is possible that lowering wages will reduce consumption and that, with the decline in demand for goods and services, the demand for labour may also fall, thus decreasing employment rather than improving it. Whether this will be the result, however, depends upon several considerations, particularly the reaction upon prices. If wages fall more rapidly than prices, labour's real wages will be drastically reduced, and consumption will fall, accompanied by increased unemployment, unless total spending is maintained by increased investment. Entrepreneurs may look upon the lower wage costs in relation to prices as an encouraging sign toward greater profits, in which case they may increase their investments and employ more people at the lower rates, thus maintaining or even increasing total spending and employment. If employers look upon the falling wages and prices as an indication of further declines, however, they may contract their investments or do no more than maintain them. In this case, total spending and employment will decline.
If wages fall less rapidly than prices, labour's real wages will increase, and consumption may rise. If investment is at least maintained, total spending in terms of constant dollars will increase, thus improving employment. If entrepreneurs look upon the shrinking profit margin as a danger signal, however, they may reduce their investments; and, if the result is a reduction in total spending, employment will fall. If wages and prices fall the same amount, there should be no change in consumption and investment; and, in that case, employment will remain unchanged.
The purchasing-power theory involves psychological considerations as well as those that may be measured more objectively. Whether it can be used effectively to control the business cycle depends upon political as well as economic factors, because government expenditures are a part of total spending, taxes may affect private spending, etc. The applicability of the theory is to the whole economy rather than to the individual firm.
LAND AND RENT
Rent in economics is specially defined. According to the neoclassical economist Alfred Marshall, rent is the income derived from the ownership of land and other free gifts of nature. He, and others after him, chose this definition for technical reasons, even though it is somewhat more restrictive than the meaning given the term in popular usage. Apart from renting land, it is of course possible to rent (in other words, to pay money for the temporary use of any property) houses, automobiles, television sets, and lawn mowers on the understanding that the rented item is to be returned to its owner in essentially the same physical condition.
The more restrictive use of the term became popular rather early among writers on economic matters. For the classical economists of the 18th and 19th centuries, society was divided into three groups: landlords, labourers, and businessmen (or the "moneyed classes"). This division reflected more or less the sociopolitical structure of Great Britain at the time. The concern of economic theorists was to explain what determined the share of each class in the national product. The income received by landlords as owners of land was called rent.
It was observed that the demand for the product of land would make it profitable to extend cultivation to soils of lesser and lesser fertility, as long as the addition to the value of output would cover the costs of cultivation on the least fertile acreage cultivated. On land of greater fertility--intramarginal land--the costs of cultivation per unit of output would be below that price. This difference between cost and price could be appropriated by the owners of land, who benefitted in this way from the fertility of the soil--a "free gift of nature."
Marginal land (the least fertile cultivated) earned no rent. Since, therefore, it was differences in fertility that brought about the surplus for landowners, the return to them was called differential rent. It was also observed, however, that rent emerged not only as cultivation was pushed to the "extensive margin" (to less fertile acreage) but also as it was pushed to the "intensive margin" through more intensive use of the more fertile land. As long as the additional cost of cultivation was less than the addition to the value of the product, it paid to apply more labour and capital to any given piece of land until the net value of the output of the last unit of labour and capital hired had fallen to the level of its incremental cost. The intensive margin would exist even if all land were of equal fertility, as long as land was in scarce supply. It can be called scarcity rent, therefore, to contrast it with differential rent.
However, because the return to any factor of production, not only to land, can be determined in the same way as scarcity rent, it was often asked why the return to land should be given a special name and special treatment. A justification was found in the fact that land, unlike other factors of production, cannot be reproduced. Its supply is fixed no matter what its price. Its supply price is effectively zero. By contrast, the supply of labour or capital is responsive to the price that is offered for it. With this in mind, rent was redefined as the return to any factor of production over and above its supply price.
With the supply price of land zero, the whole of its return is rent, so defined. The return to any other factor may also contain elements of rent, as long as the return stands above the next-most-lucrative employment open to the factor. For example, a singer's employment outside the opera may bring a great deal less than the opera actually pays. A large part of what the opera pays must therefore be called rent.
The opera singer's specific talent may be nonreproducible; like land, it is a "free gift of nature." A particularly effective machine also, though its supply can be increased in time by productive effort, may for a period also earn a quasi-rent, until supply has caught up with demand. Where its supply is artificially restricted by a monopoly, the quasi-rent may in fact continue indefinitely. All monopoly profits, it has been argued, should therefore be classified as quasi-rent. Once this point has been reached in the argument, there is perhaps no logical barrier to extending the meaning of rent to cover all property returns. After all, profits and interest can persist only as long as there is no glut of capital. The possibility of producing capital would presage such a glut, one that has been staved off only by new scarcities created by technical progress.
GENERAL THEORIES OF DISTRIBUTION
The theory of distribution deals with the way in which a society's product is distributed among the members of that society. It involves three distinguishable sets of questions. First, how is the national income distributed among persons? How many persons earn less than $10,000, how many between $10,000 and $20,000, how many between $20,000 and $30,000, and so on? Are there regularities in these statistics? Is it possible to generalize about them? This is the problem of personal distribution. Second, what determines the prices of the factors of production? What are the influences governing the wage rate for a specific kind of labour? Why is the general wage level of a country not lower or higher than it is? What determines the rate of interest? What determines profits and rents? These questions have to do with functional distribution. Third, how is the national income distributed proportionally among the factors of production? What determines the share of labour in the national income, the share of capital, the share of land? This is the problem of distributive shares. Although the three sets of problems are obviously interrelated, they should not be confused with one another. The theoretical approaches to each of them involve quite different considerations.
The basic idea in neoclassical distribution theory is that incomes are earned in the production of goods and services and that the value of the productive factor reflects its contribution to the total product. Though this fundamental truth was already recognized at the beginning of the 19th century (by the French economist J.B. Say, for instance), its development was impeded by the difficulty of separating the contributions of the various inputs. To a degree they are all necessary for the final result: without labour there will be no product at all, and without capital total output will be minimal. This difficulty was solved by J.B. Clark (c. 1900) with his theory of marginal products. The marginal product of an input, say labour, is defined as the extra output that results from adding one unit of the input to the existing combination of productive factors. Clark pointed out that in an optimum situation the wage rate would equal the marginal product of labour, while the rate of interest would equal the marginal product of capital. The mechanism tending to produce this optimum begins with the profit-maximizing businessman, who will hire more labour when the wage rate is less than the marginal product of additional workers and who will employ more capital when the rate of interest is lower than the marginal product of capital. In this view, the value of the final output is separated (imputed) by the marginal products, which can also be interpreted as the productive contributions of the various inputs. The prices of the factors of production are determined by supply and demand, while the demand for a factor is derived from the demand of the final good it helps to produce. The word derived has a special significance since in mathematics the term refers to the curvature of a function, and indeed the marginal product is the (partial) derivative of the production function.
One of the great advantages of the neoclassical, or marginalist, theory of distribution is that it treats wages, interest, and land rents in the same way, unlike the older theories that gave diverging explanations. (Profits, however, do not fit so smoothly into the neoclassical system.) A second advantage of the neoclassical theory is its integration with the theory of production. A third advantage lies in its elegance: the neoclassical theory of distributive shares lends itself to a relatively simple mathematical statement.
An illustration of the mathematics is as follows. Suppose that the production function (the relation between all hypothetical combinations of land, labour, and capital on the one hand and total output on the other) is given as Q = f (L,K) in which Q stands for total output, L for the amount of labour employed, and K for the stock of capital goods. Land is subsumed under capital, to keep things as simple as possible. According to the marginal productivity theory, the wage rate is equal to the partial derivative of the production function, or Q/L. The total wage bill is ( Q/L) L. The distributive share of wages equals (L/Q) (Q/ L). In the same way the share of capital equals (K/Q) (Q/ K). Thus the distribution of the national income among labour and capital is fully determined by three sets of data: the amount of capital, the amount of labour, and the production function. On closer inspection the magnitude (L/Q) (Q/ L), which can also be written ( Q/Q)/(L/L), reflects the percentage increase in production resulting from the addition of 1 percent to the amount of labour employed. This magnitude is called the elasticity of production with respect to labour. In the same way the share of capital equals the elasticity of production with respect to capital. Distributive shares are, in this view, uniquely determined by technical data. If an additional 1 percent of labour adds 0.75 percent to total output, labour's share will be 75 percent of the national income. This proposition is very challenging, if only because it looks upon income distribution as independent of trade union action, labour legislation, collective bargaining, and the social system in general. Obviously such a theory cannot explain all of the real economic world. Yet its logical structure is admirable. What remains to be seen is the degree to which it can be used as an instrument for understanding the real economic world.
Criticisms of the neoclassical theory.
Returns to scale.
Neoclassical theory assumes that the total product Q is exactly exhausted when the factors of production have received their marginal products; this is written symbolically as Q = ( Q/L) L + (Q/ K) K. This relationship is only true if the production function satisfies the condition that when L and K are multiplied by a given constant then Q will increase correspondingly. In economics this is known as constant returns to scale. If an increase in the scale of production were to increase overall productivity, there would be too little product to remunerate all factors according to their marginal productivities; likewise, under diminishing returns to scale, the product would be more than enough to remunerate all factors according to their marginal productivities.
Research has indicated that for countries as a whole the assumption of constant returns to scale is not unrealistic. For particular industries, however, it does not hold; in some cases increasing returns can be expected, and in others decreasing returns. This situation means that the neoclassical theory furnishes at best only a rough explanation of reality.
One difficulty in assessing the realism of the neoclassical theory lies in the definition and measurement of labour, capital, and land, more specifically in the problem of assessing differences in quality. In macroeconomic reasoning one usually deals with the labour force as a whole, irrespective of the skills of the workers, and to do so leaves enormous statistical discrepancies. The ideal solution is to take every kind and quality of labour as a separate productive factor, and likewise with capital. When the historical development of production is analyzed it must be concluded that by far the greater part of the growth in output is attributable not to the growth of labour and capital as such but to improvements in their quality. The stock of capital goods is now often seen as consisting, like wine, of vintages, each with its own productivity. The fact that a good deal of production growth stems from improvements in the quality of the productive inputs leads to considerable flexibility in the distribution of the national income. It also helps to explain the existence of profits.
Substitution problems.
Another difficulty arises from the fact that marginal productivity assumes that the factors of production can be added to each other in small quantities. If one must choose between adding one big machine or none at all to production, the concept of the marginal product becomes unworkable. This "lumpiness" creates indeterminacy in the distribution of income. From the viewpoint of the individual firm, this objection to neoclassical theory is more serious than from the macroeconomic viewpoint since in terms of the national economy almost all additions to labour and capital are very small. A related problem is that of substitution among factors. The production function implies that land, labour, and capital can be combined in varying proportions, that every conceivable input mix is possible. But in some cases the input mix is fixed (e.g., one operator at one machine), and in that situation the neoclassical theory breaks down completely because the marginal product for every factor is zero. These cases of fixed proportions are scarce, however, and from a macroeconomic viewpoint it is safe to say that a flexible input mix is the rule.
This is not to say that substitution between labour and capital is so flexible in the national economy that it can be assumed that a 1 percent increase in the wage rate will reduce employment by a corresponding 1 percent. That would follow from the neoclassical theory described above. It is not impossible, but it requires a very special form of the production function known as the Cobb-Douglas function. The pioneering research of Paul H. Douglas and Charles W. Cobb in the 1930s seemed to confirm the rough equality between production elasticities and distributive shares, but that conclusion was later questioned; in particular the assumption of easy substitution of labour and capital seems unrealistic in the light of research by Robert M. Solow and others. These investigators employ a production function in which labour and capital can replace each other but not as readily as in the Cobb-Douglas function, a change that has two very important consequences. First, the effect of a wage increase on the share of labour is not completely offset by changes in the input mix, so that an increase in wage rates does not lead to a proportionate reduction in total employment; and second, the factor of production that grows fastest will see its share in the national income diminished. The latter discovery, made by J.R. Hicks (1932), is extremely significant. It explains why the remuneration of capital (interest, not profits) has shrunk from 20 percent or more a century ago to less than 10 percent of the national income in modern times. In a society where more and more capital is employed in production, a continually smaller proportion of the income goes to the owners of capital. The share of labour has gone up; the share of land has gone down dramatically; the share of capital has gradually declined; and the share of profits has remained about the same. This picture of the historical development of income distribution fits roughly into the frame of neoclassical theory, although one must also make allowance for the short-run effects of inflation and the long-run effects of technological progress
Returns to the factors of production.
The demand side of the markets for productive factors is explained in large degree by the theory of marginal productivity, but the supply side requires a separate explanation, which differs for land, labour, and capital.
Rent.
The supply of land is unique in being rather inelastic; that is, an increase in rent does not necessarily increase the amount of available land. Landowners as a group receive what is left over after the other factors of production are paid. In this sense, rent is a residual, and a good deal of the history of the theory of distribution is concerned with the issue whether rent should be regarded as part of the cost of production or not (as in Ricardo's famous dictum that the price of corn is not high because of the rent of land but that land has a rent because the price of corn is high). But inelasticity of supply is not characteristic only of land; special kinds of labour and the size of the total labour force also tend to be unresponsive to variations in wages. The Ricardian issue, moreover, was important in the context of an agrarian society; it lacks significance now, when land has so many different uses.
Wages.
In analyzing the earnings of labour, it is necessary to take account of the imperfections of the labour market and the actions of trade unions. Imperfections in the market make for a certain amount of indeterminacy in which considerations of fairness, equity, and tradition play a part. These affect the structure of wages--i.e., the relationships between wages for various kinds of labour and various skills. Therefore one cannot say that the income difference between a carpenter and a physician, or between a bank clerk and a truck driver, is completely determined by marginal productivity, although it is true that in the long run the wage structure is influenced by supply and demand.
The role of the trade unions has been a subject of much debate. The naive view that unions can raise wages by their efforts irrespective of market forces is, of course, incorrect. In any particular industry, exaggerated wage claims may lead to a loss of employment; this is generally recognized by union leaders. The opposite view, that trade unions cannot influence wages at all (unless they alter the basic relationship between supply and demand for labour), is held by a number of economists with respect to the real wage level of the economy as a whole. They agree that unions may push up the money wage level, especially in a tight labour market, but argue that this will lead to higher prices and so the real wage rate for the economy as a whole will not be increased accordingly. These economists also point out that high wages tend to encourage substitution of capital for labour (the cornerstone of neoclassical theory). These factors do indeed operate to check the power of trade unions, although the extreme position that the unions have no power at all against the iron laws of the market system is untenable. It is safe to say that basic economic forces do far more to determine labour's share than do the policies of the unions. The main function of the unions lies rather in modifying the wage structure; they are able to raise the bargaining power of weak groups of workers and prevent them from lagging behind the others.
Interest and profit.
The earnings of capital are determined by various factors. Capital stems from two sources: from saving (by households, financial institutions, and businesses) and from the creation of money by the banks. The creation of money depresses the rate of interest below what may be called its natural rate. At this lower rate, businessmen will invest more, the capital stock will increase, and the marginal productivity of capital will decline. Although this chain of reactions has drawn the attention of monetary theorists, its impact on income distribution is probably not very important, at least not in the long run. There are also other factors, such as government borrowing, that may affect the distribution of income; it is difficult to say in what direction. The basic and predominant determinant is marginal productivity: the continuous accumulation of capital depresses the rate of interest.
One type of earning that is not explained by the neoclassical theory of distribution is profit, a circumstance that is especially awkward because profits form a substantial part of national income (20-25 percent); they are an important incentive to production and risk taking as well as being an important source of funds for investment. The reason for the failure to explain profit lies in the essentially static character of the neoclassical theory and in its preoccupation with perfect competition. Under such assumptions, profit tends to disappear. In the real world, which is not static and where competition does not conform to the theoretical assumptions, profit may be explained by five causes. One is uncertainty. An essential characteristic of business enterprise is that not all future developments can be foreseen or insured against. Frank H. Knight (1921) introduced the distinction between risk, which can be insured for and thus treated as a regular cost of production, and uncertainty, which cannot. In a free enterprise economy, the willingness to cope with the uninsurable has to be remunerated, and thus it is a factor of production. A second way of accounting for profits is to explain them as a premium for introducing new technology or for producing more efficiently than one's competitors. This dynamic element in profits was stressed by Joseph Schumpeter (1911). In this view, prices are determined by the level of costs in the least progressive firms; the firm that introduces a new product or a new method will benefit from lower costs than its competitors. A third source of profits is monopoly and related forms of market power, whether deliberate as with cartels and other restrictive practices or arising from the industrial structure itself. Some economists have developed theories in which the main influence determining distributive shares is the relative "degree of monopoly" exerted by various factors of production, but this seems a bit one-sided. A fourth source of profits is sudden shifts in demand for a given product--so-called windfall profits, which may be accompanied by losses elsewhere. Finally, there are profits arising from general increases in total demand caused by a certain kind of inflationary process when costs, especially wages, lag behind rising prices. Such is not always the case in modern inflations.
Dynamic influences on distribution.
Prices.
Neoclassical theory throws light upon the long-run changes in distribution of income. It fails to take account of the short-run impact of business fluctuations, of inflation and deflation, of rapidly rising prices. This failure is an omission, though it is true that distributive shares do not fluctuate as much as employment, prices, and the state of business generally. This lagging in the behaviour of shares can be understood by remembering that they are determined by the quotient of the real remuneration of the factor and its productivity; both variables move, according to marginal productivity theory, in the same direction. Yet inflation and deflation do have a certain impact upon distribution: if purchasing power shrinks, profits are the first income category to suffer; next come wages, particularly through the effects of unemployment. In a depression, the recipients of fixed money incomes (such as interest and pensions) gain from lower prices. In an inflation the opposite happens.
The traditional inflationary sequence was that as prices rose, profits would increase, with wages lagging behind; this would tend to diminish the share of labour in the national income. Experience since World War II, however, has been different; in many countries wage levels tended to run ahead in the inflationary spiral and profits lagged behind, although most entrepreneurs eventually succeeded in shifting the burden of wage inflation onto the consumers. The result of the postwar inflation was a slight acceleration of the increase in the share of labour, while the shares of capital and land decreased faster than they would have in the absence of inflation. Profits as a whole held their own. The struggle among the various participants in the economic process no doubt added fuel to the inflationary fires.
Technology.
Another dynamic influence is technological progress. The concept of the production function assumes a constant technology. But in reality the growth of production is much less the consequence of increased quantities of labour and capital than of improvements in their quality. This element in increased production is distributed in a way not fully explained by neoclassical theory. Part of the change in distribution that is caused by technological progress can be analyzed as resulting from changes in the elasticities of
production. If goes up, technological change is said to be "capital-using," and the share of capital will increase. This is what, in fact, may have happened; the change in technology has offset, though it has not neutralized, the decline in the share of capital caused by the employment of a higher amount of capital per worker. But another part of the fruits of technological progress is garnered by profit receivers, probably quite a substantial part. Businessmen who are quick innovators make high profits; in a rapidly changing society, profits tend to be high, a circumstance that is fortunate because profits are the mainspring of economic change. The high rate of growth experienced by the post-World War I Western world stemmed from this profit-innovation-profit nexus.
Personal income and neoclassical theory.
The neoclassical theory endeavours to explain the prices of productive factors and the distributive shares received by them. It does not come to grips with a third category of distribution, that of personal income, which is much more affected by institutional arrangements and by characteristics of the social structure. Profits in particular may be shared in various ways: they may accrue to stockholders, to workers, to management, or to the government; or they may be retained in the corporation. What happens depends on dividend policy, tax policy, and the existence of profit-sharing arrangements with workers. Neoclassical theory has little to say on these matters or on the fact that in present-day capitalist society the managers of big business are virtually in a position to fix their own personal incomes. Managers have so much power vis-à-vis the stockholders and their total share of profits is so relatively little that their ability to pay themselves high salaries is limited only by the conventions of the business world. These high incomes cannot be explained by the categories of the neoclassical theory, and they do not constitute an argument against the theory. They may well argue for changes in society's institutions, but that is a matter on which the neoclassical theory of distribution does not pontificate. A great deal of change could occur in the legal and social order without any disturbance to the theory.
Consumption
In economics the word consumption means the using up of goods and services. In modern economic terms it means, specifically, "final" consumption as distinguished from the using up of goods to produce other goods in a manufacturing industry. Final consumption must also be distinguished from the purchase by industry of fixed assets such as buildings and machinery, which is known as capital formation or investment. On the other hand, consumption expenditure by private persons is understood to include the purchase of durable goods, such as furniture or vehicles, as well as works of art that may increase in value over a period of time. The acquisition of such goods should actually be considered asset formation rather than consumption and should be classified with the acquisition of other assets such as houses, schools, roads, and hospitals.
In modern industrial economies, consumption as previously defined accounts for 70 or 80 percent of total national expenditure. Even in the Western capitalist countries a significant part of total consumption is determined directly by the expenditure of public authorities. Some of the benefits of this part of consumption, such as expenditure on defense or on public health, are widely diffused; others are directed by common consent to the benefit of particular sections of the community. These consist in part of specialized services such as education or medical care; but other services--such as unemployment compensation, state pensions for the elderly, and assistance to families deprived of the support of a wage earner--are designed to create greater equality in levels of consumption than would otherwise be obtained.
PATTERNS OF NATIONAL CONSUMPTION
The ways in which people spend their incomes show much uniformity among countries at the same economic level. Expenditure patterns in the United Kingdom, for example, are typical of western Europe. In 1949 the pattern was still affected by postwar shortages and rationing, but the level of total consumption was not very different from what it had been before the war. In the decades that followed, private consumption expenditure per person (measured at constant prices) doubled. In addition there was a great increase in public services such as health and education. Yet the broad distribution of expenditures remained strikingly constant in spite of the introduction of many new commodities and considerable changes in their relative prices. The percentage of total expenditure devoted to food fell, a phenomenon that usually accompanies a rising standard of living, and the largest proportionate increases were in the purchase and maintenance of private motor vehicles, of furniture and household goods, and of radio, television, and electrical goods. These three categories represent in part net additions to private wealth in the form of durable goods and also reflect the effect of technical progress. As in other industrial countries, much of the improvement in living standards has taken the form of more travel, better communication services, and the acquisition of labour-saving equipment.
In most of the industrialized countries there has been a compound rate of increase in the total volume of consumption expenditure per person of 10 to 12 percent per year, the main exceptions to this being the United Kingdom and Japan, where consumption has grown at double this rate. But the pattern of change is similar in almost all countries. Food consumption has grown less rapidly than total consumption, particularly in the Scandinavian countries, Germany, and the countries of North America, where the rate of increase has been about 7 percent per year; expenditure on clothing has been growing at about the same rate as total consumption. Increases in rent outlays reflect higher energy costs in all of the industrialized countries. The acquisition of durable goods continues at a very high rate in all countries.
Comparable data on consumption in the poorer countries of the world are much harder to obtain and are usually less reliable, but it is probable that, expressed as a proportion of total consumption, food expenditure is about twice as important in much of Asia, Africa, and Latin America as it is in western Europe and North America. In the most economically advanced countries, food expenditure represents only one-quarter to one-third of the total, whereas in countries where the total expenditure per household is less than the equivalent of $1,500, the proportion rises to one-half or even greater. It should be noted that in the rural regions of poor countries the housing expenditure is minimal; in these areas shelter is rudimentary and largely self-provided
Food consumption varies in character from country to country. This variation is due in part to climatic factors, and it also reflects differences in national food habits. The diet that is normally eaten in northern Europe and in Scandinavia is relatively low in fruit and vegetables but it contains a high proportion of milk, fats, and sugar. In France the consumption of vegetables and meat is relatively high. Fruit and vegetable consumption is generally high in southern Europe, while milk consumption in this area is low. In the Mediterranean countries food grains are generally preferred to potatoes and sugar as sources of carbohydrates.
But aside from these regional variations, the influence of general living standards is evident. The North American diet, for example, with its low grain and potato consumption and high consumption of sugar, meat, eggs, and fats is attributable more to a high standard of living than to any regional peculiarities of taste. These characteristics can be observed in the diets of the wealthier classes of most countries.
The influence of the general standard of living is also shown in the relative priorities that are accorded to the increased consumption of particular foods as incomes increase. These priorities are measured by economic statisticians in the form of income elasticities of expenditure, defined as the percentage increase in the consumption of an item divided by the percentage increase in income that makes the increased consumption possible. These elasticities are usually calculated for a given country by comparing the budgets of wealthy households with those of poor families. In countries such as the United States and Great Britain, the consumption of cereal foods actually decreases as incomes increase. In the less developed countries the elasticities are usually considerably higher, particularly for fruit and for products of animal origin. In these countries the consumption of carbohydrate foods is also increasing fairly rapidly as incomes rise.
THEORIES OF CONSUMER BEHAVIOUR
Factors influencing consumers.
Model of consumer behavior.
The theory and measurement of consumer behaviour forms an important part of modern economic theory. It was first developed during the 19th century on the basis of the following conceptions: that the purchase of any commodity gives the consumer a positive satisfaction or utility; the additional satisfaction derived from additional purchases of the same commodity declines as the consumer's supply of that commodity increases; and with a given amount of money to spend, the consumer distributes the expenditure among commodities to maximize the total satisfaction or utility attainable from all those purchases. This rather crude model of consumer behaviour has undergone considerable refinement by modern mathematical economists. The advantage of this approach, which has had a strong and enduring effect on the theoretical and empirical work of economists, is that it separates the main economic variables influencing consumer behaviour--that is, income and prices--from all the remaining influences, such as individual preferences, social pressures, customs, and habits, but at the same time it unites them in a single analytical apparatus. Critics have often objected that the model assumes a rational person bent on scrupulously maximizing his satisfaction and that the model is thus part of a mechanistic stream of thought that has been substantially undermined by 20th-century advances in psychology. Still, the only useful criterion of any hypothesis is the range of situations in which the derivative model is shown validly to predict events. For example, it is useful to assume that the leaves of a tree attempt to maximize the amount of sunlight they receive, since the assumption implies that leaves are denser on the sunny side of trees than on the shady side, which can be checked from experience, or that billiard players make their shots as if they knew the mathematical formulas of mechanics. Similarly, to assume that consumers behave as if they were rational utility maximizers helps to provide accurate predictions of a broad range of market phenomena; e.g., a fall in the price of a commodity will generally lead to increased consumption of that commodity, and an increase in consumer income will lead to increased consumption of most commodities. Only persistent discrepancies between predictions and events require a modification of the model's assumptions; some examples of such cases are discussed below.
Income as determinant.
The theory points to the income of consumers as the most important single determinant of their consumption patterns. It follows that in any community both the average income level and the distribution of incomes are important influences on total consumption. A community in which incomes are equally distributed consumes fewer luxury goods and fewer low-quality goods than one containing a few wealthy individuals and many poor people. Among wealthy people in early 19th-century England, a dinner with five main protein dishes--fish, meat, game, poultry, and ragout with truffles--was described as the minimum, while in poor years the families of agricultural labourers ate mainly oatmeal and potatoes; today the standardized produce of modern agriculture is part of most diets.
The classic model of consumers' behaviour implicitly assumes that the individual enjoys a constant income. In practice it may fluctuate according to the season, from year to year, or more generally over a lifetime. In the short run the consumption of some commodities is much affected by these income fluctuations, while the consumption of others is affected very little. Wage-earning households commonly have a weekly housekeeping allowance, out of which the necessities of food and clothing are bought, while the variable excess of earnings is spent on tobacco, alcoholic drinks, and entertainment. The expected average level of future income therefore influences consumption habits as much as actual present income, and commodities may be divided into two classes. The first consists of goods people buy when temporarily affluent but give up when temporarily poor, and the second consists of goods for which the pleasure of a temporarily higher level of consumption would not be worth the financial or psychological cost of giving them up in the future.
Consumers can also be influenced by their previous incomes. A person who owns an expensive car may continue to use it after his income falls, though at the lower level of income the individual would not choose to replace it with a similarly expensive vehicle in the long run. This may be a rational decision, in the sense that the value of the car in use may be greater than what it is worth in the second-hand automobile market; or it may be irrational, in the sense that an expensive habit that should have been abandoned is continued beyond the point where it can rationally be supported. The distinction is largely subjective and cannot be clearly made by an outside observer.
Over the life cycle as a whole, consumption patterns are markedly different in various occupations. In most of the unskilled or semiskilled occupations, the course of earnings is fairly stable: a young worker of 21 may earn as much as an older person. But in many of the professions an individual of 50 or 60 may earn many times the income of a person of 21; this gives the young wage earner a strong incentive to incur considerable debt with the expectation of amortizing it steadily throughout life, so that the typical consumption pattern of the occupation can be achieved earlier than otherwise. This applies particularly to such major purchases as houses, household furniture and equipment, and vehicles. Manual workers, on the other hand, whose expectations are little greater than their present consumption, generally prefer to rent living space rather than to own a house and are unwilling to raise their current consumption standards by incurring commitments of a longer term than that of ordinary installment credit.
Nonrational influences.
To be fully rational and consistent, consumers need to have access to sufficient information on goods and their prices so that they can choose those with the lowest unit price for a given quality. But consumers do not always behave this way. Natural pearls are sold at a much higher price than cultured pearls, though the difference between them is demonstrable only by dissection or with X-rays, and their quality in use is identical. Brand-name drugs sell better and at higher prices than unbranded drugs that are manufactured from the same standard formula. To some extent this is due to what an American economist, Thorstein Veblen, called the desire for conspicuous consumption: part of the attraction of the good is simply its high price. It is also the result of consumers' ignorance, made more acute by the increasing sophistication of commodities whose qualities must be measured in many dimensions. If it is costly in time for the individual to become fully informed about the comparative qualities of competing products, it is not wholly irrational for the consumer to take the market price as an indicator of quality. The lack of information has given rise to consumers' organizations in most industrialized countries; these organizations test and report on a wide range of products for their subscribers.
The influence of modern advertising techniques must also be considered. Insofar as advertising informs the consumer of the range of alternatives, it can be argued that advertising merely increases the consumer's information; and insofar as advertising consciously or subconsciously changes consumer preferences, it remains one of the many factors determining consumer preferences that the economist takes as given. Advertising, however, cannot persuade the public to buy whatever the producer offers. Advertising is likely to be most effective in influencing consumers to choose one of several almost identical products being offered, such as toothpaste, cigarettes, or gasoline. But it may also raise the demand for the group of competing products as a whole. In addition, it can be argued that the total effect of modern advertising is to shift the preferences of consumers in favor of luxury goods rather than necessities, in favor of consumption rather than saving, and in favor of employment rather than leisure.
Attitudes toward necessities and luxuries.
The distinction between necessities and luxuries is imprecise. The dividing line varies with the income and social class of the classifier and shifts as technology develops and as social values change. Only in the most undeveloped communities can necessities be defined purely in terms of physiological needs. Adam Smith wrote in 1776:
By necessaries I understand not only the kind of commodities which are indispensably necessary for the support of life, but whatever the custom of the country renders it indecent for creditable people, even of the lowest order, to be without. . . . Under necessaries, therefore, I comprehend not only those things which nature, but those things which the established rules of decency have rendered necessary to the lowest rank of people. All other things I call luxuries; without meaning by this appellation to throw the smallest degree of reproach upon the temperate use of them. Beer and ale, for example, in Great Britain, and wine, even in the wine countries, I call luxuries. A man of any rank may, without any reproach, abstain totally from tasting such liquors. Nature does not render them necessary for the support of life, and custom nowhere renders it indecent to live without them.
In the 19th century, with the development of more mathematical methods of reasoning based on a utilitarian calculus, the distinction came to be phrased differently. Necessities were defined as those commodities the demand for which has an income elasticity less than unity, and luxuries as those with an income elasticity greater than unity. These definitions imply that as a worker's income increases the expenditure on necessities increases less than, and the expenditure on luxuries more than, proportionately. But even with the elasticity approach the distinction must vary over time. In 1950 the demand for television sets had high income elasticity, whereas now, in some countries, television often is regarded as a necessity.
Economists of the early 19th century all believed that the living standards of the working classes in capitalist societies would remain close to a subsistence level, meaning that luxuries would be more or less permanently denied them. But in modern industrialized economies even the poor consume goods that the early economists would not have considered necessary.
Role of luxuries.
The historical and social role of luxury consumption is a subject of much interest. In the Mediterranean city-states during the Renaissance, the demand for luxuries provided a mainspring for the specialization of skilled labour and for the development of foreign travel and long-distance trade. The duke of Milan, Filippo Maria Visconti, possessed valuable English dogs, leopards from all parts of the East, and hunting birds from northern Europe. Some writers have argued that the luxurious consumption of the rich benefits the poor through the provision of employment opportunities that would not otherwise exist. A subtler version of this idea was proposed by Adam Smith, who contrasted the uselessness of menial labour employed by the rich for personal services with the benefits flowing from the employment of craftsmen who created luxurious products of enduring merit that eventually became available to society as a whole:
The houses, the furniture, the clothing of the rich, in a little time, become useful to the inferior and middling ranks of people. . . . What was formerly a seat of the family of Seymour is now an inn upon the Bath road. The marriage-bed of James the First . . . was, a few years ago, the ornament of an ale-house at Dunfermline.
But Smith and most of the economists who succeeded him believed that if the money spent on luxurious consumption by the rich was invested in useful production, society would benefit as a whole. The Industrial Revolution brought an increasing demand for funds for productive investment and made possible a more rapid rise in general standards of living than the world had known before. The classical economists thus argued that all luxury consumption involved a selfish diversion of labour and capital and acted as a brake on human progress.
This view was not seriously challenged until the English economist J.M. Keynes published his General Theory of Employment, Interest and Money in 1935-36. Writing at a time when millions of workers were unemployed, Keynes argued that the consumption of luxuries was socially desirable if it provided jobs that would otherwise not exist. He also suggested that capitalism might be outrunning its investment opportunities, so that in the long run the problem of finding employment for capital itself would arise--a difficulty that might be postponed if the wealthy spent more on themselves:
In so far as millionaires find their satisfaction in building mighty mansions to contain their bodies when alive and pyramids to shelter them after death, . . . the day when abundance of capital will interfere with abundance of output may be postponed.
In industrial countries since World War II, this pessimistic view has been overborne by a seemingly endless expansion in consumer industries. As fast as consumers accumulate durable goods, they become technologically or conventionally obsolete and are replaced by new goods. Instead of seeking more leisure, previously thought to be a main benefit of technical progress, the populations of the industrialized countries seem to prefer to work in order to buy more luxuries. To this extent the desire for leisure and the demand for luxuries are in direct competition.
Standards of consumption.
In Communist countries, public consumption has long been treated as more important than private luxury. In the last part of the 20th century this emphasis seemed to be giving way to the aim of catching up with the standards of consumption that prevail in capitalist countries. In the undeveloped countries of the Third World, the tension between the demand for luxuries and the low standard of living gives rise to acute economic and social problems. The rapid growth of international travel and communications since World War II has led the literate and skilled classes of every nation to seek similar standards of private consumption regardless of their national environment. This, in undeveloped countries, leads either to a highly unbalanced distribution of the national income or to the emigration of the skilled population. Thus the increasing awareness of the consumption habits of the most fortunate sections of the world's population is both a spur and a hindrance to general progress.
Economic fluctuations: stability and instability
BUSINESS CYCLES
Figure 11: Wholesale price indexes for United States, Great Britain, Germany, and France, 1790-1940.
Business cycles are best defined as fluctuations in the general level of economic activity, or more specifically, in the levels of employment, production, and prices. Figure 11 shows fluctuations in wholesale prices in four Western industrialized countries over the period from 1790 to 1940. Though some regularities in price movements are apparent, it is possible to ask whether the movements are regular enough to be called cycles.
The word cycle derives from the Greek word for circle. An object moving around a circle returns to its starting point; a wave motion, with upward and downward curves, may also be considered a cycle. The various movements characteristic of economic activity are not always as regular as waves, and for this reason some prefer to call them fluctuations.
There are many types of economic fluctuations. Because of the complexity of economic phenomena, it may be that there are as many types of fluctuations or cycles as there are economic variables. There are daily cycles in commuter traffic or the consumption of electricity, to cite only two examples. Almost every aspect of economic life displays seasonal variations: sales of coal or ice, deposits in savings banks, monetary circulation, agricultural production, purchases of clothing, travel, and so on. As one lengthens the span of observation, one finds new kinds of fluctuations such as the hog cycle and the wheat cycle, the inventory cycle, and the construction cycle. Finally, there are movements of general economic activity that extend over periods of years.
Modern economic history has recorded a number of periods of difficult times, often called depressions, during which the business economy was marked by sudden stock market declines, commercial bankruptcies, bank failures, and mounting unemployment. Such crises were once looked upon as pathological incidents or catastrophes in economic life, rather than as a normal part of it. The notion of a "cycle" implies a different view.
Juglar's eight-year cycle.
The first authority to explore economic cycles as periodically recurring phenomena was probably a French physician, Clément Juglar, in 1860. Other writers who developed Juglar's approach suggested that the cycles recur every nine or 10 years, and distinguished three phases, or periods, of a typical cycle: prosperity, crisis, and liquidation. Subsequent analysis has tended to designate 1825, 1836, 1847, 1857, 1866, 1873, 1882, 1890, 1900, 1907, 1913, 1920, and 1929 as initial years of crisis. If that is correct, then the average interval between them was eight years, rather than nine or 10 as suggested by Juglar. In the years since 1929, the regularity of business fluctuations has been somewhat offset by government anticyclical policies.
The so-called Juglar cycle has often been regarded as the true, or major, economic cycle, but several smaller cycles have also been distinguished. Close study of the interval between the peaks of the Juglar cycle suggests that partial setbacks occur during the expansion, or upswing, and that there are partial recoveries during the contraction, or downswing. These smaller cycles generally coincide with changes in business inventories, lasting an average of 40 months. Other small cycles result from changes in the demand for and supply of particular agricultural products such as hogs (three to four years), cotton (two years), and beef (five years in the Netherlands). Hide and leather production fluctuates in an 18-month cycle.
Kondratev's waves.
Longer cycles have also been studied. The construction industry has been found to have cycles of 17 to 18 years in the United States and 20 to 22 years in England. Finally, there are the long waves, or so-called Kondratev cycles, named for a Russian economist, Nikolai D. Kondratev, who showed that in the major Western countries during the 150 years from 1790 to 1940 it was possible to distinguish three periods of slow expansions and contractions of economic activity averaging 50 years in length
1. 1792-1850 Expansion: 1792-1815 23 years
Contraction: 1815-50 35 years
2. 1850-96 Expansion: 1850-73 23 years
Contraction: 1873-96 23 years
3. 1896-1940 Expansion: 1896-1920 24 years
Contraction: 1920-40 20 years
Only these three Kondratev waves have been observed.
Some students of business cycles have analyzed them by statistical methods, in the hope of finding regularities that are not immediately apparent. One speculative theory has held that the larger cycles were built up from smaller ones. Thus, two seasonal cycles would produce a two-year cycle, two of which would produce a four-year cycle; two four-year cycles would become an eight-year, or Juglar, cycle, and so on. The hypothesis is not widely accepted.
Patterns of depressions and upswings.
Cycles of varying lengths are closely bound up with economic growth. In 19th-century Germany, for example, upswings in total economic activity were associated with the growth of the railroad, metallurgy, textile, and building industries. Periodic crises brought slowdowns in growth. The crisis of 1873 led to a wave of financial and industrial bankruptcies; recovery started in 1877, when iron production ceased to fall, and by 1880 a new upswing was under way. The recession of 1882 was less severe than the previous one, but a slump that began in 1890 led to a serious depression, with complaints of overproduction.
The year 1890 was also one of financial crisis in England and the United States. The British banking house of Baring Brothers failed, partly because of a revolution in Argentina. English pig-iron production fell from 8,300,000 tons in 1889 to 6,700,000 in 1892, and unemployment increased. That depression might have been less severe but for the international financial crisis, especially intense in the United States, where in 1893 a stock market panic led to widespread bank failures.
The recession of 1900 was followed by an unusually vigorous upsurge in almost all of the Western economies. U.S. pig-iron production increased by more than 150 percent during the expansion, which lasted until 1907; building permits more than doubled; and freight traffic rose by more than 50 percent. Prices rose more and more rapidly as the U.S. economy approached full employment.
Deviations from cycle patterns.
Cycles are compounded of many elements. Historical fluctuations in economic activity cannot be explained entirely in terms of combinations of cycles and subcycles; there is always some factor left over, some element that does not fit the pattern of other fluctuations. It is possible, for example, to analyze a particular fluctuation into three principal components: a long component or trend; a very short, seasonal component; and an intermediate component, or Juglar cycle. But these components cannot be found exactly recombined in another fluctuation because of a residual element in the original fluctuation that does not have a cyclical form. If the residual is small, it might be attributed to errors of calculation or of measurement. Or, the residual might be regarded as the result of such accidental events as epidemics, floods, earthquakes, riots, strikes, revolutions, or wars, which obviously cannot be fitted into a recurring pattern. On a more sophisticated statistical level, it can be treated as "random movement." If the random element is always present, it becomes an essential element of the analysis to be dealt with in terms of probability.
A more rigorous analysis has to go even further. One difficulty in separating out the components of economic movements is that the components are not perfectly independent of each other. The determination of a long component or trend assumes that the Juglar component is already known. In the same way, determining the Juglar component requires isolating it from the long-term component. Probably only the seasonal component can be isolated independently of the others, and that because it is immediately related to such noneconomic factors as climate or custom. To avoid such difficulties, researchers have tried looking for "hidden periodicities," using a mathematical technique known as harmonic analysis, or Fourier series. Two alternative methods are open to them: they may assume a certain periodicity and try to fit the statistical data to the resulting equation, or they may ask mathematicians to supply all of the possible periodicities contained in the data and then determine which are the most probable.
For practical purposes, it would be useful to know the typical shape of a cycle and how to recognize its peak and trough. A great amount of work has been done in what may be called the morphology of cycles. In the United States, Arthur F. Burns and Wesley C. Mitchell have based such studies on the assumption that at any specific time there are as many cycles as there are forms of economic activity or variables to be studied and have tried to measure these in relation to a "reference cycle," which they artificially constructed as a standard of comparison. The object in such studies was to describe the shape of each specific cycle, to analyze its phases, to measure its duration and velocity, and to measure the amplitude or size of the cycle.
In studying various cycles, it has been possible to construct "lead and lag indicators"--that is, statistical series with cyclical turning points consistently leading or lagging behind the turns in general business activity. Researchers using these methods have identified a number of series, each of which reaches its turning point from two to 10 months before the turns in general business activity, and another group of series, which has followed the turns in business by two to seven months. Examples of leading series include published data for new business orders, residential building contracts, the stock market index, business failures, and the length of the average workweek. These and other leading indicators are widely used in economic forecasting.
Dynamic analyses of cycles.
A satisfactory explanation of cycles must isolate the forces and relationships that tend to produce these recurrent movements. There have been many theories of the business cycle. An understanding of them requires analysis of some of the factors that can cause cyclical movements.
One such factor is the relationship between investment and consumption. Any new expenditure--e.g., on building a road or a factory--generates several times as much income as the expenditure itself. This is so because those who are paid to build the road or factory will spend more of what they receive; their expenditures will thus become income for others, who will in their turn spend most of what they receive. Every new act of investment will, thus, have a stimulating effect on aggregate income. This relationship is known as the investment multiplier. Of itself, it cannot produce cyclical movements in the economy; it merely provides a positive impulse in an upward direction
To the relationship between investment and consumption must be added that between consumer demand and investment. An increase in demand for refrigerators, for example, will eventually require increased investment in the facilities for producing them. This relationship is known as the accelerator; and it implies that an increase in national income will stimulate investment. As with the multiplier, it cannot of itself explain cyclical movements; it merely accounts for a fundamental instability.
It can be shown, however, that the multiplier and accelerator in combination may produce very strong cyclical movements. Thus, when an increase in investment occurs, it raises income by some larger amount, depending on the value of the multiplier. That increase in income may in turn induce a further increase in investment. The new investment will stimulate a further multiplier process, producing additional income and investment. In theory, the interaction might continue until a point is reached at which such resources as labour and capital are being fully utilized. At that point--with no increase in employment and, therefore, no rise in consumer demand--the operation of the accelerator would cease. That halt in demand, plus the lack of new capital, would cause new investment to decline and workers to be laid off. The process thus would go into reverse. The fluctuations in national income could take various forms, depending on the characteristics of the economy and the way in which the population allocated its income between consumption and savings. Such spending habits, of course, affect both the levels of consumer demand and capital investment. This theoretical analysis does not explain actual economic fluctuations; it is merely an aid to understanding them.
The analysis can be made more realistic by taking into account three other factors. First, since the theoretical, wide-swinging cycles engendered by the interaction of the multiplier and the accelerator are observed to occur only within narrow limits, one may assume that although the economy has an inherent tendency to swing very widely there are limits beyond which it cannot go. The upper limit to the swings would be the point at which full employment or full capacity is reached; the lower limit is more difficult to define, but it would be established when the forces that make for long-term economic growth begin to operate. Thus, the upswing of a cycle stops when it meets the upper limit; and the downswing stops at the lower limit, resulting in continuous cyclical movements with an overall upward trend--a pattern corresponding to the one found in history.
The occurrence of time lags--the inevitable delays between every decision and its effects--provides another reason for expecting cyclical fluctuations to occur in any economic process. This phenomenon is illustrated, for example, in the relation between the action of a thermostat and the temperature of a room. A fall in room temperature causes the thermostat to turn on the heater; but there is a lag in time until the room warms up sufficiently to cause the thermostat to turn the heat off, whereupon the temperature begins to fall again. The shape of the curve of the temperature cycle will depend on the responsiveness of the thermostat and on the time required to raise the temperature of the room. By making various adjustments, it is possible to minimize the cycle, but it can never be eliminated entirely. In economic life, there are many such time lags: between the decision to invest and the completion of the project; between the farmer's decision to raise hogs and the arrival of pork chops at the store; between prices at the time of a decision and prices at the time the action is completed.
Random shocks, or what economists call exogenous factors, constitute the third type of phenomena affecting business cycles. These are such external disturbances to the system as weather changes, unexpected discoveries, political changes, wars, and so on. It is possible for such external impulses to cause cyclical motions within the system, in much the same way that striking a rocking horse with a stick will cause the horse to rock back and forth. The length of the cycle will be determined by the internal relationships of the system, but its intensity is governed by the external impulse.
Theories of economic fluctuation.
The analytic concepts above may be found in most of the realistic attempts to explain economic fluctuations. Theories of the business cycle, or, more properly, of economic fluctuations, may be classified in two groups: those that ascribe cyclical movements to external forces (exogenous factors); and those that attribute the fluctuations to internal forces (endogenous factors).
Agricultural theories.
Perhaps the oldest theories of the business cycle are those that link their cause to fluctuations of the harvest. Since crops depend upon soil, climate, and other natural factors that in turn may be affected by biological or meteorological cycles, such cycles will transmit their effects through the harvests to the rest of the economy. The 19th-century English economist William Stanley Jevons thought he had found the key to such a process in the behaviour of sunspots, which seemed to display a 10-year cycle. His naive explanation could not long withstand critical examination. It had a certain interest, however, in suggesting a causal factor that was completely detached from the economic system and one that could not be influenced by it in turn.
Psychological theories.
A number of writers have explored mass psychology and its consequences for economic behaviour. Individuals are strongly influenced by the beliefs of the group or groups to which they belong. There are times when the general mood is optimistic, and others when it is pessimistic. An English economist, Arthur C. Pigou, in his Industrial Fluctuations (1927), put forward a theory of "noncompensated errors." He pointed out that if individuals behave in a completely autonomous way their errors in expectations will tend to offset each other. But if they imitate each other, their errors will accumulate until they acquire a global magnitude that may have powerful economic effects. This follow-the-crowd tendency obviously operates as a factor in the ups and downs of the stock exchanges, financial booms and crashes, and the behaviour of investors. One can say, however, that the psychological factor is not enough to explain economic fluctuations; moods of optimism and pessimism must themselves rest upon economic factors.
Political theories.
Some observers have maintained that economic fluctuations result from political events. It is obvious that such events as the Napoleonic Wars, World Wars I and II, and even the Korean War of 1950-53 have had strong economic consequences. Even the imposition of a tax or an import restriction may have some dynamic effect upon the economy. The question is whether such political factors are capable of producing cyclical movements.
Technological theories.
Ever since the Industrial Revolution at the end of the 18th century, technical innovations have followed each other without end but not without pause. There have been periods of innovation and quieter periods in which the innovations were being absorbed. The world has passed through the era of steam, the era of petroleum, and the era of electricity and has entered the era of atomic energy. It is possible that if a rhythm could be found in these waves of change, the same rhythm might be responsible for corresponding movements in the economy. But it is equally possible that the technical innovations themselves have been dictated by the prior needs of the economy.
Demographic theories.
Even population has been postulated as a cause of economic fluctuations. There are, undeniably, cyclical movements of population; it is possible to find fluctuations in the rates of marriage, birth, mortality, and migration; but the extent to which such fluctuations may have been caused by economic conditions is not clear.
Monetary theories.
Some writers have ascribed economic fluctuations to the existence of money. Changes in the money supply do not always conform to underlying economic changes, and it is not difficult to see how this lack of coordination could produce disturbances in the economic system. Thus, an increase in the total quantity of money, if it is not matched by an increase in economic activity, will tend to produce higher prices; the higher prices in turn may stimulate an investment boom, and so on.
The banking system, with its ability to expand the supply of credit in a time of boom and to contract the supply of credit in time of recession, may in this way amplify small economic fluctuations into major cycles of prosperity and depression. Some theorists have emphasized the influence of the rate of interest: if the rate fixed by the banking system does not correspond to the "natural" rate dictated by the requirements of the economy, the disparity may of itself induce an expansion or contraction in economic activity.
Underconsumption theories.
In a progressive economy, production tends to expand more rapidly than consumption. The disparity results from the unequal distribution of income; the rich do not consume all their income, while the poor do not have sufficient income to meet their consumption needs. This imbalance between output and sales has led to theories that the business cycle is caused by overproduction or underconsumption. But the basic, underlying cause is society's inadequate provision for an even flow of savings out of the excess of what is produced over what is consumed. In other words, saving is out of step with the requirements of the economy; it is improperly distributed over time.
Investment theories.
The fact that changes in the supply of savings, or loanable funds, are not closely coordinated with changes in the rest of the economy lies at the heart of the numerous theories that link investment imbalance to the business cycle. Savings accumulate when there is no immediate outlet for them in the form of new investment opportunities. When times become more favourable, these savings are invested in new industrial projects, and a wave of investment occurs that sweeps the rest of the economy along with it. It is in this context that the tools of analysis--the accelerator and the multiplier--find their application: the new investment creates new income, which in turn acts as a further stimulus to investment. An early observer of this phenomenon, a Russian economist, Mikhayl Tugan-Baranovsky, in 1894 published a study of industrial crises in England in which he maintained that the cycle of investment continues until all the capital funds have been used up. Bank credit expands as the cycle progresses. Disproportions then begin to develop among the various branches of production as well as between production in general and consumption. These imbalances lead to a new period of stagnation and depression.
STABILIZATION THEORIES AND POLICIES
The ultimate objective of research into the problems of economic instability (including fluctuations in output, employment, and prices) is to provide the foundation for stabilization policy--that is, for the systematic use of fiscal and monetary policies to improve an economy's performance. The main tasks, therefore, are to explain how levels of prices, output, and employment are determined and, on a more applied level, to furnish predictions of changes in these variables--predictions on which stabilization policy can be based.
Keynesian analysis.
The problems of economic stability and instability have, naturally, been of concern to economists for a very long time. But, as a special field of investigation, it emerged most strongly from the confluence of two developments of the depression decade of the 1930s. One was the development of national income statistics; the other was the reorientation of theoretical thinking often referred to as the "Keynesian revolution."
To understand why the theoretical contributions of John Maynard Keynes are regarded as so important, one must examine the workings of a modern economy. Such an economy comprises millions of people engaged in millions of distinct activities; these activities include the production, distribution, and consumption of all of the different goods and services that a modern economy provides. Some of the economic units are large, with hierarchies of executives and other managerial specialists who coordinate the productive activities of thousands or tens of thousands of people. Aside from these relatively small islands of preplanned and coordinated activity, most of the population pursues its myriad economic tasks without any overall supervised direction. It resembles an immensely complicated, continuously changing puzzle that is continually being solved and solved again through the market system. A breakdown in the coordination of activities, such as occurred in the depression decade of the 1930s, is very rare--in fact, it happened on that scale only once--or this system of organization would not survive. The way in which the economic puzzle is solved without anyone thinking about it has been the broad main theme of economic theory since the time of the English economist Adam Smith (1723-90).
The problem of coordination.
If one singles out a particular household from the millions of economic units and studies it over a period of time, one can draw up a budget of that household's transactions. The budget will come out as a long list of amounts sold and amounts bought. If at any time this economic unit had tried to do something different from what it actually did (cutting down, say, on meat purchases to buy another pair of shoes), the solution of the economic puzzle would have been correspondingly different. At the prevailing prices the supply of meat would have exceeded the demand, and the demand for shoes would have exceeded the supply
The point is that, if the economy is to function as a coordinated system, the activities of each economic unit must be somehow controlled--and controlled quite precisely. This is done through price incentives. By raising the price of a good (relative to the prices of everything else), any economic unit can, generally speaking, be made to demand less of it or to supply more of it; by lowering the price, it can be made to demand more or to supply less. Through the conflux of prices, an individual unit is thus led to fit its activities into the overall puzzle of market demands and supplies. If economic units could not be controlled in this fashion, the market-organized system could not possibly functionIn any given situation there exists, theoretically, one and only one list of prices that will make the puzzle come out exactly right. But the amounts that economic units choose to supply or demand of various goods at any given price list depend on numerous factors, all of which change over time: the size of the population and labour force; the stock of material resources, technology, and labour skills; "tastes" for particular consumer goods; and attitudes toward consumption as against saving, toward leisure as against work, and so on. Government policies--tax rates, expenditures, welfare policies, money supply, the debt--also belong among the determinants of demand and supply. A change in any of these determinants will mean that the list of prices that previously would have equilibrated all of the different markets must be changed accordingly. If prices are "rigid," the system cannot adjust and coordination will break down.
Price flexibility.
For coordination of activities to be preserved (or restored) when the economy is disturbed by changes in these determinants, something still more is required: each separate price must move in a direction that will restore equilibrium. This necessity for prices to adjust in certain directions may be expressed as a communications requirement. To put it in somewhat extreme form: for a given economic unit to plan its activities so that they will "mesh" with those of others, it must have information about the intentions of everyone else in the system. When one of the determinants underlying market supplies and demands changes so as to disequilibrate the system, ensuing price movements must communicate the requisite information to everyone concerned.)
One may suppose, for example, that in some period of political crisis the supply of crude oil from the Middle East is cut off. The immediate result will be a worldwide excess demand for oil and oil products of large proportions--that is, supply will fall far short of demand at going prices. At the same time, those who derive their income from Middle East oil production will have their incomes reduced, and excess supplies will emerge in the markets for the goods on which those incomes previously were spent. For the system to adjust, orders will have to go out to all demanders to cut down on their consumption of oil and for all other suppliers of oil to increase their output so that the gap between demand and supply can be closed. This is, in effect, what a rise in the world price of oil and oil products will accomplish--millions of gasoline and heating oil users the world over will respond to the pinch of higher prices, and the higher prices will also create a profit incentive for supply to be increased. (Falling prices will, in an analogous manner, close the gaps in the markets in which the initial disturbance caused excess supplies to develop.)
Prices that are not rigid for some institutional reason will move in response to excess demands and excess supplies. When demand exceeds supply, disappointed buyers will bid up the price; when supply exceeds demand, unsuccessful suppliers will bid it down. This mechanism solved the excess demand for the oil problem in the illustration above. The question, however, is whether throughout the system as a whole it will always act so as to move each of the prices toward its general equilibrium value.
Keynes said no. He maintained that there can be conditions under which excess demands (or supplies) will not be "effectively" communicated so that, although certain prices are at disequilibrium levels, no process of bidding them away from these inappropriate levels will get started. This is the flaw in the traditional conception of the operation of the price system that prompted Keynes to introduce the concept of "effective demand." To pre-Keynesian economists the implied distinction between "effective" and (presumably) "ineffective" demand would have had no analytical meaning. The logic of traditional economic theory suggested two possibilities that might make the price system inoperative: (1) that, in some markets, neither demanders nor suppliers respond to price incentives, so that a "gap" between demand and supply cannot be closed by price adjustments and (2) that, for various institutional reasons, prices in some markets are "rigid" and will not budge in response to the competitive pressures of excess demands or excess supplies. Keynes discovered a third possibility that, he argued, was responsible for the depth and duration of severe depressions: under certain conditions, some prices may show no tendency to change even though desires to buy and to sell do not coincide in the respective markets and even though no institutional reasons exist for the prices to be rigid
Say's Law.
Many writers before Keynes raised the question of whether a capitalist economic system, relying as it did on the profit incentive to keep production going and maintain employment, was not in danger of running into depressed states from which the automatic workings of the price mechanism could not extricate it. But they tended to formulate the question in ways that allowed traditional economics to provide a demonstrable, reassuring answer. The answer is known in the economic literature as Say's Law of Markets, after the early 19th-century French economist Jean-Baptiste Say.
For western Europe, the 19th century was a period of rapid economic growth interrupted by several sharp and deep de pressions. The growth was made possible in large measure by new modes of organizing production and new technologies, such as the spreading use of steam power. Was it possible that output might grow so great that there would not be a market for it all? Say's Law denied the possibility. "Supply creates its own demand," ran the answer. More precisely, the law asserted that the sum of all excess supplies, evaluated at market prices, must be identically equal to the sum of the market values of all excess demands. It could be neither more nor less. In the theoretical system of traditional economics, any inequality between these sums would quickly work itself out
An important special case should be noted. The good in excess demand might, for instance, be money. One possibility, then, is excess supply for all the other goods, matched by an excess demand for money. A situation with excess demand for money matched by an excess supply of everything else is one in which the level of all money prices is too high relative to the existing stock of money. If this is the only trouble, however, Say's Law suggests a relatively simple remedy: increase the money supply to whatever extent required to eliminate the excess demand. The alternative is to wait for the deflation to work itself out. As the general level of prices declines, the "real" value of the money stock increases; this too, will, in the end, eliminate the excess demand for money.
Model of a Keynesian depression.
Involuntary unemployment.
Another possible cause of a general depression was suggested by Keynes. It may be approached in a highly simplified way by lumping all occupations together into one labour market and all goods and services together into a single commodity market. The aggregative system would thus include simply three goods: labour, commodities, and money. The Table provides a rough outline (a full treatment would be both technical and lengthy) of the development of a "Keynesian" depression. One may begin by assuming (line 1) that the system is in full employment equilibrium--that is, prices and wages are at their equilibrium levels and there is no excess demand. Next the model may be put on the path to disaster by postulating either (1) some disturbance causing a shift of demand away from commodities and into money or (2) a reduction in the money supply. Either event will result in the situation described in the Table as State 2, but the one assumed is a reduction in the money supply by, say, 10 percent. The result is shown in the right-hand column of the Table, where the quantity of commodities supplied minus the quantity demanded multiplied by the price level (p) is equal in value to the excess demand for money.
If money wages and money prices could immediately be reduced in the same proportion (10 percent), output and employment could be maintained, and profits and wages would be unchanged in "real" terms. If money wages are initially inflexible, however, business firms cannot be induced to lower prices by 10 percent and maintain output. In this example they maintain prices in the neighbourhood of the initial price level--prices, then, are also "inflexible"--and deal with the excess supply by cutting back output and laying off workers. Reducing supply eliminates the excess supply of commodities by throwing the burden of excess supply back on the labour market. Thus, output and employment (which are "quantities") give way before prices do. This brings us to State 3 where, as in the Table, the excess supply of labour times the money wage rate (w) equals the excess demand for money in value.
If, with the system in this state, money wages do not give way and the money supply is not increased, the economy will remain at this level of unemployment indefinitely. One should recall that the only explanation for persistent unemployment that the pre-Keynesian economics had to offer was that money wages were "too high" relative to the money stock and tended to remain rigid at that level.
Money wages might, nevertheless, give way so that, gradually, both wages and prices go down by 10 percent--that is to say, a reduction of the size that would have solved the entire problem had it occurred immediately (before unemployment could develop). This is shown in the last line of the Table, which represents (albeit crudely) what Keynes described as a state of "involuntary unemployment" and explained in terms of a failure of "effective demand."
In State 4, it is assumed, the excess demand for money is zero. Hence there is, at least temporarily, no tendency for money income either to fall further or to rise. The prevailing level of money income is too low to provide full employment. The excess supply of labour and the corresponding excess demand for commodities (of the same market value) show State 4 to be a disequilibrium state. The question is why the state tends to persist. Why is there no tendency for income and output to increase and to absorb the unemployment? Specifically, why does not the excess demand for commodities induce this expansion of output and absorption of unemployment?
Basically, the answer is that the unemployed do not have the cash (or the credit) to make the excess demand for commodities effective. The traditional economic theory would postulate that, when actual output is kept at a level below that of demand, competition between unsuccessful potential buyers would tend to raise prices, thereby stimulating an expansion. But this does not occur. The unemployed lack the means to engage in such bidding for the limited volume of output. The excess demand for commodities is not effective. It fails to produce the market signals that would induce adjustments of activities in the right direction. Business firms, on their side of the market, remain unwilling to hire from the pool of unemployed--even at low wages--because there is nothing to indicate that the resulting increment of output can actually be sold at remunerative prices.
Keynes called this "involuntary unemployment." It was not a happy choice of phrase since the term is neither self-explanatory nor very descriptive. Some earlier analysts of the unemployment problem had, however, tended to stress the kind of deadlock that might develop if workers held out for wages exceeding the market value of the product attributable to labour or if business firms insisted on trying to "exploit" labour by refusing to pay a wage corresponding to the value of labour's product. With the term "involuntary unemployment," Keynes wanted to emphasize that a thoroughly intractable unemployment situation could develop for which neither party was to blame in this sense. His theory envisaged a situation in which both parties were willing to cooperate, yet failed to get together. An effective demand failure might be described as "a failure to communicateThe failure of the market system to communicate the necessary information arises because, in modern economies, money is the only means of payment. In offering their labour services, the unemployed will not demand payment in the form of the products of the individual firms. If they did, the excess demand for products would be effectively communicated to producers. The worker must have cash in order to exercise effective demand for goods. But to obtain the cash he must first succeed in selling his services.
Effects of business contraction.
When business begins to contract, the first manifestation is a decrease in investment that causes unemployment in the capital goods industries; the unemployed are deprived of the cash wage receipts required to make their consumption demands effective. Unemployment then spreads to consumer goods industries. In expansion, the opposite occurs: an increase in investment (or in government spending) leads to rehiring of workers out of the pool of unemployed. Re-employed workers will have the cash with which to exert effective demand. Hence business will pick up also in the consumer goods industries. Thus the theory suggests the use of fiscal policy (an increase in government spending or a decrease in taxes) to bring the economy out of an unemployment state that is due to a failure of effective demand
Another observation may be made on Keynes's doctrine of effective demand. The fact that the persistence of unemployment will put pressure on wages also turns out to be a problem. The assumption in the foregoing discussion was that money wages were at the equilibrium level. Unemployment will tend to drive them down. Prices will tend to follow wages down, since declining money earnings for the employed will mean a declining volume of expenditures. In short, both wages and prices will tend to move away from, rather than toward, their "correct" equilibrium values. Once the economy has fallen into such a situation, Keynes pointed out, wage rigidity may actually be a blessing--a paradoxical conclusion from the standpoint of traditional economics
National income accounting.
The circular flow of income and expenditure.
A proper understanding of income and expenditure theory requires some acquaintance with the concepts used in national income accounting. These accounts provide quantitative data on national income and national product. Reliable information on these was, for the most part, not available to economists working on problems of economic instability before the 1930s. Modern economics differs from earlier work most markedly in its quantitative, empirical orientation. The development of national income accounting made this possible
The definitions of the major components of national income and product may, accordingly, be introduced in the course of explaining income and employment theory. The basic characteristic of the national income accounts is that they measure the level of economic activity in terms of both product supplied and of income generated. Correspondingly, national income analysis divides the economic system into distinct sectors. The simplest approach uses two sectors: a business sector and a household sector. All product is regarded as created by the business sector (thus, self-employed persons have to be treated as businesses in earning their income and as households in disposing of it). Final goods output is divided into two components: consumer goods produced for sale to households and investment goods for sale to firms. Similarly, all income is generated in the business sector and none of it in the household sector (nonmarket activities, such as the work of homemakers or home improvements, are not counted in national product and income). The level of income generated equals the market value of final goods output.
Next is the household sector. All resources in the economy ultimately belong to households. The households, therefore, have claim to all of the income generated through the utilization of these resources by firms in creating the national product. Not all of the income is, however, actually paid out to households, since corporations retain part of their earnings. In building a simple model of the economy, one can disregard the "gross business saving" item of the national income accounts and deal with income as if it were all paid out (which means adopting the fiction that retained earnings are first paid out to shareholders who then reinvest the same amount in the same firms). The households, finally, dispose of their income in two ways: as expenditure on consumption goods and as saving.
The foregoing discussion has made two accounting statements involving income. First, income generated (Y) equals the value of consumption goods output (Cs) plus the value of investment goods output (I): Y Cs + I. Second, consumption goods expenditures (Cd) plus savings (S) equal income disposal: Y Cd + S. Both equalities hold simply because of the way that the variables are defined in the national income accounts. They hold true, moreover, whatever the actual level of income happens to be. Such equalities, which are true simply by definition, are called identities (and are marked as such by using the sign instead of the usual equality sign). Another accounting convention may be noted here. Investment (I) is defined to include any discrepancy between consumer goods produced and consumer goods sold. If production exceeds sales, the unsold goods are part of inventory investment; if sales exceed output, inventory investment is negative, and I is reduced by the corresponding amount. It follows that Cs and Cd must be identically equal, so that it becomes unnecessary to distinguish between them by superscript. Since income generated is identically equal to income disposal, finally, it is clear that actual investment must always equal actual saving: I S. Investment is the value of additions to the system's stock of capital. Saving is the increase in the value of the household sector's wealth. For the system as a whole, the two must be equal.
Figure 12: The circular flow of income expenditures
Figure 12 shows the circular flow of income and expenditures connecting the two sectors. Investment and consumption expenditures add up to the aggregate demand for final goods output. The value of final goods output is paid out by the business sector as income to the household sector. The major part of income goes back to the business sector as expenditures on consumption goods; the remainder is allocated by households to saving. Corresponding to the counterclockwise money flow (but not shown) is the clockwise flow of the things that the money is paid for: labour and other resource services from households to firms in exchange for money income; consumer goods and services in exchange for consumption expenditures from firms to households; and equities, bonds, and other debt instruments issued by firms in return for the funds saved by households.
Figure 12 shows a break in the flow of saving as it passes into investment. From the accounting standpoint--where investment necessarily equals saving--there is no rationale for this. It has been done here to focus attention on the point in the circular flow that, in the income-expenditure theory, represents the causal nexus in the income-determining process. This theory, in its simplest form, is the next topic.
A simple income-expenditure model
.
Because accounting identities--between gross national product and gross national income, between saving and investment, and so on--express relationships that must hold whatever the level of income, they cannot be used to explain what determines the particular level of income in a given period or what causes the level of income to change from one period to the next. The explanation of what happens must be based on statements about the behaviour of the participants in the economic system; in the present context, this means the behaviour of firms and households.
The following oversimplified model of an economy assumes that the business sector will be satisfied to maintain any given level of output as long as aggregate demand (that is, expenditures on final goods) exactly equals the volume of income generated at that level of output. If, in a given period, aggregate demand exceeds the income payments made by firms in producing that period's output, firms will be expanding in the next period; if aggregate demand falls short of the income payments made, firms will contract in the next period. The naïveté of this supply hypothesis is evident from the fact that the behaviour of firms is described without any reference to the costs of their inputs or to the price of their outputs; the business sector passively adapts output and income generated to the level of aggregate demand. In this model, the level of income is entirely determined by aggregate demand. Firms will act so as to maintain that income flow if, and only if, the exact same amount that they pay out as incomes "comes back to them" in the form of spending on final goods output. If aggregate demand shrinks, production and employment will decline and there will be downward pressure on the price level; if aggregate demand swells, there will be an inflationary problem.
In the system of Figure 12, all of the income generated accrues to households. Households allocate their income to consumption and saving. With consumption there is no problem--it constitutes spending on final goods. Saving, however, does not constitute spending on final goods output. This part of the income generated by the business sector does not automatically come back to it in the form of revenue from sales. Saving, therefore, may be treated as a leakage from the circular flow.
Investment, which consists of spending of capital by the business sector on new plant and equipment and on desired additions to inventories, is, in the same terminology, an injection into the circular flow. If, for example, investment and saving each amount to $20,000,000 per year, the leakage and the injection will balance. But if saving is $20,000,000 per year and the injection of investment expenditures is only $10,000,000 per year, there will be a disequilibrium. Unsold goods will accumulate at an annual rate of $10,000,000. The business sector, however, will not rest content with this state of affairs but will act to reduce output, employment, and (perhaps) prices. Households will be forced to reduce their consumption spending. The reduction of income will go on until the planned (or desired) rates of saving and investment become equal. A similar argument will show that, if the leakage of planned saving were to fall short of the injection of planned investment, the level of income would rise.
When income is at a level such that there is no ongoing tendency for it to change in either direction, the system is in "income equilibrium." The simple system depicted in Figure 12 is in income equilibrium when the condition shown by this equation is fulfilled: I = S. This is not, however, the accounting identity discussed earlier. The symbols I and S now refer to planned, or desired, magnitudes, which may very well be unequal. When planned investment exceeds planned saving, income will be rising. When planned saving exceeds planned investment, income will be falling. An equivalent way of stating the above "equilibrium condition" is to write Y = C + I. In this equation the left-hand side is actual income and the right-hand side is planned aggregate demand.
This is the simplest class of income-determination model. It makes no allowance for international trade or government economic activity. Those may be treated in the same way that saving and investment were treated--as leakages or injections. Thus exports constitute spending by foreign nationals on domestic goods--an injection. Imports constitute spending out of domestic income on foreign goods--a leakage. Taxes are taken out of the circular flow--a leakage--whereas government expenditures are an injection. The effects of these leakages and injections on the level of income are analogous to those of saving and investment. If income is initially at an equilibrium level, an increase in a leakage (if not at the same time offset by a decrease in another leakage or an increase in an injection) will cause income to fall. An increase in an injection (not offset by a decrease in another injection or an increase in a leakage) will cause income to rise. An income equilibrium is reached when the sum of all leakages is balanced by the sum of all injections.
The multiplier.
The simple income-expenditure model of the economy is not a complete model. It suffices to show only the direction of the change in income that would result from, say, a decline in planned investment (or a rise in taxes or a decline of exports). It does not show the extent of the income change.
To do this the model must be expanded to include a description of how consumers spend their incomes. For the sake of the exposition, one may assume that the spending of households varies according to the size of their incomes. A simple way of putting this is the following equation: C = a + by. In this equation the coefficient a is a constant indicating the amount that households will spend on consumption independently of the level of income received in the current period, and the coefficient b gives the fraction of each dollar of income that will be spent on consumption goods.
If one were able to obtain reliable quantitative information on the volume of investment spending being planned and on the coefficients a and b of the "consumption function" above, one could then calculate the value of aggregate demand (C + I) for every possible level of income Y. Only one of these alternative levels of income is an equilibrium one; that is, one for which aggregate demand will ensure that all of the income paid out by firms "comes back" to the business sector as spending on final goods. The equilibrium condition is: Y = C + I.
Figure 13: Relation between income and aggregate demand
Figure 13 shows how the level of income in the system is determined, on the assumption that investment is $20,000,000, that the coefficient a is $20,000,000, and that the coefficient b (the fraction of each dollar of income that consumers will spend) is 0.6. The horizontal axis measures income, the vertical, aggregate demand (C + I). The line drawn at a 45 angle (from 0) contains all of the points at which suppliers might be in equilibrium; i.e., the points in the space at which aggregate demand would have the same value as income. The investment schedule (marked I = I0) is drawn parallel to the income axis at height 20, showing that investment spending does not depend on income. The consumption function (marked C = a + by) starts at 20 on the vertical axis (the value of a) and rises 60 cents for each dollar of income (the value of b) to the right. The aggregate demand schedule (marked C + I0) is obtained by the vertical summation of the C and I0 schedules. It contains all of the points at which demanders would be in equilibrium, showing, for each level of income, the volume of spending on final goods that they would be satisfied to maintain.
The only position that demanders and suppliers will both be satisfied to maintain is given by the intersection of the aggregate demand schedule with the 45 line. In Figure 13 this point ({Y circumflex}0) is found at an income level of $100,000,000. For this simple system, which has but one leakage and one injection, the equilibrium level of income may equally well be regarded as determined by the condition that planned saving equals planned investment. Since saving is defined as household income not spent on consumption (i.e., Y - C S), one obtains (by substituting a + by for c) the saving schedules S = -a + (1 - b) Y, which in Figure 13 is shown to intersect the investment schedule at Y = $100,000,000.
Figure 13 shows what will happen if this equilibrium is disturbed. Consider a (temporary) situation in which income is running at more than $100,000,000 per year. At all levels of income to the right of {Y circumflex}0 aggregate demand (C + I0) is seen to fall below supply as given by the 45 line. (Also, saving exceeds investment.) The business sector will not be willing to maintain this state of affairs but will contract. An excess supply of final goods is associated with falling income. Similarly, at income levels to the left of {Y circumflex}0, where investment exceeds saving, aggregate demand will exceed supply. An excess demand for final goods is associated with rising income.
Finally, Figure 13 shows how much income would fall as a result of a decline in investment by $10,000,000 per year (cf. the dotted lines). The decline in investment is shown by the shift of the investment schedule from I0 to I1, which results in a downward shift of the aggregate demand schedule from C + I0 to C + I1. The new income equilibrium ({Y circumflex}1) is found at Y = $75,000,000.
Thus a change in investment spending ( I) of $10,000,000 is found to lead to a change in income ( Y) of a larger amount, here $25,000,000, which is to say, by a multiple of 2.5. The reason is that, when the $10,000,000 is transmitted to households as income, households will increase their consumption spending by $6,000,000 (b $10,000,000). This rise in consumption spending again raises income, and of this additional income 60 percent is also spent on consumption--and so on. Each time, 40 percent of the increment to income "leaks" into saving. The relationship between the initial change in "autonomous spending" ( I) and the change in the level of income ( Y), which will have taken place once this process has run its course, is given by:
where, following Keynes, the expression (1 - b1) is called the "Multiplier."
The model of income determination presented above is exceedingly simple; it captures little of the complexity of a modern industrialized economy. It does, however, suggest one approach to the problem of stabilizing the economy at a high level of income and employment. Assuming that the consumption function is fairly stable (i.e., that the level of consumption spending associated with any level of income can, with a fair degree of accuracy, be predicted on the basis of past experience), fluctuations in income may be attributed to changes in the other variables. Historical statistics show investment spending by private business to have been the most volatile of the major components of national income; changes in investment, therefore, tend (as in the example above) to be the focus of concern for one school of economists. The implication is that the government can manipulate "injections" and "leakages" so as to offset changes in private investment. Thus a drop in investment might be offset by a corresponding increase in government expenditures (increasing an injection) or a decrease in taxes (decreasing a leakage). These measures belong to fiscal policy.
Monetary policy.
Another point of view holds that the fiscal approach presented above is misleading because it ignores the part played by monetary factors in determining the level of economic activity. The following discussion presents an alternative model, which, though equally simplistic, suggests that primary reliance be put on monetary policy.
"Money" in what follows may be taken to refer to currency (coins and notes) plus the checking deposit liabilities of commercial banks. For the sake of brevity, the model developed in the preceding section will be referred to as the income model. The naive quantity theory model that will be explained here may be labelled the money model.
The income model dealt with changes in money income in terms of the demand for and supply of output. The money model focusses on the supply of and demand for money. The income model explained the determination of the level of income in terms of relationships between its component flows. The money model emphasizes the relationship between money supply and income. The structure of the income model was based on the distinction between household and business (and government) sectors. In the money model, the distinction is between the banking sector (supplying the money) and the nonbanking sectors (the demanders). The concept of income is the same in both models.
In the money model, the supply of money is treated with the same simplicity that was accorded investment in the income model--as "autonomously" determined, which is to say that it is not affected by other factors: Ms = M. This assumes that the central bank is able completely to control the stock of money, which is held at whatever level the bank desires.
The dynamic relationship in the income model was the consumption function. Here it is the money demand function. The amount of money demanded is assumed to vary with income (and, in this naive version of quantity theory, with nothing else). The simplest relationship between income and the demand for money would be: Md = kY. Here, k is a constant. Since Y is a flow (measured per year) and Md a stock (the average stock of money over the year), k has the dimension of a "storage period." If k = 1/4, for example, the equation states that the nonbanking public desires on the average to hold a cash balance that is equal to the total of three months' income.
Figure 14: Relation between money demand and income
Since there is a determined amount of money in the system, it can be in equilibrium only when the nonbanking sector is satisfied to hold exactly the amount of money that exists, no more and no less: Md = Ms. The system represented by these three equations is shown in Figure 14. The determination of income in the system is shown by assuming Ms = $25,000,000 and k = 1/4. The amount of money demanded is equal to supply when income is $100,000,000. A reduction of the money supply to $20,000,000 will cause income to decline to a level of $80,000,000 per year.
Figure 14 shows what will happen if income temporarily exceeds the figure of $100,000,000 per year. To the right of {Y circumflex}0, the amount of money demanded exceeds the existing stock of it. The way for an individual to build up his cash balance is to reduce his disbursements below his receipts. But his spending (to the extent that it is spending on final goods at least) is somebody else's income. A general attempt to build up cash balances cannot succeed--it does not induce an increase in the money supply in this model--because it will result in a decline of income throughout the system. This decline will continue to whatever level is required to make the nonbanking sector bring the amount of money it demands into line with the amount in existence. An excess demand for money is associated with falling income. Similarly, if the amount of money demanded falls short of the amount supplied, an individual may decide to reduce his cash balance by increasing his disbursements--but the money stays in the system; incomes will rise all around. An excess supply of money is associated with rising income.
The stabilization policy that this model suggests is obvious: if the relationship between income and the demand for money is stable, the system can be maintained in equilibrium by keeping the money supply constant or, in a growing economy, by allowing the money stock to grow at roughly the same rate as real output. If the relationship between income and the demand for money is found to shift about over time, the money stock should be made to grow more rapidly in periods of increasing demand for money and more slowly in periods of decreasing demand.
Comparisons of the income and money models.
Although the two models seem to have nothing in common--the crucial variables of one do not even appear in the other--their descriptions of what happens during income level movements are not contradictory. Falling income is associated with an excess supply of goods and services in the income model, with an excess demand for money in the money model. Rising income is associated with an excess demand for goods in the first model, with an excess supply of money in the other. Evidently the two models give only partial descriptions of what is going on: one model looks at the process from the "real" side only and the other from the "monetary" side. But an excess demand for goods on one side will be associated with an excess supply of money on the other, and vice versa, so in this respect the two are consistent.
The controversy between the two schools of thought represented by the models has mainly to do with two issues. One issue is which set of policy instruments--fiscal or monetary--provides the best means of stabilizing the economy. The other, more fundamental, issue concerns the causes of income movements. As seen above, changes in investment were the main cause of income movements in the income model; changes in the money stock were the main cause in the money model. Simplistic as the two models are, they embody the conflicting hypotheses of the two contending schools. Income-expenditure theorists attribute the instability of income primarily to events that influence the business sector's expectations with regard to the profitability of new investment, thus influencing investment. The modern quantity theorists see the irregular time path of the money stock as the most important factor.
The gross features of economic history do not contradict either hypothesis. Private investment has indeed been the most volatile component of Gross National Product. Similarly, the movements of the money stock have conformed to those of money income: rapid inflation has been associated with a rapid growth of the money supply; severe recessions, with a decline in the money supply; and mild recessions, with a slowdown in the growth of the money supply. ("Mild" recessions may be thought of as recessions during which total employment stagnates, and the growth in unemployment, therefore, is largely due to the growth of the labour force.) The controversy has in large measure come to concern the direction of causation: one side maintains that shifts in investment cause income changes and infers that these in turn induce changes in the money stock which go in the same direction; the other side maintains that changes in the size or rate of growth of the money stock cause income changes that in turn will tend to fall most heavily on the investment component of income.
The problem of resolving this controversy is twofold. First, the theoretical issue is less clear-cut than implied above. Each side acknowledges that neither investment nor the money supply is autonomous and that each affects the other. The question has become, therefore, which model is "most nearly true" and which model, consequently, should be regarded as a "first approximation" in guiding stabilization policy.
Second, the empirical methods at the disposal of economists are not yet adequate for settling such issues. Attempts have been made to compare the performance of the two models by testing whether the best predictions of income are obtained by using actual data for "autonomous expenditures" and assuming that consumption will obey the consumption-income relation that has generally obtained in the past or by using actual money stock figures and assuming that money demand will obey the relation to income that has generally obtained in the past. These attempts have bogged down in disagreements on various statistical matters and must be judged inconclusive. They have shown, however, that even with consumption functions and money demand functions that are a good deal more "reasonable" than the naive relationships above, the predictions of both models are too inaccurate for the purposes of stabilization policy.
Each model emphasizes one set of disturbances ("real" or "monetary", respectively) that will cause income to change. Each gives a partial view of the process of income-level movements. What is needed, therefore, is a third model explaining the linkages between "real" and "monetary" forces that these two simple models leave out.
Interest-rate policy.
The third model brings a crucially important--but hitherto generally neglected--element into the picture of the economic system; namely, financial markets. For simplicity, the model has only one financial market; there is only one class of financial instruments (referred to as "securities") and only one yield (a single interest rate). The standard security may be thought of as a bond promising to pay annually a fixed number of dollars. The interest rate is the value of the coupon expressed as a percentage of the market price of the bond. Consequently, if excess demand for bonds brings their price up, the interest rate falls; if excess supply sends the bond price down, the interest rate rises
The working of the financial market is depicted in the model as follows. Investment by the business sector is assumed to be financed through the issue of securities. The higher the interest rate that firms must pay on their securities, the smaller will be the investment program that they see as promising to be profitable. Thus investment will be discouraged by a rise and encouraged by a fall in the interest rate. Households, in deciding how to divide their income between consumption and saving, will consider the amount of future consumption that can be gained by abstaining from consumption now (i.e., by saving). The higher the rate of interest, the larger the amount that can be spent on future consumption per dollar not spent in the present. Thus saving is encouraged by a rise and discouraged by a fall in the interest rate. Coins, notes, and some checking deposits are assets on which interest is not paid. An individual who holds them has the alternative of converting some part of his money holdings into interest-bearing form. Thus the amount of money demanded will tend to diminish when the interest rate rises and to increase when it falls. The banking system creates money by buying assets from the public, paying for the assets through the issuance of additional monetary liabilities (e.g., checking deposits). Banks must decide whether turning part of their cash reserves to an income-earning use is worth the risks of decreased "liquidity" entailed by lower bank reserves. Hence there is a tendency for the money supply to increase when the interest rate rises and to decrease when it falls
In this model, then, the interest rate acts as a price in controlling the behaviour of the individual agents whose activities are to be coordinated. The interest rate itself is determined by the demand for and supply of money and securities. An increase in planned investment will be associated with the issuance of a large volume of securities. It will tend, therefore, to create an excess supply of securities, to lower securities prices, and to raise the rate of interest. Similarly, an increase in planned saving will tend to create an excess demand for securities, to raise their prices, and to lower the rate of interest. An increased demand for money will, in part, reduce the demand for and increase the supply of securities; it tends to create an excess supply of securities and to raise the interest rate. An increase in the supply of money will tend to reduce the rate of interest
These qualitative propositions are the framework of the new model, integrating the two previous models as follows: (1) I = I(r); (2) C = C(Y,r); (3) S = Y - C; (4) S = I; (5) Md = Md(Y,r); (6) Ms = Ms(r); and (7) Md = Ms. Here, Equations 1 through 4 restate the income model with the modification that investment is no longer simply "autonomous" but depends on the current level of the interest rate (r). Equations 5 through 7 restate the money model with the modification that the demand for money and the supply of money also depend on the interest rate. Two conditions now have to be simultaneously fulfilled for the system to be in equilibrium: desired saving must equal desired investment (Equation 4), and the amount of money that individuals and firms desire to hold must equal the amount that the banking sector desires to supply (Equation 7).
Only a partial account of the ways in which this model works can be given here. The following illustrative examples begin with the system in equilibrium at full employment. The first illustration adopts the view of someone who has learned the income model and hence is thoroughly imbued with the idea that rising income results from an excess of planned investment over planned saving. Faced with the proposition, drawn from the money model, that an increase in the money supply will also cause income to rise, he will ask how such a change in the money supply can cause a discrepancy between saving and investment when there was none to begin with. The answer is that an increase in Ms will mean that there is an excess supply of money and a corresponding excess demand for commodities and securities, but the immediate impact of excess demand will be felt almost exclusively in the securities market. The excess demand for securities drives the rate of interest down--and this encourages investment and discourages saving. At that point, consequently, a "gap" opens up between desired saving and investment.
For the second illustration, consider instead someone who has learned the money model and who, consequently, knows that income falls when the amount of money demanded exceeds the supply. In Keynes's work the "disturbance" given the most play is some unspecified event that makes business firms take a darker view of the returns to be expected from new investment. Hence, the amount of investment that they will want to undertake at the prevailing interest rate declines. The question is how such a change in planned investment can cause a discrepancy between money demand and money supply when there was none to begin with. The simplest answer is that a decline in planned investment will be associated with a reduction in the amount of securities floated on the market and thus with the emergence of an excess demand for securities. This drives securities prices up, which is to say that the interest rate falls. At a lower rate of interest, individuals will desire larger money balances than before; in addition, the banks will tend to reduce the money stock somewhat. At that point, consequently, a gap will open between the amount of money demanded and the amount supplied.
The analysis of the consequences of government fiscal action is somewhat more complicated. If the government tries to stimulate the economy through increased expenditures, the effects will be felt in at least two ways. First, the increased spending is an "injection" added to commodity demand and may be treated, therefore, from the Model A standpoint in the same way as an increase in private investment. Second, however, this spending may be financed through increased taxes, through government borrowing, through creation of new money, or through some combination of the three. The strongest effects are gained by following the third alternative, the creation of new money. The excess demand for goods and services created by the increase in spending will then be matched by an excess supply of money, which, as seen above, will drive down the interest rate and cause increased investment, etc. To the direct stimulus of the spending program, this method of paying for it adds the indirectly achieved stimulus of increased private investment. (Needless to say, the double effect on money income is not always desirable. The fact that this method of financing government spending has almost always been heavily resorted to in wartime accounts for the historical association of large inflations with wars.) The method of the second alternative, government borrowing, consists of financing the increase in spending through the issue of government bonds. This creates an excess supply of securities, driving up the interest rate. At the higher interest rate, money demand is lessened and money supply somewhat increased, but the consequent excess supply of money will be of smaller magnitude than that entailed by creating new money. The higher interest rate will also discourage private investment. Thus the indirect effects of government borrowing are seen to involve a decrease in private investment partially offsetting the initial increase in government spending. The size of this offset has become one of the major issues between "monetarist" and "income-expenditure" economists. The monetarists argue that the offset is so nearly complete that fiscal action will be largely ineffectual unless it is accompanied by an increase in the money supply, but an increase in the money supply will have almost as powerful effects without any simultaneous fiscal action. The other side concedes that fiscal action will be more powerful when financed through changes in the money supply but maintains that countercyclical variations in government spending financed through borrowing must still be regarded as an important stabilization method.
The "natural" rate of interest and effective demand.
The thought of Knut Wicksell.
Around the turn of the century, the Swedish economist Knut Wicksell contributed greatly to the understanding of the function of the rate of interest in the mechanism determining income and price-level movements. Assuming an economy initially in full-employment equilibrium, Wicksell analyzed the various ways in which the system might depart from that position because of discrepancies between the prevailing market rate of interest and what he termed the "natural rate." The latter rate, hypothetical rather than directly observable, may be thought of as the interest rate level that would have to prevail for the system to remain at full employment with stable prices. In illustrating the use made of this concept, one should distinguish between processes initiated by "real" disturbances (the first two examples below) and those initiated by "monetary" disturbances (the third example).
The first example is one in which business firms see increased opportunities for profitable investment. The system is already at full employment, and hence an increase in spending on investment without a corresponding decrease in spending for consumption would spell inflation. What kind of adjustment will maintain stable prices? A rise in the interest rate will (1) moderate the increase in investment spending and (2) cause households to divert some of their income from consumption into increased saving. The hypothetical level of the interest rate that will exactly match the net increase in investment with the decrease in consumption (increase in saving) is the new value of Wicksell's "natural rate." But the adjustment of the market rate may, for several reasons, come to a halt after going only part of the way to the new natural rate level. At some level of the market rate below natural rate, where planned investment still exceeds the savings that households provide for its financing, the banks may step in and finance the difference through expansion of the money supply. Thus inflation results. In Wicksell's theory there is inflationary pressure on the system associated with a market rate below the natural level and, in the version of it given here, with an increase in the money supply.
The second example involves a change in public behaviour in that households desire to save more and consume less, out of any given level of income. The decreased demand for consumption goods threatens to cause deflation (or unemployment). To prevent this it is necessary to switch resources over to investment goods production, which requires a lowering of the interest rate. Thus an increase in saving means that the natural rate of interest declines. The adjustment of the market rate of interest may again be incomplete if falling rates induce banks, say, to reduce their new lending below scheduled loan repayments, thus reducing the money supply. Part of the saving done by households then goes, directly or indirectly, into reducing the private sector's indebtedness to banks rather than into financing investment. Thus deflationary pressure on the system is, in Wicksell's theory, associated with a market rate of interest above the natural rate and, in this example, with a decreased supply of money.
The third example is one in which banks desire to expand their loans and, thereby, their monetary liabilities--creating a "monetary" disturbance. Since "real" incentives to save and to invest have not changed, the natural rate of interest has not changed. The increased supply of bank credit will, however, drive the market rate down. It goes below the natural rate, the money supply is increased in the process, and inflation is the result.
Keynes and Wicksell.
Keynes first took up Wicksell's idea in his Treatise on Money (1930). In Wicksell's writings, discrepancies between the natural and market rates had invariably been associated with expansion or contraction of bank credit. Keynes emphasized that such discrepancies may develop and continue without expansion or contraction of the money supply, because of speculation in the securities markets. For example, if the natural rate has decreased and the market rate starts to edge down in response to an excess of the household savings offered in demand for securities over the supply of new securities marketed to finance investment, securities prices will rise. This, Keynes suggested, will cause some speculators in "old" securities to enter the market and supply savers with securities from their holdings. The excess demand pressure on the market is thus relieved and the rise in prices (fall of the market rate) halted. The motive for these transactions is the speculators' hope that they can buy back their securities at lower prices later. In the meantime, the speculators hold their funds in the form of ready money; there has been an increase in the amount of money demanded rather than, as Wicksell assumed, a decrease in the money supply.
The Wicksell-Keynes theory was an important contribution to the theory of the income-determination process. Yet there is nothing in its main elements that should have startled a pre-Wicksellian traditional economist. The natural rate is essentially the interest rate that would prevail in general equilibrium, and a market rate different from the natural rate is a disequilibrium interest rate. Traditional economics was clear enough as to the consequences that will follow if one or more of the prices in the system "gets stuck" at a disequilibrium level. The Wicksell-Keynes theory, therefore, may be regarded as a particular application of previously familiar principles.
Keynes returned to the Wicksellian theme in The General Theory of Employment, Interest and Money (1936), but in that revolutionary work he gave the theory a genuinely novel twist: he argued that the system might be seriously out of equilibrium even though the prevailing interest rate was exactly at the Wicksellian natural level. This might happen because the interest rate mechanism cannot ensure that the plans of households and business firms with regard to future consumption and production will mesh with each other. There might, for example, be an increase in household saving--that is, a decrease in the demand for current consumption goods and an increase in the planned demand for future goods. Coordination of household and business activities requires that business firms respond by shifting resources out of the production of present consumption goods and into investment activities that lay the groundwork for increased output in the future. Households, in carrying out their saving decisions, do not place contractual orders with producers for future deliveries of particular goods and services. Thus the future demands implicit in current saving decisions may not be effectively communicated to producers, as efficient coordination would require. If producers draw up their investment plans on the basis of forecasts of future demand that do not correspond to the spending that households are prepared to undertake in the future, there will be an excess demand (or excess supply) for future output.
Such effective demand failure is not the result of changes in interest rates or in the supply of money. The logical way of dealing with it--when it occurs--is through fiscal policy measures. The effective demand doctrine is the signal contribution of Keynesian economics to income and employment theory. It is thus no coincidence that Keynesian economics has become associated with an emphasis on the use of fiscal, rather than monetary, stabilization policies.
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MICROECONOMICS AND MACROECONOMICS
Many economists specialize in a particular branch of the subject. For example, there are labour economists, energy economists, monetary economists, and international economists. What distinguishes these economists is the segment of economic life in which they are interested. Labour economics deals with problems of the labour market as viewed by firms, workers, and society as a whole. Urban economics deals with city problems: land use, transport, congestion, and housing. However, we need not classify branches of economics according to the area of economic life in which we ask the standard questions what, how, and for whom. We can also classify branches of economics according to the approach or methodology that is used. The very broad division of approaches into microeconomic and macroeconomic cuts across the large number of subject groupings cited above.
Microeconomic analysis offers a detailed treatment of individual decisions about particular commodities.
For example, we might study why individual households prefer cars to bicycles and how producers decide whether to produce cars or bicycles. We can then aggregate the behavior of all households and all firms to discuss total car purchases and total car production. Within a market economy we can discuss the market for cars. Comparing this with the market for bicycles, we may be able to explain the relative price of cars and bicycles and the relative output of these two goods. The sophisticated branch of microeconomics known as general equilibrium theory extends this approach to its logical conclusion. It studies simultaneously every market for every commodity. From this it is hoped that we can understand the complete pattern of consumption, production, and exchange in the whole economy at a point in time.
If you think this sounds very complicated you are correct. It is. For many purposes, the analysis becomes so complicated that we tend to lose track of the phenomena in which we were interested. The interesting task for economics, a task that retains an element of art in economic science, is to devise judicious simplifications which keep the analysis manageable without distorting reality too much. It is here that microeconomists and macroeconomists proceed down different avenues. Microeconomists tend to offer a detailed treatment of one aspect of economic behaviour but ignore interactions with the rest of the economy in order to preserve the simplicity of the analysis. A microeconomic analysis of miners' wages would emphasize the characteristics of miners and the ability of mine owners to pay. It would largely neglect the chain of indirect effects to which a rise in miners' wages might give rise. For example, car workers might use the precedent of the miners' pay increase to secure higher wages in the car industry, thus being able to afford larger houses which burned more coal in heating systems. When microeconomic analysis ignores such indirectly induced effects it is said to be partial analysis.
In some instances, indirect effects may not be too important and it will make sense for economists to devote their effort to very detailed analyses of particular industries or activities. In other circumstances, the indirect effects are too important' to be swept under the carpet and an alternative simplification must be found. Macroeconomics emphasizes the interactions in the economy as a whole. It deliberately simplifies the individual building blocks of the analysis in order to retain a manageable analysis of the complete interaction of the economy. For example, macroeconomists typically do not worry about the breakdown of consumer goods into cars, bicycles, televisions, and calculators. They prefer to treat them all as a single bundle called 'consumer goods' because they are more interested in studying the interaction between households' purchases of consumer goods and firms' decisions about purchases of machinery and buildings.
Macroeconomics is the study of the economy as a whole.
Macroeconomics is concerned not with the details - the price of cigarettes relative to the price of bread, or the output of cars relative to the output of steel - but with the overall picture.
The distinction between microeconomics and macroeconomics is more than the difference between economics in the small and economics in the large, which the Greek prefixes micro and macro suggest. The purpose of the analysis is also different.
A model is a deliberate simplification to enable us to pick out the key elements of a problem and think about them clearly. Although we could study the whole economy by piecing together our microeconomic analysis of each and every market, the resulting model would be so cumbersome that it would be hard to keep track of all the economic forces at work. Microeconomics and macroeconomics take different approaches to keep the analysis manageable.
Microeconomics places the emphasis on a detailed understanding of particular markets. To achieve this amount of detail or magnification many of the interactions with other markets are suppressed. In saying that a tax on cars reduces the equilibrium quantity of cars we ignore the question of what the government does with the revenue. If government has to borrow less money it is possible that interest rates and the exchange rate will fall and that improved international competitiveness of U.K car producers will increase the equilibrium output of cars in the U.K.
Microeconomics is a bit like looking at a horse through a pair of binoculars. It is great for details but sometimes we get a clearer picture of the whole race by using the naked eye. Because macroeconomics is concerned primarily with the interaction of different parts of the economy, it relies on a different simplification to keep the analysis manageable. Macroeconomics simplifies the building blocks in order to focus on how they fit together and influence one another.
The main issues in macroeconomics:
1.Inflation -the annual inflation rate is the percentage increase per annum in the average price of goods and services.
What causes inflation? The money supply? Trade unions?
Why do people mind so much about inflation? Does it cause unemployment?
2.Unemployment. It is a measure of the number of people registered as looking for work but without a job. The unemployment rate is the percentage of the labour force that is unemployed. The labour force is the number of people working or looking for work. It excludes all those -from rich landowners to heroin addicts- who are neither working nor looking for work.
.Why has it increased so much?Are workers pricing themselves out of jobs by greedy wage claims? Is high unemployment necessary to keep inflation under control, or could the government create more jobs?
3.Output and Growth .Real gross national product measures the total income of the economy. It tells us the quantity of goods and services the economy as a whole can afford to purchase. Increases in real gross national product are called economic growth.
-What determines the level of real GNP? Why do some countries grow faster than others?
4. Macroeconomic policy. Almost every day the newspapers and television refer to the problems of inflation, unemployment, and slow growth. These issues are widely discussed; they help determine the outcome of elections, and make some people interested in learning more about macroeconomics. The government has a variety of policy measures through which it can try to affect the performance of the economy as a whole. It levies taxes, commissions spending, influences the money supply, interest rates, and the exchange rate, and it sets targets for the output and prices of nationalized industries.
What the government can and should do is the subject of lively debate both within the field of economics and in the country at large. As usual, it is important to distinguish between positive issues relating to how the economy works and normative issues relating to priorities or value judgements.
Economic Growth
There is general agreement amongst economists concerned with the problems of less developed countries (LDCs) that a distinction should be made between economic growth and economic development.
Economic growth is defined as an increase in the productive capacity of an economy over time, giving rise to an increase in real National Income (NI). If the rate of growth of income is greater than the rate of growth of population, income per capita will also rise.
Economists distinguish between the Gross Domestic Product (GDP) and the Gross National Product (GNP) of an economy. GDP is the total final output of goods and services produced within an economy for any given year, by both residents and non-residents. GNP is equal to GDP plus net factor (or property) incomes from abroad (that is, the difference between returns to the inhabitants of the country from property located overseas minus the returns accruing to foreigners from their property located within the reporting country). For most LDCs, net property income from abroad is likely to be negative and thus GDP will be greater than GNP.
Both domestic product and national product can be expressed in net terms (that is, after allowing for capital depreciation) and either at market prices or factor costs (that is, including and excluding respectively, indirect taxes net of subsidies). Net National Product (NNP) at factor cost is identical to National Income.
For many LDCs, economic growth has been rapid and sustained for much of the post-Second World War period. World Bank projections for the 1980s predicted that higher rates of economic growth would be difficult to reach and sustain and that there would occur a widening in both the relative and absolute gaps between the richest and the poorest countries, including the gap between the middle- and low-income LDCs.
In the early years of the evolution of development economics as a distinct area of study, economic growth and economic development were generally seen as being synonymous. The deficiencies of using GNP per capita as an indicator of economic welfare (and by implication, the level of economic development) were recognised by economists, however, and over time it became increasingly evident that economic growth on its own, although undoubtedly a necessary condition, was certainly not a sufficient condition to ensure increases in economic, let alone social, welfare.Within the concept of economic development was some notion of progress. Economic development meant growth plus structutal and institutional change which involved the move towards certain normative goals or objectives.Growth without development was a possibility if increases in per capita incomes were not accompanied either by structural changes or by the diffusion of the gains in real income among all sectors of the population.
Vocabulary
Commodity-goods sold in large quantities
Consumption- using,consuming
Cumbersome- large and difficult to move
Debate- formal discussion, contest between two speakers
Economics-study of macro and micro economics
Economy-financial state of a country
Gain- increase of possessions, increase in amount or power
Housing- accomodation
Income-money received during a given period
Issue- giving out shares, outgoing, result, outcome
Levy- money collected by authorities
Manageable- that can be managed,easily controlled
Overseas- abroad, across the sea
Purchase-something which has been bought
Rate- charge for service or work.-market price
Subsidy- money given to support unprofitable enterprises
Supply-providing something
To accrue- to come as a natural growth or development
To cite- to mention
To deal with- to do business
To distort- to give a false account of
To ensure- to make sure, guarantee
To exchange-to give one thing for another
To increase- to make, to become greater
To levy- to demand payment of taxes and dues
To owe- to have to pay money
To purchase- to buy
To subsidise- to help or support financially
To trade- to buy and sell
Trade- buisness of buying and selling
Transaction- exchange of goods or services for money
Welfare- condition of having good health, comfortable living and working conditions
The Medium of Exchange
Money, the medium of exchange, is used in one- half of almost all exchange. Workers exchange labour services for money. People buy or sell goods in exchange for money. We accept money not to consume it directly but because it can subsequently be used to buy things we do wish to consume. Money is the medium through which people exchange goods and services.
To see that society benefits from a medium of exchange, we should imagine a barter economy.
A barter economy has no medium of exchange. Goods are traded directly or swapped for other goods.
In a barter economy the seller and the buyer each must want something the other has to offer. Each person is simultaneously a seller and a buyer. In order to see a film, you must hand over in exchange a good or service that the cinema manager wants. There has to be a double coincidence of wants. You have to find a cinema where the manager wants what you have to offer in exchange.
Trading is very expensive in a barter economy. People must spend a lot of time and effort finding others with whom they can make mutually satisfactory swaps. Since time and effort are scarce resources, a barter economy is wasteful. The use of money - any commodity generally accepted in payment for goods, services, and debts - makes the trading process simpler and more efficient.
Money
The unit of account is the unit in which prices are quoted and accounts are kept.
In Britain prices are quoted in pounds sterling; in France, in French francs. It is usually convenient to use the units in which the medium of exchange is measured as the unit of account as well. However there are exceptions. During she rapid German inflation of 1922-23 when prices in marks were changing very quickly, German shopkeepers found it more convenient to use dollars as the unit of account. Prices were quoted in dollars even though payment was made in marks, the German medium of exchange.
Money is a store of value because it can be used to make purchases in the future.
To be accepted in exchange, money has to be a store of value. Nobody would accept money as payment for goods supplied today if the money was going to be worthless when they tried to buy goods with it tomorrow. But money is neither the only nor necessarily the best store of value. Houses, stamp collections, and interest-bearing bank accounts all serve as stores of value. Since money pays no interest and its real purchasing power is eroded by inflation, there are almost certainly better ways to store value.
Finally, money serves as a standard of deferred payment or a unit of account over time. When you borrow, the amount to be repaid next year is measured in pounds sterling. Although convenient, this is not an essential function of money. UK citizens can get bank loans specifying in dollars the amount that must be repaid next year. Thus the key feature of money is its use as a medium of exchange. For this, it must act as a store of value as well. And it is usually, though not invariably, convenient to make money the unit of account and standard of deferred payment as well.
Different Kinds of Money
In prisoner-of-war camps, cigarettes served as money. In the nineteenth century money was mainly gold and silver coins. These are examples of commodity money, ordinary goods with industrial uses (gold) and consumption uses (cigarettes) which also serve as a medium of exchange. To use commodity money, society must either cut back on other uses of that commodity or devote scarce resources to producing additional quantities of the commodity. But there are less expensive ways for society to produce money.
- A token money is a means of payment whose value or purchasing power as money greatly exceeds its cost of production or value in uses other than as money.
A £10 note is worth far more as money than as a 3 x 6 inch piece of high-quality paper. Similarly, the monetary value of most coins exceeds the amount you would get by melting them down and selling off the metals they contain. By collectively agreeing to use token money, society economizes on the scarce resources required to produce money as a medium of exchange. Since the manufacturing costs are tiny, why doesn't every-one make £10 notes?
The essential condition for the survival of token money is the restriction of the right to supply it.
Society enforces the use of token money by making it legal tender. The law says it must be accepted as a means of payment.
In modern economies token money is supplemented by IOU money. An IOU money is a medium of exchange based on the debt of a private firm or individual.
A bank deposit is IOU money because it is a debt of a bank. When you have a bank deposit the bank owes you money. Bank deposits are a medium of exchange because they are generally accepted as payment.
Vocabulary
Exchange-giving one thing for another
To trade-to do business by buying and selling
Swap-an exchange
Barter-interchange of goods or services without the intervention of money.
Commodity-goods sold in large quantities.
Share-a small part of a company's capital
To purchase-to buy
Purchase-something which has been bought
Bearer-person who holds a cheque or certificate
Bear market-period when share prices are falling
To defer-to put to a later date
Deferred payments-payments postponed to a later date
Bank organization
The way in which a bank is organized and operates is determined by its objectives and by the type of economy in which it conducts its business. A bank may not necessarily be in business to make a profit. Central banks, for example, provide a country with a number of services, while development banks exist to increase the economic growth of a country and raise the living standard of its population. On the other hand, the aim of commercial banks is to earn profits. They therefore provide and develop services that can be sold at a price that will yield a profit.
A commercial bank which provides the same range of services year after year is less likely to be successful than one which assesses changes in the demand for its products and which tries to match products to its customers' needs. New services are constantly being introduced and developed by commercial banks, and the full- service philosophy of many banks means that they are akin to financial supermarkets, offering a wide variety of services. However, not every bank may want to offer every kind of financial service.
Many banks offer a combination of wholesale and retail banking. The former provides large-scale services to companies, government agencies and other banks. The latter mainly provides smaller-scale services to the general public. Both types of banking, however, have three essential functions, which are:
• deposits, payments, credits
These three functions are the basis of the services offered by banks. They make it possible for banks to generate profits and to achieve their operating aims.
Several factors have combined to make banking an international business. These include the growth of multinational companies and of international capital markets, the increased competition between the banks themselves, and important improvements in communications and transportation .The major banks of the world have established extensive international operations by acquiring banks in other countries, by extending their own branch network abroad and by establishing correspondent relationships with foreign banks so as to develop profitable joint operations. The operations of these major commercial banks are dynamic and rapidly changing, and their organization is of a global nature.
TEXT1
William Sands meets David Black an ex-mate and tries to describe him the structure of the bank where he is the president.
William: I can show you an organization chart David, in the back of the annual report,which we can run through, just to make things a little clearer:
David :That's O.K
William: We were reorganized earlier this year, so the organization is still fairly new.
Actually, as you can see, we have split into six line divisions. The first of these, the Banking Division, consists of three geographic groups: Group One The Americas, Group Two Europe, and Group Three Africa, Asia and the Middle East. All these groups are offering a full range of international banking services.
Then we have the Private Banking Division which serves consumers in the domestic and international markets.
The Treasurer's Division has a wide spread of operations which includes investment portfolio management, commercial paper, government and municipal bonds, foreign exchange, bullion, and public finance.
David: So there are three operative divisions.
William :That's right, and these three operative divisions are backed up by another three servicing divisions. We have the Administrative Division which covers administrative services as well as personnel, premises and economic analysis.
The Financial and Information Systems Division includes the Comptroller's Department, the Corporate Tax Department, and the Systems and Data Processing Department.
And then finally, the Corporate Planning Division includes strategic planning, and credit policy and administration.
Here you have the annual report in case you need it for reference.
David: Thank you very much. It was extremelly interesting but i think your work is not at all easy,is it?
So, I wish you good luck.
Vocabulary:
Annual: for one year.
Annual report: a report presented each year giving details of the company's activities and financial performance during the previous financial year.
Portfolio: range, collection.
Portfolio management: buying /selling a range of shares for a client.
Domestic: in your country, not abroad.
Bullion: bars of gold or silver.
Municipal bonds: documents issued by a local government authority promising to repay loans at a certain time.
Premises: buildings and surrounding land.
To back up: to support
Backing: financial support.
Credit: time given to a customer to pay.
To credit: to put money into someone's account.
Credit control- checking that customers pay on time.
Credit limit- a maximum amount that a customer can owe.
Creditor-person who is owed money.
Credit rating-amount which a credit agency thinks a company/person should be allowed to borrow.
*Match the following words with the correct deffinition: (premises,annual report,credit policy, domestic,comptroller's department, investment portfolio management, bullion,line division, personnel, reorganized, consumers, strategic planning, commercial paper, municipal bonds)
1.Formed or structured in a new way.
2 A report presented each year,giving details of the company's activities and financial performance during the previous financial year.
3 Sections of a company which deal with different products or services from each other.
4.People who buy goods or services.
5.In your own country, not abroad.
6.Management of a client's collected investments.
7.Short-term documents usually sold by big U.S corporations, promising to pay a specified sum of money on a particular date; they may be sold again by the buyer.
8.Documents issued by a local government authority, promising to repay loans at a certain time.
9.Bars of gold or silver.
10.Employees,staff.
11.Buildings and surrounding land.
12.A department which controls the internal finances of a company.
13.Deciding the main aims of an organization.
14 Plans for the lending of money.
TEXT 2
Adam Regan is interviewed about his bank's organization.
Interviewer: I would like you to tell me how you're organized could you?
Adam: Yes, certainly. Just to give you the background, it was in 1869 when we were established as a merchant bank . We operated independently as one of the major merchant banks in the City until 1977, when Metropolitan and Provincial acquired one third interest in us, and as of last year we are now a wholly-owned
subsidiary of that bank.
Interviewer: Oh, really? I didn't realize that.
Adam: One of the consequences of our acquisition was that we sold off our non- banking related activities, though of course we still cover a full range of international banking services. Now in terms of management structure, we have an Administration Division which looks after all administrative matters. These include planning, group financial control, accounting and audit, computer services, legal services, personnel, premises and so forth.
Interviewer: Ah, yes. That's cost centre services then?
Adam: That's cost centre services, right. Next we have the Banking Division and they deal with loans, syndicated loans, project finance, overdrafts, documentary credits and correspondent banking.
Interviewer: I see.
Adam: We're very active in the markets and so therefore we have a Dealing Division. They cover foreign exchange, currency options, money market transactions, bonds, floating rate notes, Eurodollar CDs,...
Interviewer: CDs?
Adam: Certificates of Deposit.
Interviewer: Oh, I see. Yes.
Adam: CDs, financial futures and bullion. Then there's our Corporate Finance Division which has expanded quite rapidly over the last couple of years. They provide advice to a large number of UK and international companies. The activities of the Corporate Finance Division include mergers, takeovers, acquisitions and divestments, as well as stock market and USM flotations in London, and of course capital raising.
Interviewer: I see.
Adam: We also have an Investment Management Division which provides services to companies: pension funds, investment trusts, unit trusts and offshore funds. And finally there's a Leasing Division which organizes leasing packages for lessors and lessees. Well, that's who we are, and what we do. I think that sums it up.
Vocabulary
Merchant bank-a bank concerned with the financing of international trade.
Interest-percentage of the capital paid by a borrower to a lender.
Accounting and audit-the keeping of financial records and their periodic examination.
Syndicated loans- a very large loan for one borrower, arranged by several banks.
Overdraft- money overdrawn on a bank accounts to agreed limits.
Correspondent banking- activities where one bank acts as an agent for another bank.
To deal- to trade, buy, sell.
Deal- business agreement.
Bonds- documents promising to pay sums of money at specified times.
Floating rate note- note on which interest rates are fixed periodically and which can be traded on the market.
Financial futures- contracts to buy or sell currencies, bonds, bills at a stated price at some future time.
To merge- to join together.
Merger- the joining of two or more companies into one.
Takeover- the buying of a majority of the shares of a company.
Divestment- the selling-off of interests.
U.S.M flotation- the starting of a new limited company where the shares are not included in the official list on the Stock Exchange.
Unit trust- an organization which collects and pools money from many small investors and invests it in securities for them.
Offshore funds-money placed in countries with very low taxes.
Lease-contract for renting property or equipment for a period of time.
Lessee-person who pays for a lease.
Lessor- person who receives money for a lease.
* Match the terms (1-20) with the right definition(A-T).
1. merchant bank
2. clearing bank
3. wholly-owned subsidiary
4. accounting and audit
5. syndicated loan
6. overdraft
7. documentary credit
8. correspondent banking
9. currency option
10. bonds
11. floating rate note
12. Eurodollar CD
13. financial futures
14. merger
15. takeover
16. divestment
17. USM flotation
18. investment trust
19. unit trust offshore funds
20. offshore funds
A. The selling-off of interests.
B. A very large loan for one borrower, arranged by several banks.
C. Money overdrawn on bank accounts to agreed limits.
D. Documents promising to pay sums of money at specified times.
E. Money placed in countries with very low taxes.
F. The joining of two or more companies into one.
G. A bank which is a member of a central organization through which cheques are presented for payment.
H. Activities where one bank acts as an agent for another bank.
I. A contract where the buyer has the right to demand purchase or sale of a specified currency, but no obligation to do so.
J. A bank mainly concerned with the financing of international trade.
K. An organization which collects and pools money from many small investors and invests it in securities for them.
L. A company entirely owned by another company.
M. A limited company formed to invest in securities.
N. A method of financing international trade where the bank accepts a bill of exchange from the exporter for the invoice amount, in return for receipt of the invoice and certain shipping documents.
O. The buying of a majority of the shares of companies.
P. Contracts to buy or sell currencies, bonds and bills, etc. at a stated price at some future time.
Q. Note on which interest rates are fixed periodically, and which can be traded on the market.
R. Document given for a deposit repayable on a fixed date, the currency being dollars which are deposited outside the USA.
S. The keeping of financial records and their periodic examination.
T. The starting of a new limited company, where the shares are not included in the official list on the Stock Exchange.
TEXT 3
Ronald Sims describes the organization of a Scandinavian Savings Bank.
Ronald: In order to understand how we're organized, it's perhaps first necessary to understand just what we are, and that means a Savings Bank. This has some important implications as to why we're organized the way we are. We were the oldest and largest Savings Bank in the country. In 1990 we merged with the two largest regional Savings Banks and effectively this now gives us a nationwide network of branches to serve the private customer.
Head Office of course is here, that's in the central region, and there are two other regional offices. There's a Board of Directors, which is elected by the Board of Trustees of the bank, and a Managing Director, who has two Deputy Managing Directors who are responsible to him.
The one Deputy Managing Director is responsible for the branch network of offices, and reporting to him are the three Regional Managers, for the northern, central and southern regions.
The other Deputy Managing Director is responsible for the Corporate Business Division, and the formation of this division, really, was one of the main objectives of the merger: to pool our resources and to gain access to the lucrative markets dominated by the commercial banks.
We've still got a long way to go, of course, but we've turned from a Savings bank which, prior to 1980, was not able to accept deposits in excess of the equivalent of ten thousand dollars, because of the regulations, into a commercially competitive bank which last year, for instance, granted an international debenture loan of forty-five million dollars and which had a loan portfolio fifty per cent of which, in terms of volume, related to corporate customers.
And we've done this virtually from scratch, building up our client list of small and medium-sized companies, establishing and expanding worldwide correspondent banking relationships, and, of course, making major investments in terms of personnel and technology. In our case, the new organization structure was very necessary for us to be able to broaden the scope of our activities.
Vocabulary
Savings bank- bank where your money earns interest.
Trustees- people responsible for administering money or property for the benefit of others.
Lucrative markets- markets in which there are good profits.
Commercial banks- banks which offer a wide range of services to the public, to companies .
Debenture loan- loan of money at a fixed rate of interest, involving a certificate of the debt.
Loan portfolio-an entire collection of loans.
To broaden-to increase, to extend.
Corporate-referring to the whole company.
Company-a registered business
To invest- to put money into a bank, building society, shares or other project in order to earn interest.
Investment- money put into a bank or project with the intention that it should increase in value.
Safe investment- non-risky investment
What can you say instead of the following words:
*set up in 1990
*bank set up to accept deposits from members of the public.
*joined together.
*system of local offices over the whole country.
*people responsible for administering money or property for the benefit of others.
*markets in which there are good profits.
*before
*banks which offer a wide range of services to the public, to companies and other organizations.
*more than
*loan of money at a fixed rate of interest, involving a certificate of the debt.
*an entire collection of loans.
*arrangements with banks who act for each other.
*people who work here.
*increase the range or extent of our operations.
Bank performance
Banks necessarily use sophisticated accounting systems to record as clearly as possible what the financial situation of the bank is. Normally such a system is based on the principle of the double entry, which means that each transaction is entered twice, as a credit in one account and as a debit in another account. If we deposit £100 with a bank, for example, the bank enters a debit for the receiver and a credit for the giver. The former represents an asset to the bank, since it is a sum of money at the bank's disposal, as well as a liability, since it will one day have to be repaid. The balance sheet of a bank gives us a view of its financial situation at one point in time, usually 31 December of a particular year. But we do not know what has happened between two balance sheets. This information is provided by the profit and loss account for the period in question. Neither statement is exactly uniform from bank to bank, but both contain certain essential features.
The largest asset of a bank is normally its total portfolio of loans. Deposits usually constitute the largest liability. Balance sheets usually include the following items listed as assets:
• Cash on hand and due from banks - money in vaults, balances with other banks, cheques in process of collection.
• Investments - bonds, shares, etc.
• Loans - to companies, the general public, etc.
• Fixed assets - buildings, equipment, etc.
Items listed in the balance sheet as liabilities are:
• Deposits - all money owed to depositors
• Taxes payable - national and local
• Dividends payable - decided on, but not yet paid
The profit and loss account records the income of a bank, and here, typically, the items in order of size are:
• interest on loans
• return on investments
• fees, commissions, service charges
The granting of credit provides the largest single source of bank income. Typically, two thirds of an American commercial bank's yearly earnings result from interest on loans. Nine out of every ten dollars they lend come from depositors' funds. The following items normally constitute the main expenses in a bank's profit and loss account, again in typical order of size:
• interest paid
• salaries and other benefits
• taxes
A bank's accounting systems, then, are designed to record and present the many transactions that take place every day. Substantial reserves over and above statutory requirements are an indication to customers of the bank's strength, that it has run its business well and has retained profits in the business for future operations. Profitability indicates the effectiveness of a bank's performance and how well it has managed the resources under its control. Published figures thus provide some essential data on the liquidity, safety and income of a bank.
TEXT 4
Presenter: Bill River gives an informal presentation of his bank to a prospective client.
Bill:I have here a copy of our last annual report for your reference which you'll probably want to look through later. But I can give you right now a very brief overview of our last year performance.
Client: That's o.k.
Bill: As of January 31st 1994, the Lacey Bank Corporation was the fifth largest bank in the United States, based on stockholders' equity, and sixth largest based on deposits. This bank has over one thousand two hundred offices around the world with some fourteen thousand employees spread over thirty-five foreign countries. And within this worldwide framework we are offering a wide range of financial services to a very diverse customer base which includes corporate clients, government agencies and correspondent banks.
In 1994 we achieved record earnings coupled with our tenth consecutive year of profit growth in what is, as you know, an intensely competitive environment.
Consolidated net income was five hundred and fifty million dollars, ten per cent up on 1988, and this was the second year that our net income reached the half-billion dollar mark.
A part of the bank's policy is to maintain a strong capital base and at the end of 1994 our total assets amounted to over sixty-five billion dollars. We hold deposits of around thirty-seven point eight billion dollars and net interest income alone in fiscal 90 was one point nine billion dollars. In addition, we hold two point two billion dollars' worth of investment securities. Net income, the net income per share for the period was five dollars sixty-five. We think it was a good year and we are proud of it.
Vocabulary
Overview-description
Stock-quantity of goods for sale, inventories.
Stockholders' equity-based on money received from the sale of the parts into which the capital of a company is divided.
Deposit-sums of money left with the bank.
Corporate clients- company customers.
Correspondent banks- banks in other countries with whom we have an agency relationship.
To earn-to receive money for work
Earnings-salaries, profits, dividends, interest received.
Earnings per share- dividends per share shown as percentage of the market value of a share.
Income-money received through operations or investment
Earned income- money earned through work.
Consolidated net income-the annual income of the group of companies after the payment of costs.
Assets-something of value which is owned by a company
Current assets- assets in daily use by a business.
Fixed assets- property and machinery
Frozen assets- assets which cannot be sold.
Intangible assets- assets which cannot be seen.
Liquid assets- cash or bills which can be easily converted into cash.
Tangible assets- assets which can be seen.
Securities- investments in stocks and shares.
Security- guaranty that a debt will repaid.
The securities market- place where shares can be bought/should.
Investment securities- placement of money in shares to produce profit.
Try to find the meaning of the following :
*a very short general description.
*sums of money left with the bank.
*money received from the sale of the parts into which the capital of a company is divided.
*it includes company customers.
*banks in other countries with whom we have an agency relationship.
*the highest ever profits after transfers to reserves.
*the tenth year in a row of profit growth.
*the annual income of the group of companies after the payment of costs.
*the value of all the things we own.
*the financial year.
*placements of money in shares so as to produce profit.
*the last report presented each year giving details of the company's activities and financial performance during the previous financial year.
TEXT 5
Max Proney gives some information about his bank to a group of professional visitors from abroad.
Max: We have a diagram which gives a very brief summary of some of the key figures relating to our performance in 1994. We'll be meeting these figures again later in greater detail, but it may be useful at this stage to present them and to indicate a number of important trends.
If we begin with income then, you will see that the total group income amounted to a record level of one hundred and fifty-five million pounds, an increase of nearly fifteen per cent on the previous year, a rate of increase slightly above that of recent years. Interest received amounted to six hundred and fifteen million pounds, and interest paid to five hundred and sixteen million, leaving us with a net interest income of ninety-nine million pounds. This is eleven per cent up over the 1989 figure and represents sixty-four per cent of the total group income for 1994. The net interest income is quite satisfactory in itself, given the very difficult market conditions, but what is especially significant is the increase in non-interest income from forty-six to fifty-six million pounds, an increase of some twenty-two per cent. A very important part of the bank's policy lies in limiting dependence on net interest as a source of income and in developing its fee and commission earning activities, and 1994 income in this area accounted for a two per cent higher contribution to total income than was the case in 1989. This is an encouraging trend, as it reflects the bank's response to the changing economic environment in general and to the sensitivity of interest rates in particular.
Non-interest income then of fifty-six million pounds, making the total income for the year of one hundred and fifty-five million pounds, twenty million pounds higher than the previous year.
Vocabulary
Trends-general development in a market, business.
Income-money received through operations or investment.
Earned income- money earned through work.
Unearned income- money received from investments.
Net interest income-the amount by which the total interest received is higher then the total interest paid during the period.
Key figures- the most important figures.
Rate- charge for service or work or for loans.
Going rate- market price.
To run - to manage, to organise.
Running- operating,continuing,consecutively.
*Choose the best answer.
1 A brief summary is:
a) a small amount of something; b) several numbers added together to make a total;c) a short report of the main points; d) a full report with details.
2 Key figures are:
a) figures that are easy to understand; b) the most important figures; c) figures that give an answer to a problem; d) figures that are well-known.
3 Trends are:
a) movements or directions; b) goals that you try to reach; c) events that are likely to happen; d) events that happen quite often.
4 A record level of income is:
a) an amount that will never be reached again;
b) an amount that is written down so that it will not be lost or forgotten;
c) an amount that stays the same and does not go up or down;
d) a higher amount than ever before.
5 Net interest income is:
a) the amount by which the total interest received is higher than the total interest paid during the period;
b) the amount by which the total interest received is lower than the total interest paid during the period;
c) the total interest received by the lender;
d) the amount earned on an investment after paying for its capital cost.
6 Something which is especially significant is:
a) the only one of its kind; b) the very best of its kind; c) important and worth noting; d) widely-known and accepted.
7.Fee and commission earning activities are:
a) the buying and selling of currencies for profit;
b) plans to lend money profit;
c) services that are sold by an agent;
d) services for which charges can be made.
8.A contribution to total income is:
a) a fixed amount of money paid at regular intervals;
b) money that is owed or payable;
c) an amount of money that is taken away from the total.
d) an amount given or supplied.
9.The economic environment is:
a) an area of the economy;
b) the future of the economy;
c) the economic situation;
d) financial laws and regulations.
10.The sensitivity of interest rates is:
a) the way in which interest rates affect each other;
b) the way in which interest rates are easily influenced or affected;
c) the changes in interest rates;
d) the way in which interest rates are worked out.
TEXT 6
The presentation continues:
Max: We've seen the income; let's now look at the outgoings. The largest of these is staff costs which increased by ten million pounds, or eighteen per cent, to sixty-five million pounds in 1992. This increase is larger than in previous years and is partly due to the increase in staff numbers needed to handle the expansion of the bank's fee-generating activities which I have just mentioned.
Provisions for doubtful debts increased to eight million pounds. Depreciation on leased assets and on premises and equipment, calculated on a straight line basis, amounted to fifteen million pounds.
Other expenses increased by a little under seventeen per cent, from twenty-four million to twenty-eight million pounds, the smallest annual increase since 1988, which I think illustrates our determination to keep costs under control.
Tax - not much to say there really - other than to note that we paid five million pounds, or twenty-five per cent more than in 1989, taking us, in fact, up to twenty five million pounds.
Dividends remained unchanged over the previous year at five million pounds, as the major part of the year's profit was retained to expand our consolidated capital base. Our balance sheet footings have been growing steadily over recent years and this was in fact the first year in which they passed the three billion pounds mark.
After allocation of the dividends, there remained a net undistributed balance for the year of nine million pounds which was transferred to reserves.
Vocabulary:
Outgoings-amount of money spend.
Staf costs-money involved in paying employees.
Fee generating activities-services for which charges can be made.
Depreciation on leased assets- the decline in value of property which is hired.
Premises-buildings and the land on which they stand.
Expenses- money spent on the running of the bank.
Dividents- the part of the company's profits which is paid to the shareholders.
Retained-kept by the company and not paid to the shareholders.
Footings-totals.
To allocate- togive money in certain proportions
Allocation- setting aside money for.
Undistributed balance- amount of money kept by the company and not paid to shareholders.
Reserves-amount of money set aside from profits for a special purpose.
To grow- to become larger.
To transfer- tom ove from one place to another.
Transfer pricing- adjustment of price son sales made between parts of a multinational company.
* Note down what you think it can be said instead of the words in italics.
1 ... let's now look at the (amount of money spent)
2 The largest of these is... (money involved in paying the employees)
3 ... to handle the expansion of the bank's (services for which charges can be made)
4. ............. increased to eight million pounds ... (money put aside to cover possible credit losses)
5. .............(the decline in value of property which is hired) and on..... and equipment ... (buildings and the land on which they stand)
6. Other increased by ... (money spent on the running of the bank)
7. ... the smallest increase ... (yearly)
8. ...............remained unchanged ... (the part of the company's profits which is paid to shareholders)
9. ...as the major part of the year's profit was....... (kept by the company and not paid to shareholders)
10. Our balance sheet............. (totals)
11. After.......... of the dividends ... (setting aside money for)
12. ...there remained a net............... (amount of money kept by the company and not paid to shareholders).
13. ...nine million pounds, which was............... (moved over to funds put aside to cover unexpected events).
Foreign exchange
Foreign exchange dealing is, as its name implies, the exchange of the currency of one country for the currency of another. The rate of exchange is the value of one unit of the foreign currency expressed in the other currency concerned.
With the growth of global trade, many companies need foreign currencies to pay producers in other countries. A British company with a supplier in Germany, for example, will probably use sterling to buy Deutschmarks from its bank in order to pay an invoice from the German company. The bank buys the Deutschmarks from another bank at a particular rate and provides them to its customer at a higher rate, thus making a profit. Similarly, a bank may make gains on buying and selling currencies on the inter-bank market. Making a profit on the transaction is the basic idea of foreign exchange dealing.
Currencies can be bought or sold in the foreign exchange market either for immediate delivery, that is at the spot rate, or for delivery later (e.g. two weeks, three months, etc.) at a forward rate. The forward market is useful for companies, since if a company knows that it will need a particular foreign currency to pay a bill in four weeks' time, for example, a forward deal enables it to protect itself against future adverse movements in the exchange rate which would have otherwise had the effect of making the foreign goods more expensive.
When dealing in foreign exchange, normally by telephone, the bank quotes both the selling and buying rate of a currency at which it is prepared to transact business. Settlement for a spot transaction is two working days later. Thus if a contract is made on Monday, the seller delivers the amount sold and receives payment on Wednesday. Similarly if the contract is made on Tuesday, value is Thursday.
Currency traded in this way is delivered to the buyer's account with a bank in the main centre, or one of the main centres, for the currency in question. In the case of sterling, for example, this is London, for Dutch guilders it is Amsterdam and Rotterdam, and for Belgian francs it is Brussels and Antwerp. The buyer decides the bank where his or her account is to be credited.
The foreign exchange dealer fills in a dealing slip containing basic information such as the date and time of the deal, the contracting party, the amount and rate agreed on, the date of settlement, and the place of delivery of the currency dealt in. As soon as a foreign exchange transaction has been carried out, both banks send a written confirmation containing the basic information mentioned above. Any discrepancies may thus be detected quickly.
A bank holding debts or claims in a foreign currency is itself exposed to an exchange risk, unless the debts and claims neutralize each other by being of equal size and by having roughly the same maturity dates. Dealers therefore aim for a balanced total position. If the amount of a bank's claims in dollars, for example, is larger than the total debts in dollars, then the bank has a long position, but if the debts are larger than the claims, the bank is short in dollars. As long as the total position balances, there is no risk for the bank.
TEXT 7
Ken Williams explains some of the basic principles of foreign exchange dealing.
Ken: We're accounted in sterling, but generally all dealings are based on the dollar. So, for instance, your spot prices are dollar Deutschmark, OK? That's the big market really, dollar Deutschmark. And it's the movement in the dollar which is really moving the market. I mean, for instance, yesterday the dollar rates firmed up a little. They went up about a sixteenth to an eighth of a per cent. So people buy dollars because the interest differential between dollars and Deutschmarks is widening. So I mean, if you buy dollars, OK, you, you can lend them out on the next day at, say, eleven and a half per cent. You're short of Deutschmarks that day, and you have to purchase, borrow those for one day, and that's about five and a half per cent. So you're talking about six per cent difference. The basic idea of spot dealing is to buy dollars low and sell high. That's the basis of making a profit.
Interviewer: So why would you need Deutschmarks on a particular day? You said you'd be short in Deutschmarks so you'd have to borrow them.
Ken: Well, to square the account for that day. We're dealing ahead all the time. The spot market is dealing two working days forward. So, for instance, if I bought dollars against Deutschmarks, I would come in tomorrow and find that on the seventeenth I'm short in Deutschmarks and long in dollars. So then I would go into the market and say 'What's your tom/next dollar mark?'
Interviewer: What's your what?
Ken: Tom/next dollar mark. They're dealing terms, OK?
We have spot which is normal buying and selling of currencies. Then we have a tom/next. Now a tom/next simply means tomorrow to the next day. Then we have a spot/next which is your two days' forward dealing value date to the next day. Then you have a spot a week, a spot a fortnight. Then you go one, two, three months and so on. We also have outrights. So someone can ask 'What is your spot dollar mark outright tomorrow?' It's just that you're quoting a spot rate but it's from tomorrow, and you adjust the price, depending what the price is for the tom/ next swap. It's always, it's always relative to the two day forward dealing rate.
Interviewer: So the ... yeah, yeah, OK. I don't, I don't see what an outright is.
Ken: Well, an outright is simply ... we also have the term swaps, in forward dealing which is when you lend one currency and borrow another for a certain period time. There are two related contracts, one sale and one purchase, and you're taking into consideration different interest rates, trading on the movement in two currencies. By using a simple calculation these swaps can calculate into another currency's deposits, so that the relationship between the two currencies determines the forward pricing. Now an outright is if someone wants to buy Deutschmark and sell dollars on any particular day. It's not, it's not connected to a corresponding spot transaction. Say, for instance, two month's time, a company has to cover its Deutschmark payments, so they cover their foreign exchange exposure by buying Deutschmarks from tomorrow to that day. So they would ring us and say 'What is your price spot dollar mark outright to the tenth of October?' And that is an outright.
Presenter: So now we know a little about the principles and terminology of foreign exchange dealing.
Vocabulary:
Spot prices- prices for funds which will be exchanged two working days later.
To firm up-to increase.
Interest differencial-difference in interest rates.
To purchase- to buy.
Profit-a result where the income is higher than the costs.
To square- to balance.
Spot a fortnight- a period of two weeks beginning two working days from now.
Outrights- deals where someone buys one currency and sells another on any particular day.
To quote- to state the price that you will charge for a spot rate.
Swap- an exchange of one currency for another,for a certain period of time.
Deal- a business agreement.
To deal- to buy and sell.
* Write down the words that are used in place of those printed in italics.
1. We're accounted in (British pounds.)
2. So, for instance, your( prices for funds which will be exchanged two working days later) are dollar Deutschmark.
3. I mean, for instance, yesterday the dollar rates (increased slightly).
4. So people buy dollars because the (difference in interest rates) between dollars and Deutschmarks is (increasing).
5. You're short of Deutschmarks that day and you have (to buy), borrow those for one day...
6. That is the basis of making (a result where the income is higher than the costs).
7. Well, (to make totals equal, to balance) the account for that day.
8. .......and find that on the 17th that I am (in a position where I have sold more Deutschmarks than I have bought, and bought more dollars than I have sold.)
9. Then you have spot a week,( a period of two weeks beginning two working days from now.)
10. We also have (deals where someone buys currency and sells another on any particular one day).
11. It's just that you're (stating the price that you will charge for) a spot rate.
12 ... depending what the price is for the tom/next (exchange of one currency for another, for a certain period of time.)
13 ... so that the relationship between the two currencies (fixes, decides) the forward pricing.
14 ... so they cover their foreign exchange (risk or possibility of loss) by buying Deutschmarks
Meetings
Banks provide a wide variety of services to companies, and a company operating internationally is likely to use several banks around the world to meet its various needs. Banks keep in touch with these customers by telephone and perhaps with regular meetings, to maintain the relationship and to market new services.
Most companies use banks at one time or another to finance their operations. As with any other type of loan, banks charge interest on corporate loans. Interest rates for loans in Britain, for example, can be charged in one of three ways:
• at a margin above the bank's base rate. Each bank decides its own base rate, and then charges the company a rate of interest which is related to this. A big customer with a very good reputation may be charged the bank's base rate plus 0.5%, for example, while a smaller company might be charged the base rate plus 3%.
• at a margin above LIBOR, the margin again depending on the bank's assessment of the corporate customer.
• at a fixed rate of interest for the period of the loan.
The first two ways are variable and are adjusted periodically to reflect movements in interest rates on the market. They may also be negotiable. The third may be dangerous for the bank when market rates are erratic.
A company involved in a business where income and expenditure are subject to constant changes needs a variable borrowing facility. This is met most simply by an overdraft facility. The company opens an account with the bank, and an overdraft with a specified limit is granted on the account.
Many companies make a profit not only from the goods or services which they sell, but also from the money that they have. Cash managers utilize funds at their disposal, buying and selling shares, treasury bills and so on, to generate profit in the form of investment income. Rather than move valuable foreign shares and securities around the world by post, a company will deposit them for safe keeping with a bank in the foreign country. A company in Sweden which buys shares on the American market, for example, will use the custodian services of a US bank. Banks naturally charge fees and/or commissions for custodian services.
TEXT 8
Presenter: Simon Stillman meets Oliver Richardson .
Simon: Could we take up the question of the interest rate charged for this overdraft facility?
Oliver: Yes, of course.
Simon: It seems to be rather high: one per cent over Wallers base rate. First of all, what is the base rate?
Oliver: It's our basic lending rate which at the moment is eleven per cent.
Simon: Yes, I see. It's more or less the overnight rate, then, as I understand it, your base rate.
Oliver: Yes.
Simon: But a mark-up of one per cent seems rather high. As you know, we work with a lot of banks, and, quite frankly, one per cent is just too expensive for us.
Oliver: Yes, I see.
Simon: I think you'll have to think about this, Oliver, because we're not interested in having the facility if it is going to be so expensive for us to use it. We work with Key Commercial Bank too, and just for your information there we pay zero point two per cent above LIBOR, more or less the same as Wallers base rate.
Oliver: What kind of reduction did you have in mind?
Simon: Well, a margin more in line with what we can get from the other banks. Say zero point two five per cent above your base rate.
Oliver: Zero point two five.
Simon: Yes, at the very highest. We'd be prepared to pay that little bit extra simply to maintain our working relationship. But one per cent is just too high for a company like Denavian.
Oliver: Yes, the...
Simon: By the way, I haven't told you, but it could be useful for you when you take this up in the credit committee in the bank. We have been rated now by Alibright and Rich, and for short-term debt we have A one plus, and as you know that's the best you can get.
Oliver: That's credit rating?
Simon: Yes, credit rating, and for the long-term we have triple A. And that's also the best. There's no risk involved for you, so one per cent for the overdraft facility ... we'd really like you to review that.
Oliver: Fine, I've made a note of it. I'll take it up when I get back to London, and I'll get in touch with you. All right?
Simon: Yes, do that. Then you can confirm it. If it's positive. Otherwise, there's not much point in us keeping this facility.
Vocabulary:
Overdraft - amount of money which a person or company withdraws from a bank account and which is more than is in the account.
Overdraft facility- arrangements with a bank for an overdraft to a certain limit;
Overnight rate-the rate of interest charged for a loan at call from one day to another.
Mark-up- the gross profit margin or an increase in price.
Margin- the relation between profit and selling price.
Libor-London Inter-Bank Offered Rate, the rate of interest between London banks on some deposits.
Credit committee- a group of bank staff who control the lending of the bank.
Credit rating- a formal and detailed examination of the financial strength of a company.
To confirm- to give agreement.
Debt- money owed.
*Match the words with the correct definition:
1) credit rating,
2) confirm,
3) overnight rate,
4) credit committee,
5) review,
6) overdraft facility,
7) LIBOR,
8) mark up,
9) margin,
10) quite frankly
a. the rate of interest charged for a loan at call from one day to another.
b. a bank service providing for borrowing on current account up to an agreed maximum limit.
c. the gross profit margin or an increase in price.
d. honestly and directly, without wishing to hide anything.
e. London Inter-Bank Offered Rate, the rate of interest between London banks on some deposits.
f. the relation between profit and selling price.
g. a group of bank staff who control the lending of the bank.
h. a formal and detailed examination of the financial strength of a company.
i. to look at or examine again.
j. to give agreement.
Financial news
Modern information technology has led to news being transmitted worldwide quicker than ever before. Time differences around the world mean that financial news is being made twenty-four hours a day, and it is this barrage of readily accessible information that serves as a basis for many of the business decisions that are made concerning international banking and financing. Techniques of analysis are applied to information to determine its implications and to try to discern trends in the future.
Many prices are determined by a complex interaction of factors. With regard to currencies, it may be said that one factor governing prices is the interaction of supply and demand. Interest rates prevailing in different countries affect currency exchange rates. If interest rates rise in the UK for example, US investors may move funds to the UK to earn higher interest income. They will then sell dollars for sterling, and the demand for sterling will rise, while at the same time the supply of dollars will rise too. The dollar will therèfore fall in value, while the price of sterling will rise.
Trade between countries may also affect currency rates. If, say, Japanese exports to Germany rise, and German exports to Japan remain the same, there will be an increase in the supply of Deutschmarks as Japanese exporters sell them for dollars. This will normally increase the value of the Yen in relation to Deutschmarks.
Government intervention may also affect exchange rates. If sterling is weak, for instance, the Bank of England may enter the market to buy sterling with some of its reserves of other currencies. This will reduce the supply of sterling, thereby increasing its value.
Stock market prices in a particular country are often affected by stock market prices elsewhere in the world, and markets tend to move together, as indicated by the worldwide crash in the autumn of 1987. The share price of any one company will obviously tend to be influenced by the financial performance of the company, details of which are released at various times during the financial year.
The factor of supply and demand mentioned ealier will also tend to affect commodity prices. A bad coffee harvest in Brazil will increase the price of coffee because demand will exceed supply. The over-production of oil, on the other hand, will lead to a fall in the price of the commodity, since there will be a glut of oil available on the market.
TEXT 9
Presenter: The financial news headlines, and more detailed news of the currency markets.
Newsreader: Here is the Financial News, read by Margret Sinclair. The dollar recovered after a weak start. The pound strengthened. Gold was slightly stronger, and silver slightly weaker. London share prices were steady, but New York prices drifted down.
A survey published in London yesterday states that over the past five years trading on the world's foreign exchanges has more than doubled in size. It estimates that Forex volume now stands at almost fifty-five thousand billion dollars a year. London remains the leading centre, with nearly fifty billion dollars traded here every day. Despite increasing competition from the Far Eastern market, New York is in second place and Zurich third.
In the European foreign exchanges the dollar closed yesterday little changed, after recovering from early weakness. Trading was thin, with dealers waiting for US economic indicators due on Friday, when US consumer prices and durable goods orders will be released. In London the dollar closed at two marks sixty-three point seven pfennigs, and later in New York at two marks sixty-three point nine. That's a gain of two and three quarters on the previous close there.
In Tokyo today the dollar slipped back a little, ending at two hundred and fifteen point eight five yen, against a previous close of two hundred and sixteen point two. Some selling by the Bank of Japan was noted, but the dollar was helped by the covering of short positions.
The pound yesterday was stronger against most currencies, aided by firmer spot oil prices.
In the latest currency prices in London this morning, the pound is at one dollar forty-four point five cents, that's one and a quarter cents up on the closing price yesterday. The German mark is two marks sixty-three point eight pfennigs to the dollar. The Swiss franc is unchanged at two francs sixteen point six. The French franc is eight francs forty, and the Dutch guilder is weaker at two guilders ninety- seven point five. The Japanese yen is unchanged at two hundred and fifteen point eight five yen to the dollar.
Presenter: So now we know about the currency exchange rates for the day in question.
Vocabulary:
To recover- to get better after a downturn.
Survey-a report based on inspection.
To drift- to fall slightly.
Forex volume- the volume of foreign exchange.
Gain- an increase in volume.
To slip back- fall slightly.
Choose the one best answer
1. If prices drifted down they:
a) fell heavily; b) fell slightly; c) fell quickly; d) rose then fell.
2. A survey is:
a) a report based on inspection; b) a document that describes what is expected in the future; c) a detailed description of goods; d) an official list of things or events.
3. Forex volume is:
a) a sum of money that is borrowed; b) a sum of money that is invested; c) the volume of money in a country; d) the volume of foreign exchange.
4. If trading was thin:
a) buying and selling was not very successful; b) there was a lot of buying and selling; c) there was not much buying or selling; d) there was no buying or selling at all.
5. US economic indicators are:
a) the index of retail prices produced by the US government; b) figures that show the difference between the amount of money flowing into and out of the USA; c) figures dealing with economic activities in the USA; d) the total amount of money that other countries owe to the USA.
6. US consumer prices are:
a) a list of prices to be paid for goods imported into the USA; b) the index of retail prices produced by the US government; c) the prices charged for goods exported from the USA; d) the prices charged for US dollars expressed in the money unit of another country.
7. Durable goods orders are:
a) orders for goods which are intended to be used over a period of time;
b) orders for goods which are used up soon after they are bought;
c) orders for any type of goods; d) orders for goods to be exported.
8. If information is released, it:
a) is for sale; b) is kept secret from the public; c) is made known to the public; d) is written down and recorded.
9. A gain is:
a) a change in value; b) an increase in value; c) a fall in value; d) a value that stays the same.
10. If the dollar slipped back a little, it:
a) fell slightly; b) fell unexpectedly; c) fell quickly; d) rose then fell.
11. The covering of short positions is:
a) banks buying a currency because they had previously sold more than they had bought; b) banks selling a currency because they had previously bought more than they had sold; c) banks buying and selling currencies so as to make a profit; d) banks buying a currency and selling it soon.
12. If the pound was aided by firmer spot oil prices, it was:
a) helped by higher spot oil prices; b) not helped by higher spot oil prices; c) helped by lower spot oil prices; d) not helped by lower spot oil prices.
TEXT 10
Presenter: Now we will hear news relating to companies and stock markets.
Newsreader: The company headlines today are that Lewhill is to open a thirty million pound production centre in Birmingham. It will employ around fifteen hundred people. Welby Engines have landed a twenty-five million pound order from Air Texas, and the latest bid for Basterfields by the Canadian giant Garvin has been rejected.
On the interim results front, Luxdon's third quarter profit of three hundred thousand pounds came as a setback, after first half profits of two and a half million pounds. Another company reporting was Fisher Hogg, who pleased the market, however, with a fifty per cent profits rise compared with last quarter.
On the London stock market yesterday, shares remained close to last week's record highs. Financial and discount houses were a firm sector, with United Alverson advancing twenty pence to seven pounds sixty-eight. Banks too made further gains, and Key Commerce rose twelve to six seventy-six.
Among the other features, Ainscough and Lee were up nine at four thirty- seven on bid hopes, and Sheldon jumped thirty to two forty-five on their Monday sale of their Quinton stake. Hale and Owen stuck at two oh four, despite reporting treble interim profits which in fact conceal a setback, if one disregards the proceeds from the sale and leaseback of their Birmingham headquarters. Berry Sugar were down eight at one seventy one, on doubts about the commodity price.
On Wall Street on Tuesday, leading stocks were moderately firmer, though the market was mixed. Falling stocks outnumbered rising ones by seven hundred and ninety-eight to seven hundred and twenty-eight, on a moderate volume of one hundred and one million shares. Bonds were strong.
In Tokyo today there were heavy falls for many shares, especially among the market leaders. Hong Kong shares slipped back a little. In Australia, shares fell sharply across the board although trading was subdued.
Presenter: Some specific news about British companies and share prices there, followed by stock market news from other parts of the world.
-Vocabulary-
Market- place where products and services can be bought and sold.
Capital market- place where companies can look for investment capital.
To land- to succeed in obtaining.
Bid- price offered
Setback- diappointment and difficulty.
On the interim results front-in the area of news dealing with the outcome of a company's trading during only part of the year.
Shares- the parts into which the ownership of a company is divided.
Financial and discount houses- finance companies and finance organizations which buy and sell bills of exchange.
A firm sector- an area of business activity tending to rise.
Bid hopes- hopes of an offer to buy.
To conceal- to hide.
Doubt- uncertainty.
Commodity price- price of the raw material.
Bonds- documents promising to pay sums of money at specified times.
To fall across the board- to move downwards suddenly.
Trading was subdued- there was a lot of buying and selling.
Write down the words used instead of those in italics:
**they have (succeeded in obtaining) a very important order.
**this is the latest( price offered) for Grandfields.
**(in the area of news dealing with the outcome of a company's trading during only part of the year) Luxdon's third profit of $ 300 000 came as a ( disappointment and difficulty).
**(the parts into which the ownership of a company is divided) remained close to last week's record highs.
**(finance companies and finance organizations which buy and sell bills of exchange) were an (area of business activity tending to rise ).
**on Wall Street (major shares were slighty higher in price).
**(documents promising to pay sums of money at specified times) were strong.
**in Australia ( all share prices moved downwards suddenly) although (there was not a lot of buying and selling).
TEST -1-
*Chose from the words in brackets to complete the sentences.
(Bank of England, bearer,base rate,Stock Exchange,stock, bear, shares, bond, bull,asset).
1.The American central bank is the equivalent of ................ in Britain.
2.The units of ownership of a company allowing the holder to receive a proportion of the company's profits are the .........
3.In the U. K.a fixed amount of a paid -up capital held by a stockholder is a ............
4.If the market is thought to be good and prices on the Stock Exchange are thought to be likely to rise the market is called a .........market.
5.If the market is thought to be poor and prices on the Stock Exchange are likely to fall the market is called a ..........market.
6.A promise to pay a sum of money over an agreed time by anyone licensed to do so such as a government insurance firm is a .....
7.Certificates of ownership of bond that can be tranferred from seller to buyer without any formalities are ...........bonds.
8.Something that is owned by an individual or a company has monetary value and can be sold to pay debts is an .........
TEST-2
*Match the following sentences with the words or phrases (a-k).
1.The holder of these has lent the company money but has no voting rights.
2 A group of six accountants have decided to form an association to carry on business in common and make a profit.
3.The investors give these people the power to run the company .
4.This company holds more than 50% of the voting shares in another company.
5.Members of the public can only invest in this company if they are invited to do so.
6.Investments in many companies can be made by buying shares on this market.
7.The public at large can be shareholder in this company.
8.The golf club was set up with the intention of not making a profit.
9.Fifty one per cent of the voting shares of this company are held by another company.
10.This is the meeting which is held once a year for the shareholders.
a.subsidiary
b.group
c.non-profit-making
d.stock exchange
e.partnership
f.directors
g.private limited
h.debentures
i.public limited
j.holding company
k.annual general meeting
TEST-3-
Choose the correct answer in each of the following:
1.Funds coming into a firm are known as ................of funds.
a.springs
b.sources
c.origination
d.income
2.The ways these funds are used are known as the ....................of funds.
a.application
b.delegation
c.disposal
d.consumption.
3.................funds include money in our hands and in the bank.
a.working
b.current
c.profit
d.cash
4.When you take away current liabilities from current assets you have the amount of .............funds.
a.liability
b.working capital
c.asset
d.flow
5.Financial statements about cash funds are usually known as.....................statements.
a.cash flow
b.cash resource
c.cash outflow
d.cash loss
6.An item which doesn't involve flow of funds is .........................
a.sales of fixed assets
b.drawings
c.depreciation
d.loan repayment
7.An item which involves flow of funds is...............
a.provision for bad debts
b.book loss on sale of fixed assets
c.sale of fixed asset
d.book profit on sale of fixed asset.
8.After making adjustment for items which dont't involve the flow of funds the net profit or loss is known as...............
a.gross profit
b. outflow of funds
c. cash movements
d.total generated from operations..
TEST-4-
*Fill in the missing words in each of the following sentences.Chose from the alternatives beneath each sentence:
1.The Board of .......is responsible for deciding on and controlling the strategy of a corporation or company.
a.workers
b.directors
c.control
2.Small businesses depend on investors providing .........capital.
a.venture
b.individual
c.cooperative
3.Investors are influenced by the projected.........on their capital.
a.market
b.return
c.rate
4.The capital needed to run a business is provided by............
a.gain b.risk c.investment
5.Rent and rates which do not change as turnover volume changes make up the...........costs of a company.
a.fixed
b.contribution
c.variable
6.Every company must watch its...........carefully if it is to avoid banrupcy.
a.market managers
b.cash flow
c.production lines.
7.The..........account shows whether the company is profitable or not.
a.profit and loss
b.volume
c.shareholders
8.Banks require.........to guarantee a loan.
a.accounts
b.shares
c.securities
9.Insurance companies may use .............to negotiate the amount of insurance to be paid.
a.claim forms
b.tariff companies
c.insurance adjusters.
10.The Stock Exchange deals with the purchase and sale of...........
a.stocks and shares
b.bulls and bears
c.statements and invoices.
TEST-5-
Choose the correct words from the following: bookkeeping, interest, creditor, company, profit, current, capital, net, shares, debtor, divident, statement, to complete the definitions.
1.Recording financial transactions is...........
2.A legal organisation,formally registered in one of three ways and having a life independent of its members is a ............
3.A person or organisation that owes money is a................
4.A person or organisation to whom money is owed is a.....................
5.The assets,including cash, debtors and stocks used in a company's trading available at the present moment are its...................assets
6.The equal parts into which the ownership of a company is divided are its..................
7.The money paid to shareholders out of a company's profits is the ..................
8.A company's turnover, less its cost of sales,is its gross......................
9.A company's turnover after the cost of sales, tax,rent and other liabilities are deducted is its.................profit.
10.The sum of money paid by a borrower to a lender for the use of the lender's money is the.............on the loan.
11.The document send to the debtor by the creditor, showing how much is owed and for what, is the .............of account.
12.The shareholders' investment in a company is the share..............
TEST-6-
1. I have been requested to... a deposit
a) leave
b)let
c) put
d) do
2. An I.O.U...
a) is a small loan
b) is the same as a cheque
c) is a bill exchange
d) is a promise to pay on the part of the debtor
3. Your payment is ... and your account is now in the red.
a) overtime
b) overdue
c) overtaxed
d) overcome
4. The bank does not want to lend me any money. I shall have to go to the...
a) borrower
b) hireling
c) pawnbroker's
d) cash-register
5. Counterfoil is a synonym for...
a) stub
b) ticket
c) coupon
d)draft
6. A bad cheque may be referred to as a ... check
a) red
b) black
c) dud
d) void
7. A bill of exchange is drawn up by...
a) the payer
b) the debtor
c) the creditor
d) the drawee
8. When the acceptor stipulates some special condition, the acceptance of a bill is said to be...
a) particular
b) qualified
c) specialized
d) peculiar
9. A hire purchase transaction involves payment by...
a) scattering
b) instalments
c) settlements
d) periods
10. The contract provides for the ... to leave 10% of the loan on deposit.
a) lender
b) depositor
c) borrower
d) creditor
11. Most foreign bills are payable 30, 60 or 90 days after...
a) record
b) sight
c) fill in
d) signature
12. Deeds of property may be ... as security for loans.
a) hedged
b) dredged
c) pledged
d) fledged
13. You are supposed to give a few days'... before withdrawing the balance of your deposit account.
a) period
b) delay
c) warning
d) notice
14. The bill will ... due on January 30th.
a) fall
b) come
c) get
d) reach
15. The acceptor of a bill of exchange is the...
a) drawer
b) lender
c) payee
d) drawee
16. When making a deposit you have to fill in the...
a) folder
b) paying-in-slip
c) application form
d) statement of account
17. Banks collect ... and lend them out again.
a) coins
b) bookings
c) savings
d) ratings
18. Owing to the credit ... it is increasingly hard to obtain cash.
a) squeeze
b) loan
c) back
d) stop
19. We grant loans to our clients and arrange for ... facilities.
a) overdrive
b) overdraft
c) overdone
d) overpaid
20. The ... system is the British equivalent to the French Cheques Postaux.
a) Biro
b) Giro
c) Tiro
d) Barrow
Translate into English:
1. Am vrea sa va rugam sa deschideti un cont curent pe numele Mateescu and Co.
2.Credeti ca putem sa deschidem un cont current pe numele Stanculescu and Co.?
3. Pentru a deschide contul, anexam un cec emis de banca Carpatica în valoarea de 200.000 000 lei.
4. Acest cec în valoare 500 000 000 lei tras asupra bãncii Carpatica va constitui depozitul nostru initial.
5.Vreau sa anexez cecul meu in valoare de
20 000 000 lei, platibil la ordinul dumneavoastrã.
6.Credeam ca stiti ca trebuie sã platiti taxe bancare pentru cecurile internationale.
7. Puteti plati prin cec, ordin de platã sau cashier's check. Aceasta plata trebuie sa fie trasa asupra unei banci din SUA.
8. Plata se va face prin transfer bancar.
9. Anexam cecurile noastre în valoare de 600000000 lei, ca plata corespunzatoare urmatoarelor facturi...
10. La care banca sunteti?
11.Eu stiu ca nu puteti achita cecuri fãrã acoperire.
12. Pentru creditarea corecta am dori sa indicati întotdeauna numarul dumneavoastra de cont.
13. Am aprecia dacã ati plati imediat.
14. Va rugäm sa platiti astazi, deoarece procesarea cecului dureaza .
15.Cum doriti sa platiti: în numerar sau cu carte dc credit?
16 Trebuie sa andosati cecul pe verso inainte de a-l incasa or depune.
17. Va cerem permisiunea sã depãsim limita contulul nostru cu pânã la 7 000 $ intre martie 25 si iulie 25.
18. Ne-ati face un mare serviciu daca ne-ati sustine în acest moment.
19. Contul dumneavoastrã este descoperit cu 1000 $.
20. Suntem de acord sã va aprobam o depasire a contulul în valoare de 500 $ pâna în martie anul curent.
21. Suntem gata sã va acordam un împrumut, cu conditia sa fie garantat.
22. Va trebui sã asigurati garantii pentru acoperirea avansului.
23. Suntem dispusi sa fim garantul dumneavoastrã.
24. Ca o garantie, va vom oferi titluri de valoare.
25. Va rugam sã ne remiteti garantiile.
26 Din cauza tranzactiilor sale financiare dubioase, i-am blocat contul.
27. Noi oferim credite clientilor nostri si le acordam conditii avantajoase de rambursare.
28. Rata de bazã (de referinta) este rata pe care bancile o aplica celor mai solvabili clienti.
29. Ei nu au întocmit documente care sa precizeze conditiile împrumutului.
30. Graficul de rambursare este prezentat in contractul de împrumut.
31. Care este cursul de schimb al zilei pentru €uro în raport cu dolarul SUA?
32. Va oferim dolari la cel mai bun curs posibil .
33. Acestea sunt variatii ale cursului de schimb, rata de baza, cursul de schimb actual (curent).
34 Bancnotele si cecurile de calatorie în dolari SUA pot fi convertite în lire daca prezentati pasaportul la ghiseul din colt.
35. Pastrati borderoul, care va va fi de folos pentru a schimba yenii în moneda tarii dumneavoastra la sfârsitul excursiei.
36 Agentul de schimb este cel care va va spune cursul la care veti putea schimba valuta dumneavoastra.
37. Cotatiile monedelor echivalente dolarilor SUA sunt doar aproximative. Pentru cursurile exacte ar fi bine sa va adresati bancii dumneavoastra.
38. Pentru remiteri de fonduri în alte valute decât dolari veti fi creditati cu echivalentul valorii primite pentru remiterea dumneavoastra.
39. Alaturat va trimitem cecul în valoare de 8000$ reprezentând plata corespunzatoare facturii anexate. Am convenit suma datorata,considerând ca la data platii cursul de schimb pentru €uro era destul de ridicata.
40.Vrem sa va instiintam ca cererea dumneavoastrá de cumparare a fost refuzata deoarece ati depasit limita creditulul acordat.
41. Documentele care trebuie prezentate sunt urmatoarele:
* o trata la vedere pentru valoarea creditulul
* un certificat de origine
* un certificat (o polita ) de asigurare.
42. Dupa cum am convenit, documentele de expeditie va vor fi înmânate de agentii (reprezentantii) Bancii Carpatica la plata tratei, la scadenta.
43 Am tras asupra dumneavoastra valoarea facturii de 400 $, la 6o de zile de la prezentare, prin banca de care am vorbit, careia i-am remis documentele de expeditie.
44.Puteti sa vindeti creantele dumneavoastra unei societati de factoring.
45.Ar fi bine sa oferiti garantie sub forma de obligatiune.
46.Va vom pregati comanda atunci când vom primi confirmarea creditului de la Banca Bucuresti.
47.Contul meu este deja descoperit asa ca evit emiterea de cecuri in clipa de fata.
48.Cecurile descoperite îi fac pe majoritatea vânzatorilor cu amanuntul sa refuze acest instrument de plata si sa solicite plati in numerar pentru valori mici.
48.Banca Centrala si-a diminuat rata de baza pentru a evita o criza severa.
49.Trebuie sa aflu care este rata dobanzii la banca despre care mi-ai vorbit.
50.Ai un cont la o banca de stat?
51.Ce garantie oferiti pentru acest împrumut?
52.Vreau sa aflu mai mult despre creditul încrucisat .
53.Nu stiu prea multe despre metoda numita compensare.
54.Daca preturile nu vor fi sustinute ele se vor prabusi vertiginos deoarece piata este saturata.
55.Am vrea sa cumparam 100 de actiuni ale societatii amintite cu conditia ca detaliile tranzactiei sa ne parvina prin avocatul firmei noastre.
1.Translate into Romanian:
Modern banking appeared in England and Scotland at the end of the XVIIIth century-1694 and 1695.We certainly know that the Bank of England held a dominant position for about two centuries and enjoyed a monopoly on overseas operations and acting as the government's banker's;in 1946 it was nationalized and we can consider it today as a typical central bank.
It was in 1760 when Scotland was the first country to have set up a modern banking system with seven banks which carried out transactions through a clearing house
In 1826 the first joint stock banks were set up in England and in the XVIIIth century there were 100 clearing banks. The English banking system became a highly concentrated system with the great banks :Lloyd's, Barclays, Midland, Wesminster and National Provincial.
Today there are four major banks:Lloyd's, Midland, Natwest, Barclays which are involved in wholesale banking activities through diferrent subsidiaries.
The U.S Banking system is quite peculiar today having more than 10 000banks .Unfortunately none of them among the top ten in the world.
2-Translate into Romanian:
Deferred shares do not take part in profits until the preferred share and ordinary share dividents have already been paid. Founder's shares are issued to the promoters of the company.Ranking after other shares they may yield nothing during the early years.They may bring huge dividends later.Industrials are the shares of industrial companies. Blue chips are the shares of particularly well known and sound companies.
An investor who buys stocks gets tangible shares of a corporation, which can be held for a long term.The person who buys or sells stock index futures is making a short term bet on which direction the market is going towards the near future usually a month or less.The investor buying into futures -buying shares on credit- has to put up only a fraction or percentage of the amount of the investment.And this is called the margin .Stock index futures contracts represent an obligation to buy or sell an index at a stated price before a stated date.
3.Translate into Romanian:
Attempts to introduce other costs and benefits of development, which would move GNP toward a broader welfare measure, lack a logical basis and tend instead to result in a confusion of concepts. Research on 'social' indicators has failed to produce an alternative which is as readily accepted and com prehended as GNP per head ... Systems of social accounts which could integrate social indicators through some unifying concept have not been able to overcome successfully all the difficult problems encountered.
The search for a composite index of social welfare, analogous to GNP as an index of production, has been a fruitless one so far, since it has proved virtually impossible to translate every aspect of social progress into money values or some other readily accepted common denominator. The great deal of work devoted to composite indices, however, suggests the need for a single number which, like GNP per head, can be quickly grasped and gives a rough indication of "social" development.
4.Translate into Romanian:
Many firms lay down definite terms of payment and expect their customers to abide by these terms, but special arrangements may be made in certain cases. The purchaser should, however, pay his accounts at due date whatever is arranged, as it is unwise to gain a reputation for slow payment. Promptitude in payment in normal circumstances makes it easier to obtain consideration when actual need to delay payment for a time arises.
In general, terms of payment may be classified into cash on or before delivery of the goods and credit. By far the greater number if transactions are on credit, and generally longer periods of credit are given by wholesalers to retail customers than by manufacturers to wholesalers.
5.Translate into Romanian:
The primary need when starting a business, whether a retail firm, a wholesale warehouse, or manufacturing concern, is money. Goods have to be bought for stock, premises leased or bought and fitted out to suit the requirements of the business, and some money retained for current expenditure such as wages. A small retail business may he set up by a person with very small financial resources; more ambitious concerns will entail great expense before they are able to commence operations.
The money which must be got together to start the enterprise is called the capital of the firm. How the original capital is provided depends upon the form the business unit takes.
6.Translate into Romanian:
Classes of Shares. The shares into which a company's capital is divided may be of different classes according to the rights given to their holders in respect of them. They may also be of different amounts, for example £1, £5, £10, or £25 shares, but the £1 share is most general. Shares in a public company are freely transferable and, unless a further issue of shares is made, the only way in which a person may become a shareholder in a going concern is to purchase the shares of a present holder.
Preference Shares are those which have a prior claim to the profits of the company.
Ordinary Shares are generally entitled to the remainder of the profits after the preference share dividends have been paid.
If Deferred Shares exist, then the ordinary shares have a limited dividend and the deferred shareholders are entitled to the remainder of the profits.
When joint-stock companies raise loans, they usually give to the lenders a form of security, named a debenture, which gives to the holder a right to a fixed interest.
A company may make application for its fully-paid shares to be converted into stock, which may be transferred in fractions of a pound, whereas shares cannot be subdivided. Shares must each bear a distinctive number; stock is unnumbered.
7.Translate into Romanian:
Bills of Exchange put debts into tangible form. A creditor receiving one has a legal acknowledgement of the debt, and if the amount is not paid when due he can sue on a bill without proving that he has delivered goods. He may sell or discount the bill at the bank, which makes a profit called discount for the accommodation; or he may, in payment of one of his own debts, endorse the bill to one of his creditors. The debtor gets longer time in which to pay and so he may take advantage of special opportunities for buying. Thus it will be seen that Bills of Exchange are very useful commercial documents.
Vocabulary
agreement- contract
as agreed- dupa cum ne-am înteles
bank run- panica bancara
bearer- bond- titlu la purtator
bill of exchange-trata,cambie
clearing bank-banca de compensatie
clearing-compensare
closing- încheiere
collateral- garantie
counterfoil- talon,matca,cotor
debtor-debitor
deferred shares-actiune cu plata ulterioara
draft- trata
exchange rate- cursul de schimb
face value-valoare nominala
fall due to- a ajunge la scadenta
fee-comision
financial dealings- tranzactii financiare.
floatations- emisiuni de titluri
founder's share-actiune de fondator
funding-finantare
futures- contracte la termen
glutted-saturat
gilt-edged securities- titluri de valoare
hedging- acoperire financiara
Giro- serviciu de cecuri postale
instalment- plata partiala,rata
invoice- factura
lender-creditor,
loan agreement-contract de împrumut
loan on mortgage-împrumut ipotecar
loan repayable-împrumut rambursabil
margin-marja,coeficient de siguranta.
no effects/uncovered-fara acoperire
order-comanda
outstanding -restant
overdraft- suma cu care s-a depasit contul
overdrawn account- cont descoperit
overdrawn- descoperit
overdue- restant,neachitat
pawnbroker- propietarul unei case de amanet
payee- beneficiar
premises -sediu
prime rate-rata de baza
rate shift- variatii ale cursului de schimb
remittance-remitere
repayment-rambursare
securities-garantii
security-garantie
settlement-reglementare,decontare
share certificates- titluri de actiuni
shipping documents- documente de expeditie
standing order- ordin de plata
statement of account-extras de cont
stub-matca,cotor
swap agreement-acord de swap, acord de credit încrucisat
swap- credit încrucisat
swift- sistemul de transfer electronic al fondurilor
tax shelter- paradis fiscal
teller- casier
term deposit- depozit la termen
terms -conditii
to acknowledge- a confirma
to be over - a depasi
to comply with- a fi în concordanta cu
to deem- a considera,a estima
to default- a nu-si plati datoriile
to deny- a refuza
to enclose- a anexa
to grant-a acorda
to incur- a atrage asupra sa
to pawn- a amaneta
to providea - asigura
to recocile- a face sa concorde
to set out -a preciza
to settle- a achita
to stand surety -a fi garantul
to underwrite securities- a subscrie titluri de valoare
unsecured credit- credit negarantat
to abide- a ramâne,a sta,a suporta,a respecta,a se conforma
due- datorat,cuvenit, scadent
to retail- a vinde cu amanuntul
instalment- plata partiala, rata
to entitle- a da dreptul la
expenditure- cheltuiala,consum
joint- comun,asociat, mixt, colectiv
joint stock company- societate anonima pe actiuni
debenture- obligatiune, împrumut pe termen lung
tangible- concret, palpabil
to acknowledge- a recunoaste, a confirma
acknowledgement- constatare, confirmare, certificare, recipisa,chitanta
bill- titlu de valoare, polita, factura
to discount- a reduce, a diminua
to endorse- a andosa, a gira, a subscrie
wholesaler- angrosist
warehouse- depozit de marfuri, magazie
premises- local
lease- contract de închiriere
to set up a business- a porni o afacere
lender- împrumutator
lessor- propietar care da cu chirie
lessee- chirias
to claim- a pretinde, a revendica
issue- emisiune, punere în circulatie
to issue- a emite, a pune în circulatie
Tourism - The Worlds Biggest Industry
The Business of Hotels
? The Importance of Hotels
?Travel and Hotels
?Two Centuries of Hotelkeeping
?Hotel Location
?Types of Hotel
Hotel Products and Markets
? The Hotel as a Total Market Concept
? Hotel Facilities and Services as Products
? Hotel Accommodation Markets
? Hotel Catering Markets
? Hotel Demand Generating Sources
? Hotel Market Areas
? Hotel Market Segmentation
? Buying and Paying for Hotel Services
? Hotel Marketing Orientation
? Special Features of Hotel Marketing
? Property Ownership
? Property Operation and Maintenance
Hotel Organization
? Rooms
? Food and Beverage
? Miscellaneous Guest Services
? Hotel Support Services
? The Management Structure
Hotel Services
?Rooms and Beds
?Room Sales
?Mail and Other Guest Services
? Uniformed Services
? Hotel Housekeeping
? Food and Drink
? Restaurants
? Miscelaneous Guest Services
Tourist Attractions
?Tourism Today
?Local Tours
Paris
?Foreign Tours
The Bahamas
Tourism - The Worlds Biggest Industry
Against the background. of unparalleled growth in the latter half of the twentieth century, tourism now finds itself at a crossroads in its development. On the one hand, it is heralded as 'the world's biggest industry' by a number of global organisations including the World Travel and Tourism Council (WTTC) and the World Tourism Organisation (WTO), which highlights the fact that tourism overtook both crude petroleum and motor vehicles to become the world's number one export earner in 1994. Its economic significance is also illustrated by the fact that tourism receipts were greater than the world's exports of other selected product groups, including electronic equipment, clothing, textiles and raw materials.
In addition, receipts from international tourism have achieved growth rates in excess of exports of commercial services and merchandise exports during the period 1984 to 1994. For the period 1985 to 1995 the trend is similar, with the following average annual percentage growth rates:
* Tourism l2per cent
* Commercial services 12 per cent
* Merchandise exports 10 per cent
WTO data also indicate rapid and sustained growth in international tourist arrivals and receipts from tourism over the last 30 years. Today, tourism is seen as a major contributor to global economic development, creating employment and generating wealth on a truly international scale. An increasing number of countries rely heavily on receipts from tourism for their economic and social well-being.
In direct contrast to this very positive outlook for the industry, many national governments are reluctant to invest public funds in tourism development and promotion, with tourism spending often being cut when more pressing social and economic needs arise. The decisions, in 1997, by the governments of Canada, the United States of America and Belgium to transfer responsibility, for tourism to private sector enterprises or regional authorities serve to illustrate this point well. In Britain, the funding of the English Tourist Board has been cut drastically since the early 1990s, the decision of a government that considered the industry to he sufficiently mature and able to fund its own expansion with diminishing public financial support. At a time of increasing corrcern for the environment and the retention of cultural identities, tourism is also viewed by governments and consumers alike as a potentially destructive force, causing harmful environmental and socio-cultural impacts in destination areas and on host communities. Paradoxically, it is not difficult to argue that the withdrawal of public funding and control from tourism development may well accelerate the industry's harmful environmental and socio-cultural effects.
It is against this background of a complex and rapidly expanding industry seeking to maintain its credibility and promote its economic benefits, often in the face of declining governmental and host community support.
The Business of Hotels
I The Importance of Hotels
Hotels play an important role in most countries in providing facilities for the transaction of business, for meetings and conferences, for recreation and entertainment. In that sense hotels are as essential to economies and societies as are adequate transport, communication and retail distribution systems for various goods and services. Through their facilities hotels contribute to the total output of goods and services, which makes up the material well-being of nations and communities.
In many areas hotels are important attractions for visitors who bring to them spending power and who tend to spend at a higher rate than they do when they are at home. Through visitor spending hotels thus often contribute significantly to local economies both directly, and indirectly through the subsequent diffusion of the visitor expenditure to other recipients in the community.
In areas receiving foreign visitors, hotels are often important foreign currency earners and in this way may contribute significantly to their countries' balance of payments. Particularly in countries with limited export possibilities, hotels may be one of the few sources of foreign currency earnings.
Hotels are important employers of labour. Thousands of jobs are provided by hotels in the many occupations that make up the hotel industries in most countries; many others in the industry are self-employed and proprietors of smaller hotels. The role of hotels as employers is particularly important in areas with few alternative sources of employment, where they contribute to regional development.
Hotels are also important outlets .for the products of other industries. In the building and modernization of hotels business is provided for the construction industry and related trades. Equipment, furniture and furnishings are supplied to hotels by a wide range of manufacturers. Food, drink and other consumables are among the most significant daily hotel purchases from farmers, fishermen, food and drink suppliers, and from gas, electricity and water undertakings. In addition to those engaged directly in hotels, much indirect employment is, therefore, generated by hotels for those employed in industries supplying them.
Last but not least, hotels are an important source of amenities .for local residents. Their restaurants, bars and other facilities often attract much local custom and many hotels have become social centres of their communities.
Travel and Hotels
Staying away from home is a function of travel and three main phases may be distinguished in the development of travel in the northern hemisphere.
Until about the middle of the nineteenth cenruiy the bulk of journeys were undertaken for business and vocational reasons, by road, by people travelling mainly in their own countries. The volume of travel was relatively small, confined to a small fraction of the population in any country, and most of those who did travel, did so by coach. Inns and similar hostelries along the highways and in the principal towns provided the means of accommodation well into the nineteenth century.
Between about 1850 and about 1950 a growing proportion of travellers went away from home for other than business reasons and holidays came to represent gradually an important reason for a journey. For a hundred years or so, the railway and the steamship dominated passenger transportation, and the new means of transport gave an impetus to travel between countries and between continents. Although the first hotels date from the eighteenth century, their growth on any scale occurred only in the nineteenth century, when first the railway and later the steamship created sufficiently large markets to make the larger hotel possible. Hotels together with guest houses and boarding houses dominated the accommodation market in this period.
By about the middle of the twentieth century in most developed countries of the world (a little earlier in North America and a little later in Europe) a whole cycle was completed and most traffic returned to the road, with the motor car increasingly providing the main means of passenger transportation. Almost concurrently the aircraft took over unmistakably both from the railways and from shipping as the principal means of long-distance passenger transport. On many routes holiday traffic came to match and often greatly exceed other traffic. A growing volume of travel away from home became international. Hotels entered into competition with new forms of accommodation - holiday centres and holiday villages in Europe, motels in North America, and various self-catering facilities for those on holiday.
Two Centuries of Hotelkeeping
Hotels are some two hundred years old. The word 'hotel' itself came into use in England with the introduction in London, after 1760 , of the kind of establishment then common in Paris, called 'hotel garni', or a large house, in which apartments were let by the day, week or trench. Its appearance signified a departure from the customary method of accommodating guests in inns and similar hostelries, into something more luxurious and even ostentatious. Hotels with managers, receptionists and uniformed staff arrived generally only at the beginning of the nineteenth century and until the middle of that century their development was relatively slow. The absence of good inns in Scotland to someextent accelerated the arrival of the hotel there; by the end of the eighteenth century Edinburgh, for example, had several hotels where the traveller could get elegant and comfortable rooms. Hotels are also known to have made much progress in other parts of Europe in the closing years of the eighteenth and early years of the nineteenth century, where at the time originated the idea of a resort hotel.
In North America early accommodation for travellers followed a similar pattern as in England, with most inns originating in converted houses, but by the turn of the eighteenth century several cities on the eastern seaboard had purpose-built hotels and in the first half of the nineteenth century hotel building spread across America to the Pacific Coast. The evolution from innkeeping to hotelkeeping, therefore, proceeded almost in parallel in the Old and in the New Worlds and the rise of the hotel industries on both sides of the Atlantic had probably more in common than is generally recognized. What America might have lacked in history and tradition, it more than made up in pioneering spirit, in intense rivalry between cities and entrepreneurs, and in the sheer size and growth of the travel market.
In the last century hotels became firmly established not only as centres commercial hospitality for travellers, but often also as important social centres of their communities. Their building, management and operation became specialized activities, with their own styles and methods. The present century brought about growing specialization and increased sophistication in the hotel industries of most countries, as well as their growth and expansion. But the growth and the diversity of hotel operations has been also matched by the growth and diversity of competition in the total accommodation
market.
Information about accommodation facilities in individual countries essentially reflects the designations used for them by the countries concerned and the coverage of various types in the available statistics. Only very broad inter-country comparisons are possible. One source is the annual report of the Tourism Committee of the Organisation for Economic Co-operation and Development (OECD), which distinguishes between beds available in hotels and similar establishments, and in what is described as supplementary accommodation.
The ratio of beds in hotels and similar establishments to beds in supplementary accommodation gives an indication of the relative importance of the hotel sector in the total accommodation market of individual countries. In most countries the accommodation profile tends to reflect the relative importance of foreign and domestic users, of leisure and business travel, and of other influences. In many countries hotels and similar establishments appear to be minority providers of accommodation.
Hotel Location
Hotel services are supplied to their buyers direct in person; they are consumed at the point of sale, and they are also produced there.
Hotel services must be, therefore, provided where the demand exists and the market is the dominant influence on hotel location. In fact, location is part of the hotel product. In turn, location is the key influence on the viability of the business, so much so that a prominent entrepreneur could have said with conviction and with much justification that there are only three rules for success in the hotel business: location, location, location.
We have seen earlier that from the early days all accommodation units followed transport modes, Inns and other hostelries were situated along the roads and at destinations, serving transit and terminal traffic. The rapid spread of railways marked the emergence of railway hotels in the nineteenth century. In the twentieth century motor transport created a new demand for accommodation along the highways and the modern motel and motor hotel have been distinctive responses to the new impetus of the motor car. A similar but les pronounced influence was passenger shipping, which stimulated hotel development in ports, and more recently air transport, which brought about a major growth of hotels in the vicinity of airports and air terminals.
Secondly, although this is closely related to transport, many hotels are located to serve first and foremost holiday markets. In their areas of highest concentration, holiday visitors are accommodated in hotels in localities whcre the resident population may represent only a small proportion of those present at the time, as is the case in many resorts.
The third major influence on hotel location is the location of economic activity and of industry and commerce in particular. Whilst again not separable from transport development, industrial and commercial activities create demand for transit and termInal accommodation in industrial and commercial centres, in locations not frequented by holiday visitors.
Different segments of the travel market give rise to distinctive patterns of demand for hotel accommodation and often distinctive types of hotels. In business and industrial centres hotels normally achieve their highest occupancies on weekdays and in resorts in the main holiday seasons; their facilities and services reflect the requirements of businessmen and of holiday visitors respectively. Between these clearly defined segments come other towns and areas, such as busy commercial centres with historical or other attractions for visitors, which may achieve a more even weekly and annual pattern of business.
Types of Hotels
The rich variety of hotels can be seen from the many terms in use to denote particular types. Hotels are referred to as luxury, resort, commercial, residential, transit, and in many other ways. Each of these terms may give an indication of standard or location, or particular type of guest who makes up most of the market of a particular hotel, but it does not describe adequately its main characteristics. These can be only seen when a combination of terms is applied to an hotel, each of which describes a particular hotel according to certain criteria. It is helpful to appreciate at this stage what the main types of hotels are, by adopting particular criteria for classifying them, without necessarily attaching precise meanings to them.
• Thus according to location hotels are in cities and in large and small towns, in inland, coastal and mountain resorts, and in the country.
• According to the actual position of the hotel in its location it may be in the city or town centre or in the suburbs, along the beach of a coastal resort, along the highway.
• By reference to its relationship with particular means of transport_there are motels and motor hotels, railway hotels, airport hotels (the terms also indicating location).
• According to the purpose of visit and the main reason for their guests' stay, hotels may become known as business hotels, holiday hotels, convention hotels, tourist hotels.
• Where there is a pronounced tendency to a short or long duration of guests' stay it may be an important hotel characteristic, so that the hotel becomes a transit or a residential hotel.
• According to the range of its facilities and services a hotel may be open to residents and non-residents, or it may restrict itself to providing overnight accommodation and at most offering breakfast to its guests, and be a hotel garni or apartment hotel.
• Whether a hotel holds a licence for the sale of alcoholic liquor or not, is an important dimension in the range of available hotel services, and the distinction between licensed and unlicensed hotels is, therefore, of relevance in describing a hotel in most countries.
• There is no universal agreement on how hotels should he described according to size, but by reference to their room or bed capacities we normally apply the term small hotel to one with a small amount of sleeping accommodation, the term large hotel to one with several hundred beds or bedrooms, and the term medium size hotel to one somewhere between the two, according to the size structure of the hotel industry in a particular country.
• Whatever the criteria used in hotel guides and in classification and grading systems in existence in many countries, normally at least four or five classes or grades have been found necessary to distinguish adequately in the standards of hotels and these have found some currency among hotel users. The extremes of luxury and basic standards, sometimes denoted by five stars and one star respectively are not difficult concepts; the mid point on any such scale denotes the average without any particular claims to merit. The intervening points are then standards above average but falling short of luxury (quality hotels) and standards above basic (economy).
Last but not least comes the ownership and management. Individually owned independent hotels, which may he managed by the proprietor or by a salaried manager, have to he distinguished from chain or group hotels, invariably owned by a company. Independent hotels may belong to a hotel consortium or cooperative. A company may operate its hotels under direct management or under a franchise agreement.
The above distinctions then enable us to describe a particular hotel in broad terms, concisely, comprehensively and meaningfully, e.g.:
• Terminus Hotel is a medium-sized economy town centre unlicensed hotel, owned and managed by a small company, catering mainly for tourists visiting the historic town and the surrounding countryside.
• Hotel Excelsior is a large independent luxury hotel on the main promenade of the coastal resort, with holiday visitors as its main market.
• The Crossroads Hotel is a small licensed quality transit motor hotel, operated as a franchise, on the outskirts of the city, which serves mainly traveling
Hotel Products and Markets
The aim of this subject is to outline the facilities and services provided by hotels, who are the people who use hotels, why they use hotels, and what influences their choice of particular hotels. In providing answers to these questions, we can formulate a conceptual model of a hotel, which attempts to explain in simple terms how particular hotel products meet the needs of particular hotel markets, and establish a basis for a more detailed examination of the hotel business.
The Hotel as a Total Market Concept
From the point of view of its users, a hotel is an institution of commercial hospitality, which offers its facilities and services for sale, individually or in various combinations, and this concept is made up of several elements.
Its location places the hotel geographically in or near a particular city, town or village; within a given area location denotes accessibility and the convenience this represents, attractiveness of surroundings and the appeal this represents, freedom from noise and other nuisances, or otherwise.
Its facilities which include bedrooms, restaurants, bars, function rooms, meeting rooms and recreation facilities such as tennis courts and swimming pools represent a repertoire of facilities for the use of its customers, and these may be differentiated in type, size, and in other ways.
I ts service comprises the availability and extent of particular hotel services provided through its facilities, the style and quality of all these in such terms as formality and informality, degree of personal attention, and speed and efficiency.
Its image may he defined as the way in which the hotel portrays itself to people and the way in which it is perceived as portraying itself by them. It is a byproduct of its location, facilities and service, but it is enhanced by such factors as its name, appearance; its associations by who stays there and who eats there; by what it says about itself and what other people say about it.
Its price expresses the value given by the hotel through its location, facilities, service and image, and the satisfaction derived by its users from these elements of the hotel concept. The individual elements assume greater or lesser importance for different people. One person may put location as paramount and be prepared to accept basic facilities and service for an overnight day, ignoring the image, as long as the price is within a limit, to which he is willing to go. Another may be more concerned with the image of the hotel, its facilities and service. However, all the five elements are related to each other, and in a situation of choice most hotel users tend either to accept or reject as a whole, that is the total concept.
There are varying degrees of adaptability and flexibility in the hotel concept, ranging from the complete fixity of its location to the relative flexibility of price, with facilities, service and image lending themselves to some adaptation in particular circumstances with time.
Hotel Facilities and Services as Products
In the early days of innkeeping the traveller often had to bring his own food to places where he stayed the night-bed for the night was the only product offered But soon most establishments extended their hospitality to providing at least some food and refreshments. Today many apartment hotels, hotels gami, and motels confine their facilities to sleeping accommodation, with little or no catering provision. But the typical hotel as we know it today, normally provides not only accommodation, but also food and drink, and sometimes other facilities and services, and makes them available not only to its residents but also to non-residents.
Although the range of hotel facilities and services may extend as far as to cater for all or most needs of their customers, however long their stay, and for a hotel to become a self-contained community with its own shops, entertainments and recreation facilities, it is helpful at this stage to describe the hotel concept in a simpler form, by including only the main customer needs typically met by most hotels.
The main customer demand in most hotels is for sleeping accommodation, food and drink, and for food and drink for organized groups. These four requirements then relate to accommodation, restaurants, bars and functions, as the principal hotel products.
Sleeping accommodation is provided for hotel residents alone. Restaurants and bars meet the requirements of hotel residents and non-residents alike, even though separate facilities may be sometimes provided for them. Functions are best seen as a separate hotel product bought by organized groups; these groups may be resident in the hotel as, for example, participants in a residential conference, or be non-residents, such as a local club or society, or the group may combine the two. The total hotel concept - of location, facilities, service, image and price - can he, therefore, sub-divided according to the needs of the customer and the particular facilities brought into play to meet them. The cluster of elements of the total hotel concept is then related to each particular hotel product. Each hotel product contains the elements of the location, facilities, services, image and price, to meet a particular customer need or set of needs. The first approach to the segmentation of the hotel market is, therefore, taken by dividing hotel users according to the products bought.
Corresponding to each hotel product there are the buyers of that product who constitute a market for it.
Hotel Accommodation Markets
Hotel users who are buyers of overnight accommodation may be classified according to the main purpose of their visit to a particular location into three main categories as holiday, business and other users.
Holiday users include a variety of leisure travel as the main reason for their stay in hotels, ranging from short stays in a particular location on the way to somewhere else to weekend and longer stays when the location represents the end of a journey. Their demand for hotel accommodation tends to be resort oriented, seasonal and sensitive to price.
Business users are employees and others travelling in
the course of their work, people visiting exhibitions, trade fairs, or coming together as members of professional and commercial organizations for meetings and conferences. Their demand for hotel accommodation tends to be town- and city-oriented, non-seasonal and less price-sensitive, except in the case of some event attractions such as conferences and exhibitions, which may he usefully regarded as a separate category.
Other hotel users comprise visitors to a particular location for a variety of reasons other than holiday or business, e.g. those attending such family occasions as weddings, parents visiting educational institutions, visitors to special events, and common interest groups meeting for other than business and vocational reasons, re-locating families and individuals seeking permanent accommodation in an area and staying temporarily in an hotel, people living in an hotel permanently. The characteristics of this type of demand are more varied than those of the first and second group, and it is, therefore, often desirable to sub-divide it further for practical purposes.
Within and between the three main groups, which comprise the total market for hotel accommodation, there are several distinctions important to individual hotels. We have noted already that some hotel users give rise to demand for transit and short-stay accommodation; others are terminal visitors with a longer average stay. Also, for example, much business demand is generated by a relatively small number of travellers who are frequent hotel users; most holiday and other demand comes from a very large number of people who use hotels only occasionally. Moreover, business users often book accommodation at short notice, whilst holiday and other users tend to do so longcr in advance. And in allthree groups some people are individual hotel users, and others stay in hotels in groups.
Hotel Catering Markets
Hotel restaurants, bars and function rooms may be conveniently grouped together as its food and beverage or catering facilities, and the meals and refreshments they provide as the hotel food and beverage or catering products. Corresponding to them there are again buyers of these products who constitute the hotel catering markets and who may be classified in various ways. For our purposes there is a basic distinction between the demand exercised by hotel residents, by non-residents, and by organized groups.
The first category of users of hotel restaurants and bars is related to the basic function of the hotel in providing overnight sleeping accommodation, and consists of hotel residents, whom we have classified earlier as holiday, business and other users Their use of hotel catering facilities tends to be influenced by the reason for their hotel stay and by the terms on which they stay. Breakfast is their common hotel purchase, but otherwise a hotel resident may have his meals in his hotel or elsewhere, and he is more likely to be a hotel restaurant or bar customer in the evenings than at midday.
The second category is non-residents, individually or in small groups, when eating out. They may, in fact, be staying at other hotels or accommodation establishments or with friends or relative or be day visitors to the area, for holiday, business or other reasons Alternatively they are local residents, for whom the hotel restaurants and bars represent outlets for meals and refreshments, as a leisure activity or as part of their business activities. This category tends to represent important hotel users at midday as well as in the evenings, particularly at weekends.
The third category of users of hotel catering facilities is organized groups who make advance arrangements for functions at the hotel, which may call for separate facilities and organizational arrangements. They include local clubs, societies, business and professional groups, as well as participants in meetings and conferences originating from outside the area.
Hotel catering products represent a greater diversity than its accommodation products and it is often correspondingly more difficult to classify them and the markets for them in practice. Moreover, hotels are not alone in supplying them. In the market for meals and refreshments for individuals and groups a hotel competes not only with other hotels, but also with restaurants outside hotels, pubs and clubs, to name but a few other types of outlet.
Therefore, catering in hotels is a separate hotel function, with its own objectives, policies and strategies, and with its own organization.
Hotel Demand Generating Sources
For most people the use of hotels represents what is known as derived demand because few stay or eat in hotels for its own sake; their primary reasons for doing so lie in their reasons for visiting an area or for spending their time there in particular ways. When describing hotel accommodation and catering markets we have seen that hotel users have different degrees of freedom and choice as to whether they buy hotel services or not. Some have
few or no alternatives; for them only hotels provide the facilities and services which they require in a particular area in pursuit of their business, vocational and other interests; the incidence of their hotel usage arises to a great extent from their working circumstances. For many others the use of hotels is a matter of choice; they do so in their pursuit of leisure and recreation; for them hotel usage involves a discretionary use of their time and money. This distinction helps us identify the demand generating sources for hotels in a given area, which are of three main types-institutional, recreational and transit.
Institutional sources include industrial and commercial enterprises, educational institutions, government establishments and other organizations in the private and public sector, whose activities are involved in the economic life of the community and in its administration. These institutions generate demand for hotels through their own visitors and their other requirements for hotel facilities and services.
Recreational sources include historical, scenic and other site attractions and event attractions, which generate demand for hotels from tourists; local events and activities in the social and cultural life of the community, which generate demand from clubs, societies and other organizations; happenings of significance to individuals and families.
The third source of demand stems from individuals and groups with no intrinsic reason for spending time in a particular locality, other than being on the way somewhere else and the need to break a journey. This source of demand is closely related to particular forms of transport; it expresses itself on highways, at ports and at airports, and may be described as transit.
It will be readily apparent that this view of demand generating sources for hotels is closely related to several aspects of the hotel business considered earlier - for example, to the three-fold classification of the hotel accommodation market into holiday, business and other users; to the three main influences on hotel location - travel, holidays and economic activity; and to the types of hotel. By adopting in each case a somewhat different viewpoint, it is possible to highlight the interdependence between the location, markets and products of hotels.
Hotel Market Areas
We can define a hotel market in several ways by reference to the people who buy hotel services, as a network of dealings between the hotel and its users, or as an area which a hotel serves. In the first two approaches hotel users may come from within the area, from various parts of the country, and from abroad; we then refer to the local, domestic and foreign markets, and subdivide them in appropriate ways. In the third approach described below we view the hotel market area as a physical area served by the hotel.
For hotel accommodation it is necessary to identify all the institutional and recreational sources of demand, which may be served by a particular hotel. The area drawn in this way round the hotel may extend from its immediate vicinity to a radius of several miles or more. How far it does extend depends on the geographical distribution of the demand generating sources, the mode of transport used by the hotel users of each source, and the availability of other facilities in the area. The head office of a large firm, a university, a historic castle, and a town which is a festival centre, may be all within a market area of a hotel, if the hotel is reasonably accessible from these points, and if its location at least matches the location of other hotels. The market area may coincide for a number of hotels within close proximity of each other, which offer a similar concept in terms of facilities, service, image and price. On the periphery the market area for a hotel may overlap with the market areas of other hotels some distance away. At periods of peak demand it may extend further than at times of low demand. For transit the accommodation market area is related to the journeys undertaken through the area - their origin and destination, the method of transportation, the time of day, the time of year and other circumstances of the journeys.
For hotel catering services the market area depends on market density - the availability of spending power within an area, as well as on the accessibility of the hotel to the different sources of demand, and on the availability of other catering services in the area. In this there is a close analogy with the concept of a catchment area for other retail outlets, as far as the resident population is concerned. How far do people go from where they live to do their shopping? The distance may vary according to the purchase they are to make. Similarly there may be a smaller market area for hotel lunches than for hotel dinners and functions, because close proximity to the hotel may he a more important consideration for a midday meal than for an evening out.
Hotel Market Segmentation
The market for hotel products may be divided into several components or segments and this enables individual hotels to identify their actual and potential users according to various criteria. Segmentation then provides a basis for the marketing of hotel products, for paying close attention to the requirements of different users, and for monitoring the performance in the markets chosen by a hotel.
We divided hotel users, according to the product bought by them, into buyers of accommodation, food, drink and functions. We divided the accommodation market, according to the reasons for the users' stay, into holiday, business and other users, and the hotel catering market into hotel residents, non-residents and functions. According to the origin of demand we also identified institutional, recreational and transit sources of demand.
Another basis for segmentation is the needs of hotel users and the means_they have to pay for their satisfaction, by dividing them according to their socio economic characteristics. Socio-economic classifications seek to group people according to their occupation and employment status. For example, the British Joint Industry Committee for National Readership Surveys (JICNARS) defines social grades as shown in the following table:
Social Grade Definitions
Social grade
Social status
Occupation
A
Upper middle
class
Higher
managerial,
administrative
or professional
B
Middle class
Intermediate
managerial,
adminisniative or
professional
C 1
Lower middle
class
Supervisory or
clerical, and
juniormanagerial,
administrative or
professional
C2
Skilled working
class
Skilled manual
workers
D
Working class
Semi- and
unskilled manual
E
Those at the
lowest level of
subsistence
State pensioners
or widows (no
other earner),
casual or lowest
grade workers
Social grade A might be expected to stay in luxury and quality hotels, B in medium hotels, C in economy hotels. However, this is an oversimplification, because the same people may interchange between segments according to the circumstances in which they find themselves. A businessman on an expense account may stay in a quality hotel, but travelling for pleasure with his family he may stay in a lower grade hotel. Moreover, the incidence of hotel usage among DE groups is minimal. Nevertheless, segmentation by socio-economic criteria is an important approach to market segmentation. For some purposes age, family composition, life cycle stage, or other criteria may be more appropriate.
A concomitant of market segmentation is product branding, with a view to differentiating an hotel from others in the minds of buyers, long established in other consumer industries. Some hotel groups have focused on branded segments distinguished by levels of service; examples include Holiday Inn upmarket Crowne Plaza, core brand Holiday Inn and limited service Garden Court.
Other brands have been created by grouping like operations, such as Forte Posthouses and Whitbread Lanshury Hotels, or by acquisition, such as Porte Crest and Mount Charlotte Thistle.
We anticipate that product segmentation will assume even greater significance in the future development of hotel companies. It is an effective method for hotel companies to maintain or expand market share and in some instances create new markets.
Product branding will become more focussed and will reflect increasing levels of segmentation.
In the light of this, the future of the 'all purpose hotel' is doubtful in terms of its competitiveness in the market place.
Buying and Paying for Hotel Services
It is important to understand how a buying decision is made, who makes it, and who pays for the hotel services bought.
The buying decision itself may be basically of two kinds -deliberate or impulsive. Before embarking on journeys, business people may ask secretaries to reserve hotel rooms in the towns they are to visit for specified nights. A family may arrive at their choice of holiday hotel after a scrutiny of hotel guides. A society may make several inquiries before choosing the venue for their annual dinner dance. These are deliberate buying decisions made with some _advance planning and with advance reservations. A tourist looking for somewhere to stay when travelling by car, or on arrival at the railway station or airport, is likely to make an impulse decision, in much the same way as a couple walking through the streets of a town and 'discovering' a restaurant which appears to be to their liking. Purchases of hotel products are both deliberate and impulse purchases and most hotels respond to both, although different operational policies and procedures normally apply to each.
Many people make their own arrangements for travelling and for staying in hotels. However, many hotel bookings are made by people who do it for others: the secretary for the boss, the travel agent for the client, the business travel department of a large company for its employees. In these circumstances it is important to know who the buying agent is and where that person is located, if the knowledge derived from the analysis of the hotel demand generating sources is to be applied to bringing about sales. Most hotels can no longer hope to fill their beds, restaurants and bars by simply waiting for the guest.
According to the source of payment for hotel services, hotel users are also of two basic kinds - those who pay themselves and those whose hotel bills are covered or reimbursed for them. Most leisure use of hotels represents personal expenditure out of disposable incomes, the bulk of business use of hotels in the wide sense is paid for directly or indirectly by third parties - employers and other agencies on behalf of the guest. Although many business users have no fixed limits as to the charges they incur in hotels, many tend to observe what they and their organizations regard as acceptable. The understanding of these practices is important to hotels too. The decision on the market segments to be catered for is closely related to decisions on pricing and we have seen that price is an integral element of each hotel's total concept.
Hotel Marketing Orientation
Hotels serve people and their success depends on how well they serve them in places where they wish to be served. This is only a way of stating in the simplest of tenns the application to hotel operations of the marketing concept, which is concerned with the consumer as a starting point in the conduct of business.
The marketing concept is beginning to be understood by hoteliers. Although some continue to regard sales andmarketing as synonymous, most hotels no longer operate in the seller's market and even massive sales effort is not likely to generate a sustained high volume of business, if consumer needs are not genuinely met in the planning, design and subsequent operation of an hotel.
The basic hotel concept stresses the view of the hotel, as it is seen by the hotel user rather than the hotel operator, as a business to meet the needs of hotel users. Some of these needs are basic and physical, such as sleeping in clean beds or eating wholesome meals; others such as those met by the image of the hotel are acquired needs, which reflect what a person aims to be as an individual. A successful hotel must seek to meet both sets of needs. So that an hotel can meet the needs of hotel users, individual hotel services have to be seen as hotel products sold to particular markets. A hotel cannot be all things to all people. Each hotel has to achieve a match between its particular products and particular market segments, i.e. groups of people with more or less similar characteristics and requirements for hotel services. In this there is a difference between the hotel accommodation and catering products, in that each may to some extent cater for different markets. But this difference only reinforces the need for harmony in the total hotel concept. In order to achieve the match between hotel products and markets, there is a need for a careful analysis of the sources of demand for hotel services in the market area served by the hotel and an understanding of how hotel services are bought and paid for.
From this model of a hotel a translation can be made to particular operations. This takes the form of hotel policies, philosophies and strategies.
Special Features of Hotel Marketing
Marketing is first and foremost about matching products and markets and in this sense the marketing of hotel services is in principle no different from the marketing of other consumer products. But there are special features of hotel products and markets and hence of hotel marketing.
For most users hotel rooms are a means to an end and not an end in itself and the demand for them is what is known as derived demand - the reason for their use may be a business visit or a holiday or something else but rarely the room itself, and the same applies to some extent to other hotel services.
The availability of the most important hotel product, the hotel room, is fixed in time and place. In the short term the number of rooms or beds on offer cannot be significantly changed and location is part of the highly perishable product, which cannot be stored for future sale or follow the customer. The demand for hotel accommodation and other services fluctuates from day to day, from week to week and from one part of the year to another. A waste occurs when demand falls and there is a definite upper limit to the volume of business in a period of peak demand.
Hotel investment is primarily an investment in land and buildings and interior assets. The bulk of the capital invested in the fixed assets of the hotel, combined with the continuity of hotel activity, gives risc to high fixed costs, which have to be covered irrespective of the volume of business. Three key factors are, therefore, critical to a successful hotel operation - the right location, correct capacity, and a high level of utilization, all of them imply marketing decisions - first in the conception of the hotel and in its operation subsequently.
In the conception of the hotel, marketing can contribute first through a market feasibility study to assess the demand. A study may identify the best market opportunity for a hotel, a gap in the market, a location or choice between alternative locations, for a particular hotel concept; or, given a particular location, a study can determine the most appropriate hotel concept. The translation of the concept into an operational facility then takes place through product formulation and development. In the operation of the hotel, marketing can contribute through a continuous process of market research, product development, promotion, selling, monitoring and review - the stages of a marketing cycle.
In the planning of a new hotel, there is full scope for the adherence to the marketing concept from the outset. In an existing hotel, there is often an important distinction between the short-and long-term marketing tasks. In the short term the marketing task may be to adjust customers' wants to available facilities and services, but the long-term task is to modify the facilities and services to the customers' wants.
In the short run our existing facilities and services are given within narrow limits. We may research the market to see which market segments are or could be attracted to them, make such adjustments to our products as are possible, but the main effort is likely to focus on promotion and selling. With low occupancies and low utilization of restaurants, bars and function rooms, in the short run the sales effort becomes dominant. But it is no excuse for doing just that; it is both necessary and possible to proceed with changing the products: toestablish who our customers could be and what their needs are (market research), and to formulate and develop products meeting their needs (product formulation and development). This approach ultimately calls for less sales effort, which is then designed to demonstrate to people that their needs can be met; it is of particular importance in hotels.
Marketed commodities and articles are concrete, physical and capable of measurement; most of them can be inspected and many of them even tried out before purchase. Services are less tangible and hotel services particularly so. Hotel services cannot be easily defined and described in terms of clearly measurable products and their qualities. They are often bought individually or as part of a package, and they may be bought directly by the user or through an intermediary, for example, a travel agent. In hotels, as in other walks of life, it is necessary to make it easy to buy only more so.
Property Ownership
An investment in hotels is first and foremost an investment in land and buildings, which represent the dominant assets of hotels. Other fixed assets are:
• plant and equipment, including such major items as air conditioning, boilers, lifts, and heavy kitchen equipment;
• furniture, furnishings, and small equipment;
• china, glass, linen and cutlery.
Accordingly there is a dual nature of investment in hotels - as an investment in land and buildings and an investment in interior assets. This distinction has been recognized in three principal ways in recent years.
First, the building shell may be owned by a developer, sometimes as part of some larger project, and leascd to anhotel operator on a rental basis. This is also implied by some hotel groups, which apply internal rentals to hotels owned by them; in this way the hotel profits are assessed after taking into account the notional rental of the land and building.
Secondly, hotel companies make use of sale-and-lease- back arrangements as a means of financing the investment, which reduces the capital requirement for the hotel operator.
Thirdly, interior assets may be also leased by the hotel operator rather than bought, thereby also reducing the capital requirement.
There are, therefore, various arrangements as to who is involved in property ownership and in hotel management. A hotel operator may invest in the property represented by land and buildings or enter into a leasing arrangement and invest only in the interior assets, or an operator may enter into a management contract without any direct capital investment.
Property Operation and Maintenance
In large hotels and in hotel groups normally a senior person is ultimately responsible for technical services who may be variously described as the technical services, buildings and services, or works director, officer, or superintendent, or simply as chief engineer, or by some such title. In large organizations the technical services may be subdivided between those responsible for buildings, for engineering, and for other services.
Although technical considerations may be the direct concern of hotel management in smaller hotels, they arespecialist activities normally entrusted to specialist staff and sometimes 'contracted out'.
Property operation, maintenance and energy costs are costs of hotel operation, as distinct from the capital investment outlay on the assets. They are, therefore, appropriately included in hotel profit and loss statements.
In the Uniform System of Accounts for Hotels property operation and maintenance includes costs of repairs and maintenance of buildings, plant and equipment, furniture and furnishings, as well as the maintenance of grounds, related wages and salaries, and work let out on contract. The costs incurred by hotels contributing to Horwath International reports in the early 1990.
III.Hotel Organization
Organization is the framework in which various activities operate. It is concerned with such matters as the division of tasks within firms and establishments, positions of responsibility and authority, and relationships between them. It introduces such concepts as the span of control (the number of subordinates supervised directly by an individual), levels of management (the number of tiers through which management operates), delegation (the allocation of responsibility and authority to designated individuals in the line of 'command').
Until not so long ago - about the middle of this century and even later than that the typical hotel of almost any size was characterized by a large number of individuals and departments directly responsible to the hotel manager who was closely concerned with his guests and with all or most aspects of the hotel operation. Theremight have been one or more assistant managers who had little or no authority over such key individuals as the chef, the head waiter or the housekeeper. The hotel manager usually combined the 'mine host' concept of hotel keeping with a close involvement in the operation. He normally had all or most of the technical skills that enter into the business of accommodating and catering for guests. Although he might have given more attention to departments in which he felt confident about his expertise, and less to those in which his knowledge and skills might have been lacking, his approach was essentially that of a technician rather than the manager of a business. Hotels served those who chose to use them. The financial control was exercised by the owners or by accountants on their behalf. Personnel management rarely extended beyond the 'hiring and firing' of staff. Hotel buildings and interiors were not often viewed as business assets required to produce a return comparable to other commercial investments; maintenance and energy were cheap.
Several influences have tended to change this profile generally and the approach to hotel organization in particular in the second half of the twentieth century. The market for hotels, the number of hotels, and the size of individual operations have grown, against the background of economic and social conditions in most parts of the world. Business and management thought and practice have found their way into hotels, with the entry into the hotel business of firms engaged in other industries, development of hotel education and training, and higher quality of management. Innovation in hotel organization, at first largely confined to a few firms in North America, has spread to others in other countries. These and other influences have brought about changesin the ways in which hotels organize their activities today.
Three particular developments illustrate the changes in hotel organization in post-war Britain. One relates to the grouping of functions. In the early I 950s hotel reception, uniformed services and housekeeping were invariably regarded as separate departments, each reporting directly to the hotel manager; twenty years later many large hotels had front hall managers, rooms managers, or assistant managers with specific responsibilities in this area. Similarly, over the same period in most large hotels food and beverage managers came to be appointed, responsible for all the hotel activities previously organized in restaurants, bars and kitchens under the direct control of the hotel manager. Secondly, there has been a growth in specialists. In the early 1950s only a few large hotels had a staff manager, a public relations officer or a buyer; by the early 1970s personnel, sales and marketing, and purchasing departments were common features of the large hotels and of hotel groups. Thirdly, where each hotel used to be more or less self-sufficient in the provision of its various guest services and supporting requirements, many of these are now provided through internal rentals and concessions and through specialist suppliers and operators such as outside bakeries, butcheries and laundries.
The accommodation function may be described in terms of reception, uniformed services and housekeeping. Several typical organizational approaches may be identified in respect of these activities in practice:
- all three activities operate as separate departments with their own heads of department;
-reception and uniformed services are grouped together as the front hail or front house of the hotel under an assistant manager for whom this is the sole or main responsibility;
- reception and uniformed services are grouped together as a front hail or front house department with its own head of department.
- all three activities are grouped together as the rooms department under an assistant manager for whom this is the sole or main responsibility;
- all three activities are grouped together as the rooms department with its own head of department.
The first approach provides for a direct line of responsibility and authority between each separate head
Rooms
The accommodation function may be described in terms of reception,uniformed services and housekeeping. Several typical organizational approaches may be identified in respect of these activities in practice:
- all three activities operate as separate departments with their own heads of department;
-reception and uniformed services are grouped together as the front hail or front house of the hotel under an assistant manager for whom this is the sole or main responsibility;
- reception and uniformed services are grouped together as a front hail or front house department with its own head of department.
- all three activities are grouped together as the rooms department under an assistant manager for whom this is the sole or main responsibility;
- all three activities are grouped together as the rooms department with its own head of department.
The first approach provides for a direct line of responsibility and authority between each separate head of department and the hotel manager and hence for a close contact between the two levels of management; however, it extends the hotel manager's span of control and he is required to coordinate the separate departments. The other four approaches are designed to reduce the hotel manager's span of control and provide for a coordination of related activities at an intermediate level but increase the number of levels through which management has to operate, and reduce the amount of direct contact between the hotel manager and the departments concerned.
Several activities were described in connection with rooms, which may be arranged differently in large hotels:
In most hotels advance reservations form an integral part of hotel reception and the same employees deal with them and with other reception tasks. But advance reservations may be dealt with in a separate section of the reception office or in a separate department, to enable employees to concentrate on the respective tasks without conflicting demands on their time and attention. Sometimes all advance reservations are concentrated in the sales department, which has a responsibility for maximizing hotel occupancy.
In smaller hotels guest accounts are normally handled by book-keeper/receptionists, but strictly speaking guest accounts represent an extension of the accounting function of the hotel. Therefore, where guest accounting is handled by bill office clerks and cashiers, they normally form a part of the accounts department.
• In some hotels room service is provided by housekeeping staff, but room service is clearly part of the food and beverage function of the hotel.
Food and Beverage
Several typical organizational approaches identified in respect of this function in practice:
? may be each sales outlet and supporting service operates as a separate department with its own head of department;
• several departments are grouped together under an assistant manager for whom they represent the sole or main responsibility, e.g. purchasing and storage, bars and cellars, the 'back-of-the-house' activities including the kitchen, and so on;
• several of these departments are grouped together as one department under its own head of department;
• all food and beverage activities are grouped together under an assistant manager for whom they represent the sole or main responsibility; • all food and beverage activities are grouped together as a food and beverage department with its own head of department.
The same observations apply to these approaches as are made above in relation to rooms, regarding lines of responsibility and authority, span of control and levels of management; the size of the span of control and the number of management levels are conflicting considerations.
Several aspects of the food and beverage function are closely related to each other but also to other parts of the hotel operation:
• Most hotels have facilities serving both food and beverages, although in some of them food or beverages may predominate. Whilst it is usually relatively easy to separate the revenue from each, it is often impractical to separate accurately all the costs of operation other than the cost of sales, because the same employees may handle both products, and because other goods and services provided in the same outlet may not be readily identifiable as either food or beverages. In these circumstances food and beverages are treated together, analysed by sales outlet, and the related responsibilities are reflected in the organization structure.
• Food and beverage control based on the food and beverage cycles may be appropriately seen as part of the total accounting function of the hotel. In these circumstances such employees as restaurant cashiers and cost control clerks are included on the staff of the hotel accountant. • 'Where there is a separate sales department, food and beverage sales are usually closely monitored by that department, and such arrangements as reservations for functions may form part of the responsibilities of the sales department.
Miscellaneous Guest Services
Miscellaneous guest services are illustrated in terms of such activities as telephones and laundry and the typical organizational approaches for most of term are shown to be of two main kinds:
• the services are operated under direct management of the hotel as minor operated departments;
• the services are operated under rental and concession arrangements with the hotel by another firm.
The alternative arrangements may apply in the provision of the following main services to guests:
beauty shop and hairdressing
secretarial services
florist
squash courts and
tennis courts
garage
gifts and souvenirs
laundry and dry cleaning
swimming pool
newspapers and magazines
tobacconist
Direct management of these services normally provides for a closer direct control and supervision by the hotel and for greater flexibility in operation. In many hotels the services are merely grouped as residuary hotel activities for accounting and control purposes and are in practice provided as part of the services of other hotel departments, e.g. reception, uniformed services, housekeeping or general administration, and are not separate departments in the organizational sense. Only when the volume of a particular service is sufficiently large, it may be organized as a separate department. And it is only then that the option arises for the service to be provided for the guests by another operator, because it warrants his involvement, under a rental or concession arrangement. Such arrangement then relieves the hotel from operating what is often to the hotel operator an unfamiliar service and allows it to concentrate on its primary activities.
Therefore, major deciding factors are the size of the operation, the availability of suitable operators of particular services, and the operational philosophies of the hotel or hotel group, as well as the quality of service and the financial return to the hotel, which may result from one or the other approach.
Hotel Support Services
In practice the non-revenue service activities are organized in one of three main ways:
• retained among the hotel manager's own responsibilities;
• assigned to an assistant manager as one of his or her responsibilities;
• assigned to a separate department with its own head of department.
To a greater or lesser extent each of these activities may also draw for its performance on external specialist advice and assistance.
The main specialist activities, which may be organized in one of these ways, and examples of the external sources of advice and assistance available to the hotel in respect of each, can be summarized as follows:
Accounting and finance
Hotel accountants and consultants
Public accountants and auditors
Professional stock-takers
Personnel services
Personnel recruitment and selection specialists
Work study, personnel and industrial relations advisers
Training boards and other agencies
Purchasing
Hotel accountants and consultants
Furniture and equipment
specialists
Various suppliers
Sales and marketing
Market research agencies
Advertising agencies
Public relations consultants
Property operation,
maintenance, energy
Architects, builders, designers
Consulting engineers
Utility undertakings
Advisory services are also sometimes provided by professional bodies, trade associations for their members, the technical press and other agencies.
Apart from any operational philosophies, the adoption of the organizational approaches, in respect of a particular activity, is largely determined by the size of operation: the first is normally associated with a small hotel; the second with medium size; and the third with large operations, but no hard and fast rules apply. Each of these activities comprises specialist knowledge and skills, as distinct from normal operational know-how inherent in the primary operating activities.
The Management Structure
Following the discussion of the division and grouping of operated and service activities into departments, it is next necessary to consider the total management structure of the hotel; this comprises all positions of responsibility and authority below top management, which is represented in a hotel company by the board of directors. The management team consists of the hotel manager, one or more deputy or assistant managers, and the heads of departments. A discussion of the management structure is concerned with these posts and with the relationships between them.
According to the size of the hotel and the particular arrangement in operation, the hotel chief executive may be variously designated as managing director, general manager or simply hotel manager. He or she may to agreater or lesser extent participate in the formulation of the hotel policies and strategies, and will invariably be responsible for their implementation and for the hotel performance. In larger hotels this level may be subdivided betweena managing director or general manager and the hotel manager or a resident manager. The former then reports to the board and normally coordinates the work of the specialist departments and of the hotel or resident manager, who is in turn responsible for the day-to-day management of the hotel activities.
The complexity and continuity of the hotel activities normally give rise to the need for one or more deputy or assistant managers. A deputy hotel manager normally has authority over the heads of departments. But there is much variation in the role, authority and responsibilities of hotel assistant managers.
In some instances they are the hotel manager's deputies in all but name, in respect of the whole operation or some parts of it, e.g. food and beverages, front hall, 'back of the house', and so on; in other cases they have these specific responsibilities in addition to their general role as the manager's deputies. But many so-called assistant managers perform roles, which are more appropriately described as those of general assistants (assisting where required throughout the hotel) or of personal assistants to the manager (acting on his behalf as he directs them to do). Yet in other cases their main role is guest contact.
All the roles described above may be appropriate in particular circumstances, but effective hotel management calls for a clear definition of responsibility and authority. The relationships with heads of departments are especially important in this context. Titles, which describe the particular roles, can be helpful in this direction.
In order to provide clear-cut lines of responsibility and authority and an effective coordination of related activities, some hotels function without assistant managers as such: those who would normally be in such positions are allocated specific responsibilities and appropriate titles to describe them.
Those in positions of heads of departments fall into two distinct categories. Heads of operated departments are known as line managers, with direct lines of responsibility and authority to their superiors and to their subordinates in respect of each operated department. Heads of service departments are specialists who provide advice and service to line management, and relieve them of such specialist tasks as are considered to be more effectively discharged through the appointment of specialists; they have no direct authority over employees other than those of their own departments. Line management includes, for example, head receptionists, head housekeepers, head chefs and restaurant managers. Specialists include accountants, buyers, personnel and purchasing officers and similar posts. In order to draw a distinction between the two, it is helpful to confine the designation 'manager' to operated departments.
It is also relevant to refer in this context to a confusion, which often arises with various trainee positions. It is difficult to justilt such titles as 'trainee manager' unless its holder has been designated to fill a specific post, for which he is training. A person who is undergoing training with a view to an ultimate unspecified position of responsibility is more appropriately described as a management trainee.
IVHotel Services
Rooms and Beds
The primary function of a hotel is to accommodate those away from home and sleeping accommodation is the most distinctive hotel product. In most hotels room sales are the largest single source of hotel revenue and in many, more sales are generated by rooms than by all the other services combined. Room sales are invariably also the most profitable source of hotel revenue, which yield the highest profit margins and contribute the main share of the hotel operating profit.
Hotels contributing to annual reports of Horwath International earned on average the proportions of their total revenue shown in the following from room sales in the early 1990s.
Room Sales as a Ratio of Hotel Revenue in Main Regions
1990
1991
1992
(%)
(%)
(%)
Africa and the Middle East
46.0
43.6
45.2
Asia mid Australia
54.1
56.0
57.9
Europe
49.2
49.1
47.0
North America
63.9
62.9
71.6
Latin ArnericalCaribbean
53.8
58.5
56.
Three main hotel activities are earning the room revenue: hotel reception, uniformed services and Room Sales
A large proportion of hotel guests reserve their rooms from a few hours to several weeks or months before they actually arrive at the hotel. They do so in person, by telephone, telegram, Telex or Fax, by mail, through travel agents, and in a growing number of cases through central reservations systems. Hotel reservations create a multitude of contractual relationships between the hotel and its guests, which begin at the time each reservation is made and continue until the departure of the guests or until their accounts are settled after their stay. Advance reservations are an important responsibility on the part of the hotel, both in the legal and in the business sense, and call for a system which enables room reservations to be converted into room revenue. When guests arrive in hotels, they are asked to register by providing the receptionist with certain particulars about themselves. The hotel register, in which the particulars are entered, has two main functions; one is to satisfy the law, which makes hotel registration of guests a legal requirement in most countries. The second function is to provide an internal record of guests, from which data are obtained for other hotel records.
In most hotels room allocations of accommodation reserved in advance are made before the guests' arrival and only guests registering without a previous reservation are allocated rooms on arrival, but in some hotels all room allocations are made only when guests arrive. The registration and room allocation are then the starting point for guests' stay and a signal for the opening of their accounts, as well as for notifying uniformed staff, the housekeeping department, telephonists, and others, of arrivals.
Several main records document the room sale in the reception office:
• reservation form or card standardizes the details of each booking, forms the top sheet of any documents relating to it, and enables a speedy reference to any individual case;
• reservation diamy or daily arrival list records all bookings by date of arrival and shows all arrivals for a particular day at a glance;
• reservation chart provides a visual record of all reservations for a period and shows at a glance rooms reserved and those remaining to he sold;
• hotel register records all arrivals as they occur and gives details of all current and past guests;
• reception or room status board shows all rooms by room number and floor and gives the current and projected status of all rooms on a particular day, with details of occupation;
• guest index lists all current guests in alphabetical order with their room numbers and provides an additional quick point of reference in larger hotels.
Mall and Other Guest Services
A combined key and mail rack is a standard feature of most hotel reception offices and reflects two typical responsibilities of the office room keys and guest mail, Arranged by room number and floor, it corresponds in layout to the reception or room status board and is complementary to it.
In the course of a day's business room keys arc issued from the rack to arriving guests and to residents who call for them; keys are returned to the rack by guests going out of the hotel or departing at the end of their stay. The rack is a point of reference regarding the occupation of rooms and the whereabouts of guests.
Mail may arrive for guests before, during and after their stay at the hotel, and may consist ç.f ordinary or registered mail, packets and parcels, cables and' telegrams, Telex messages, Fax transmissions, express mail and personal messages left for guests. Mail awaiting guests' arrival should be handed to them when they are registering; mail arriving after a guest has left the hotel, should be forwarded. During the guest's stay speed is the essence of Fax transmissions, security is the essence of registered mail, bulkiness is the essence of parcels; each calls for standard procedures of their own. But the key and mail rack is the focus; it accommodates much of the mail the guest collects when collecting the room key; it can serve to alert the receptionist to items such as parcels or registered mail, stored elsewhere.
Three basic aids are, therefore, related and complementary in the provision of key, mail and other guest services:
• guest index shows whether a particular person is resident and that person's room number;
• reception or room status board shows who is occupying a particular room;
• key and mail rack indicates whether the guest is in the hotel and whether there is any mail for that person.
In many hotels the reception office or a separate section of it also acts as a source of information to guests
- about hotel facilities and services, about the locality, about transport and other matters. In other hotels the keys, mail and information to guests are provided by uniformed staff, and there are usually good reasons for one or the other arrangement. But who does what and to whom the guest can turn, should be made clear to the guest in terms of individual needs and requirements rather than in terms of the hotel organization structure, particularly in larger hotels. Such notices as 'Reception' and 'Hall Porter'have different connotations in different hotels and are not necessarily self-explanatory even for experienced hotel users. Counters and sections of the front hall of the hotel clearly labelled 'Registration', 'Keys', 'Mail', 'information', 'Guest Accounts', and so on, are more meaningful to guests.
Uniformed Services
The second component of the accommodation function is uniformed services, which form an integral part of the front hail ftmnctions of the hotel and provide a variety of personal services to guests.
Servicing arrivals and departures are the most common uniformed services. The meeting and greeting of arriving guests, their luggage and the parking of their ears, are the first responsibilities, which extend from the hotel entrance and car park to the hotel bedrooms. On departure, guests, luggage and transportation are again their primary responsibilities. In an hotel with a hundred departing guests in the morning, followed by a similar volume of arrivals in the afternoon and evening, uniformed staff attend in a day's business to some two hundred people, handle several hundred pieces of luggage, park several doPzen cars, and arrange several dozen taxis. The guests, their luggage, and their vehicles, therefore, play a major part in the provision of uniformed services.
During the guest's stay uniformed staff are often the main source of informatinn about the hotel and the locality, and the guest's main source of such arrangements as theatre tickets, tours, car hire and other services. The hail porter's desk or an enquiry counter in the front hail are then the information centres of hotels, which contribute much to the range of guest services and to their integration.
In some hotels other guest services may be provided by uniformed staff. Newspapers, as well as other small articles, may be supplied to guests by uniformed staff who may also act as messengers, lift operators and men's cloakroom attendants. In many hotels uniformed staff are the only people on duty during the night and particularly in smaller hotels maintain a whole range of hotel services provided by other departments in day time: to receive and register late arrivals, to serve light refreshments, to operate the hotel switchboard, to arrange early morning calls, as well as to clean public rooms and to ensure the security of the hotel.
The provision of uniformed services varies greatly between hotels of different sizes, types and standards, and their organization tends to be influenced by all these factors, as well as by established practices, As mentioned earlier, information to guests may he provided by the reception office or as part of uniformed services or by both. The cleanliness of public rooms may be the responsibility of uniformed staff, the housekeeping department, or outside contractors. What hotel services are available during the night and by whom they are provided, is another source of variation. These differences are legitimate, as long as they reflect the particular requirements of guests and the particular circumstances of each hotel, and as long as the respective functions are defined and understood by staff and made clear to guests where they affect them.
Hotel Housekeeping
The basic housekeeping function of the hotel is the servicing of guest rooms. In its scope, guest bedrooms may be the sole or main responsibility of the hotel housekeeping department, but it may extend to other areas of the hotel.
Normally hotel guests spend at least one-third of their stay in their room. The design, layout, decor, furniture and furnishings of the hotel bedroom are fundamental to meeting their needs and in creating customer satisfaction, and these may be significantly influenced by the housekeeping department. The cleanliness and good order, the linen and other room supplies, and the smooth functioning of the room are the focus of the department. This may include other guest services, such as early morning teas, guest laundry, baby sitting and other personal services. The main housekeeping records are made up of arrival and departure lists and notifications received from the reception office and the housekeeping own room status report, together with separate records in respect of additional services provided by the department.
The extension of the housekeeping function outside the hotel bedroom normally includes the cleaning of bedroom floors and may include staircases, public cloakrooms and other public areas of the hotel. However, it is quite common for such public rooms as hotel lounges to be cleaned by uniformed staff, for the responsibility for the men's and women's cloakrooms to be divided between uniformed staff and the housekeeping department, and for restaurants and bars to be cleaned by the staff of those departments. More recently, hotels have been engaging outside contract firms for the cleaning of public rooms.
Other housekeeping services often include the provision of first aid to guests and staff, dealing with lost property, and floral arrangements throughout the hotel. When staff accommodation is provided by the hotel, it may be included as part of the head housekeeper's responsibilities. Although in many countries hotels increasingly use outside laundries and dry cleaning firms for their requirements, many hotels operate their own dry cleaning and laundry facilities. These 'in-house' facilities may be then organized as separate departments of the hotel or as sections of the housekeeping department.
This outline of the hotel housekeeping function illustrates three organizational approaches. One seeks to integrate a number of related functions within a major housekeeping department. The second assigns certain functions to the housekeeping department and others to other departments of the hotel, largely on the basis of physical areas. The third consists of 'buying in' certain services from outside suppliers rather than operating them directly as hotel facilities. Food and Drink
The food and drink service is the second major activity of most hotels and in many of them it accounts for a larger proportion of employees than the provision of sleeping accommodation and related services. This is due to two main factors:
• in contrast to hotel rooms, meals and refreshments in hotels may be supplied to non-residents as well as to resident guests and include substantial functions sales;
• the provision of meals and refreshments is relatively labour intensive.
The provision of sleeping accommodation is a service activity, in which there is a negligible use of materials, and there is no cost of sales. The provision of meals and refreshments results in composite products made up of commodities and of service, and the use of materials represent the cost of sales. Food and drink enter into meals and refreshments served in hotels in several stages from their purchase by the hotel to their sale in the same or altered form to the hotel customer. According to the size and diversity of the hotel markets there may be more than one restaurant and bar and also food and drink service in rooms and through functions.
Restaurants
Restaurants establishment where refreshments or meals may be procured by the public. The public dining room that came ultimately to be known as the restaurant originated in France, and the French have continued to make major contributions to the restaurant's development.
The first restaurant proprietor is believed to have been one A. Boulanger, a soup vendor, who opened his business in Paris in 1765. The sign above his door advertised restoratives, or restaurants, referring to the soups and broths available within. The institution took its name from that sign, and "restaurant" now denotes a public eating place in English, French, Dutch, Danish, Norwegian, Romanian, and many other languages, with some variations. For example, in Spanish and Portuguese the word becomes restaurante, in Italian it is ristorante; in Swedish, restaurang; in Russian, restoran; and in Polish, restauracia. Although inns and hostelries often served paying guests meals from the host's table, or table d'hôte, and beverages were sold in cafés, Boulanger's restaurant was probably the first public place where any diner might order a meal from a menu offering a choice of dishes.
Boulanger operated a modest establishment; it was not until 1782 that La Grande Taverne de Londres, the first luxury restaurant, was founded in Paris. The owner, Antoine Beauvilliers, a leading culinary writer and gastronomic authority, later wrote L 'Art du cuisinier (1814), a cookbook that became a standard work on French culinary art.
The most illustrious of all 19th-century Paris restaurants was the Café Anglais, on the Boulevard des Italiens at the corner of the rue Marivaux, where the chef, Adoiphe Dugléré, created classic dishes such as sole Dugléré (filets poached with tomatoes and served with a cream sauce having a fish stock base) and the famous sorrel soup potage Germiny. On June 7, 1867, the Café Anglais served the now-famous "Three Emperors Dinner" for three royal guests visiting Paris to attend the Universal Exposition. The diners included Tsar Alexander 11 of Russia; his son the tsarevich (later the tsar Alexander III); and King William I of Prussia, later the first emperor of Germany. The meal included souffles with creamed chicken (a Ia reine), fillets of sole, escalloped turbot, chicken a la portugaise (cooked with tomatoes, onions, and garlic), lobster a la parisienne (round, flat medallions glazed with a gelatin-mayonnaise mixture and elaborately decorated), ducklings a Ia rouennaise (the carcasses stuffed with liver and pressed, presented on a platter with boned slices of the breast and the grilled legs, and served with a red wine sauce containing pureed liver), ortolans (small game birds) ontoast, and eight different wines.
Toward the end of the 19th century, in the gaudy and extravagant era known as ia belie époque, the luxurious Maxim's, on the rue Royale, became the social and culinary centre of Paris. The restaurant temporarily declined after World War I but recovered under new management, to become an outstanding gastronomic shrine.
France produced many of the world's finest chefs, including Georges-Auguste Escoffier, who organized the kitchens for the luxury hotels owned by César Ritz, developing the so-called brigade de cuisine, or kitchen team, consisting of highly trained experts each with clearly defined duties. These teams included a chef, or gros bonnet, in charge of the kitchen; a sauce chef, or deputy; an entremettier, in charge of preparation of soups, vegetables, and sweet courses; a rótisseur to prepare roasts and fried or grilled meats; and the garde manger, in charge of all supplies and cold dishes. In Escoffier's time, the duties and responsibilities of each functionary were sharply defined, but in modern times, rising labour costs and the need for faster service have broken down such rigidly defined duties. In the kitchens of even the leading modern restaurants, duties at the peak of the dinner-hour preparations are likely to overlap widely, with efficiency maintained amid seeming chaos and confusion.
I n the 20th century, with the development of the automobile, country dining became popular in France, and a number of fine provincial restaurants were established. The Restaurant de la Pyramide, in Vienne, regarded by many as the world's finest restaurant, wasfounded by Fernand Point and after his death, in 1955, retained its high standing under the direction of his widow, Madame "Mado" Point. Other leading French provincial restaurants have included the Troisgros in Roanne; the Paul Bocuse Restaurant near Lyon; the Auberge de 1'Ill in Illhaeusern, Alsace; and the hotel Côte d'Or, at Saulieu.
French restaurants today are usually in one of three categories: the bistro, or brasserie, a simple, informal, and inexpensive establishment; the medium-priced restaurant; and the more elegant grand restaurant, where the most intricate dishes are executed and served in luxurious surroundings.
Other nations have also made many significant contributions to the development of the restaurant.
In Italy the botteghe (coffee shop) of Venice originated in the 16th century, at first serving coffee only, later adding snacks. The modern trattorie, or taverns, feature local specialities. The osterie, or hostelries, are informal restaurants offering home-style cooking. In Florence small restaurants below street level, known as the buca, serve whatever foods the host may choose to cook on a particular day.
Austrian coffeehouses offer leisurely, complete meals, and the diner may linger to sip coffee, read a newspaper, or even to write an article. Many Austrians frequent their own "steady restaurants," known as Stain,nbe
In Hungary the csárda, a country highway restaurant, offers menus usually limited to meat courses and fish stews.
The beer halls of the Czech Republic, especially in Prague, are similar to coffeehouses elsewhere. Food is served, with beer replacing coffee.
The German Weinstube is an informal restaurant featuring a large wine selection, and the Weinhaus, a food and wine shop where customers may also dine, offers a selection of foods ranging from delicatessen fare to full restaurant menus. The Schenke is an estate-tavern or cottage pub serving wine and food. In the cities a similar establishment is called the Stadischenke.
In Spain the bars and cafés of Madrid offer widely varied appetizers, called tapas, including such items as shrimp cooked in olive oil with garlic, meatballs with gravy and peas, salt cod, eels, squid, mushrooms, and tuna fish. The tapas are taken with sherry, and it is a popular custom to go on a chateo, or tour of bars, consuming large quantities of tapas and sheny at each bar. Spain also features the marisco bar, or marEs querIa, a seafood bar; the asadoro, a Catalan rotisserie; and the tasca, or pub-wineshop.
In Portugal, cervejarias are popular beer parlours also offering shellfish. Fado taverns serve grilled sausages and wine, accompanied by the plaintive Portuguese songs called fados (meaning "fate").
In Scandinavia sandwich shops offer open-faced, artfully garnished sandwiches called smorrebrod. Swedish restaurants feature the smorgasbord, which literally means "bread and butter table" but actually is a lavish, beautifully arranged feast of herring, shrimp, pickles, meatballs, fish, salads, cold cuts, and hot dishes, served with aquavit or beer.
The Netherlands has broodjeswinkels, serving sandwich open-faced shops, called sandwiches, seafoods, hot and cold dishes, and cheeses from a huge table.
English city and country pubs have three kinds of bars: the public bar, the saloon, and the private bar. Everyone is welcome in the public bar or saloon, but the private bar is restricted to habituës of the pub. Pub food varies widely through England, ranging from sandwiches and soups to pork pies, veal and ham pies, steak and kidney pies, bangers (sausages) and a pint (beer), bangers and mash (potatoes), toad in the hole (sausage in a Yorkshire pudding crust), and Cornish pasties, or pies filled with meat and vegetables.
In the tavérnas of Greece, customers are served such beverages as retsina, a resinated wine, and ouzo, an anise-flavoured aperitif, while they listen to the music of the bou:ouki. Like other Mediterranean countries, Greece has the groceiy-tavérna where one can buy food or eat.
The Turkish iskembeci is a restaurant featuring tripe soup and other tripe dishes; muhalleb icE shops serve boiled chicken and rice in a soup and milk pudding.
Characteristic of Japan are sushi bars that serve sashimi (raw fish slices) and sushi (fish or other ingredients with vinegared rice) at a counter. Other food bars serve such dishes as noodles and tempura (deep- fried shrimp and vegetables). Yudofu restaurants build their meals around varieties of tofu (bean curd), and the elegant tea houses serve formal Kaiseki table d'hôte meals.
In China, restaurants serving the local cuisine are found, and noodle shops offer a wide variety of noodles and soups. The dim-sum shops provide a never-ending supply of assorted steamed, stuffed dumplings and othersteamed or fried delicacies.
A common sight in most parts of Asia is a kind of portable restaurant, operated by a single person or family from a wagon or litter set up at a particular street location, where specialties are cooked on the spot. Food and cooking utensils vary widely in Asia.
The cafeteria, an American contribution to the restauranfs development, originated in San Francisco during the 1849 gold rush. Featuring self-service, it offers a wide variety of foods displayed on counters. The customer makes his selections, paying for each item as he chooses it or paying for the entire meal at the end of the line. Other types of quick-eating places originating in the United States are the drugstore counter, serving sandwiches or other snacks; the lunch counter, where the diner is served a limited quick-order menu at the counter; and the drive-in, "drive-thru," or drive-up restaurant, where patrons are served in their automobiles. So-called fast-food restaurants, usually operated in chains or as franchises and heavily advertised, offer limited menus-- typically comprising hamburgers, hot dogs, fried chicken, or pizza and their complements--and also offer speed, convenience, and familiarity to diners who may eat in the restaurant or take their food home. Among fast-food names that have become widely known are White Castle (one of the first, originating in Wichita, Kan., in 1921), McDonald's (which grew from one establishment in Des Flames, Ill., in 1955 to more than 15,000 internationally within 40 years), Kentucky Fried Chicken (founded in 1956), and Pizza Hut (1958). Many school, work, and institutional facilities provide space for coin-operated vending machines that offer snacks and beverages. The specialty restaurant, serving one or two special kinds of food, such as seafood or steak, is another distinctive American establishment.
The Pullman car diner, serving full-course meals to long distance railroad passengers, and the riverboat steamers, renowned as floating gourmet palaces, were original American conceptions. They belong to an earlier age, when dining out was a principal social diversion, and restaurants tended to become increasingly lavish in food preparation, decor, and service. In many modern restaurants, customers now prefer informal but pleasant atmosphere and fast service. The number of dishes available, and the elaborateness of their preparation, has been increasingly curtailed as labour costs have risen and the availability of skilled labour decreased. The trend is toward such efficient operations as fast-food restaurants, snack bars, and coffee shops. The trend in elegant and expensive restaurants is toward smaller rooms and intimate atmosphere, with authentic, highly specialized and limited menus.
Miscelaneous Guest Services
Accommodation, food and drink services are the major activities of hotels, which generate all or most hotel revenue, account for all or most of their employees, and represent the principal products provided by the major hotel departments.
But the present-day hotel guest normally also expects other facilities and services. In addition to a comfortable room, and meals and refreshments in a restaurant or bar or in the room, a guest may want to use the telephone or have clothes laundered or dry cleaned. In a large modern hotel a guest may anticipate to be able to buynewspapers, magazines and souvenirs, have a haircut, obtain theatre tickets, and book an airline ticket for the next stage of a trip.
The hotel services other than accommodation, food and drink may be provided to the guest by the hotel or by other operators on the hotel premises. The revenue- earning activities provided directly by the hotel are variously described as ancillary or subsidiary revenue- earning, and are grouped for accounting and control purposes in what are known as minor operated departments, to distinguish them from major operated departments concerned with rooms, food and beverages. Both are distinguished from rental and concession arrangements, under which some of these and other services may be provided to guests by outside firms operating in the hotel.
The three basic components of the accommodation function are present in most hotels and are normally organized in separate departments. But their organization and staffmg often differ in hotels of different sizes, types and standards. In smaller hotels only a few people may be engaged in each and cover a wide range of duties; as the hotel increases in size, each activity may be subdivided into separate departments or sections, in which those engaged in them perform more specialized tasks.
A transit city hotel with a short average length of stay calls for a somewhat different approach from that of a resort hotel, which accommodates guests for longer and often such regular periods as one or two weeks. There is also a relationship between prices, the range and quality of facilities and services provided, and the way they are organized. For all these and other reasons it is possible to describe the hotel activities related to the accommodation of guests only in broad and general terms.
V. Tourist Attractions
Tourist attractions have an important role to play in world tourism since they often provide the motivating force for travel, thereby energising the many components of the tourist industry. The scope of the attractions sector is immense; logically anything that has the power to draw visitors to it can be considered an attraction. Moreover an attraction may not be a readily identifiable place or feature, but a visitor's overall perception of a destination as an attractive place to visit, distilled from a variety of surces and images. London's current popularity as a tourist destination with young visitors from around the world is a good case; they are not attracted primarily by the traditional Big Ben, Buckingham Palace, Houses of Parliament but rather by the image of the capital as a "cool" place to hear good music and have an enjoyable time.
Touristic attractions occur at a variety of scales. Many internationally famous attractions such as:
San Francisco's Golden Gate Bridge
Red Square in Moscow
The Ponipidou Centre in Paris are household names on many tourists' "must see" lists.
Domestic tourists travel within their own countries to a variety of attractions, some of which are provided free of charge while others charge admission. These may be day visits or a part of a long holiday or short break.
Tourist attraction are provided by both commercial and non-commercial organizations. Many historic buildings, areas of landscape or wildlife interest, museums and ancient monuments are in the care of public bodies and voluntary groups which aim to preserve or conserve vital parts of a country's heritage while at the same time making facilities available to tourists.
Types of tourist attractions
Tourist attractions are generally classified into one of
two categories:
Natural attractions
Man made attractions such as:
Heritage attractions (e.g. Williamsburg)
Museums and ancient monuments ('e.g Louvre in Paris)
Theme parks (e.g. Walt Disney World in Florida)
Entertainments (e.g The Sydney Opera House)
Sport facilities (e.g Winter Olimpic Gaines)
Leisure shopping venues ('e.gThe Metro Center in Englanc
Wildlife areas (e.g Busch Garden in Florida)
Tourism today
The mass tourism that exists in the world today is a phenomenon of the post-industrial society of the latter half of the twentieth century. Tourism has become an integral part of the move away from economies based on heavy engineering and manufacturing to a rapidly expanding service sector. The growth in international and domestic tourism since the 1950s has been nothing short of dramatic, with international tourist arrivals climbingfrom 25 million in 1950 to a record 592 million in 1996 (World Tourism Organisation, 1997). When we add to this the fact that the volume of domestic tourism worldwide is estimated by the World Tourism Organisation to be approximately ten times greater than that of international tourism (World Tourism Organisation. 1983), the scale of the tourism phenomenon can begin to be appreciated. Greater wealth, higher educational standards, increased mobility and more leisure time have all contributed to unparalleled demand for holidays and excursions at home and abroad. Overseas travel is no longer the preserve of the privileged few, but is available to the majority, as developments in transportation, increased competition and global communications technology have reduced the real cost of holidays. Private and public sector organisations have responded to the increased demand by providing a wide range of facilities and products to meet the needs of an increasingly discerning travelling public. It must be remembered, however, that tourism is a very recent phenotnenon that has hitherto been allowed to grow in a business environment relatively free of regulation and trade restrictions. Such an unrestricted environment is unlikely to continue in years to come.
The current scale and scope of the international tourism industry is illustrated in recent data from the World Travel and Tourism Council (1996), which indicate that in 1996 the world travel and tourism industry is estimated to have:
* Gmployed 255 million people
* Generated an output of US $3.6 trillion
* Contributed 10.7 per cent of global gross domestic product (.GDP) o invested US $766 billion in capital projects
* Generated( US $761 billion in world exports
* Paid US $653 billion in taxes worldwide
Such figures demonstrate the economic significance of the tourism industry on a global scale and confirm that the age of mass tourism has truly arrived in spectacular fashion.
Local Tours
Paris
Paris is the capital of France and one of Europe's largest conurbations. The city was founded more than 2,000 years ago on an island in the Seine River, some
233 miles (375 kilometres) upstream from the river's mouth on the English Channel. The modern city has spread from the island (the lie de la Cite) and far beyond both banks of the Seine. The City of Paris itself covers an area of 41 square miles (105 square kilometres); the Greater Paris conurbation, formed of suburbs and other built-up areas, extends around it in all directions to cover approximately 890 square miles. Paris occupies a central position in the rich agricultural region known as the Paris Basin, and it constitutes one of eight départements of theIle-de-France administrative region. It is by far the nation's most important centre of commerce and culture.
NEIGHBOUR FlOODS AND SIGHTS
Paris' many old buildings, monuments, gardens, plazas, boulevards, and bridges compose one of the world's grandest cityscapes. An impressive spot from which to view the city is the Chaillot Palace, which stands on a rise on the Right Bank of the Seine to the west, where the river begins its southwestward curve.
The Chaillot Palace.
The Chaillot Palace dates from the International Exposition of 1937. It replaced the Trocadéro Palace, a structure left over from the 1878 International Exposition. The Chaillot Palace is made up of two separate pavilions, from each of which extends a curved wing. The Musée de I'Homme, the Naval Museum, the Museum of French Monuments, and the Cinema Museum are located there. Under the terrace that separates the two sections are two theatres, the National Theatre of Chaillot and a small hall that serves as one of the two motion- picture houses of the national film library.
The terrace, which is lined by statues, gives a splendid view across Paris. The slope descending to the river has been made into a terraced park, the centre of which is alive with fountains, cascades, and pools. The Trocadéro Aquarium is in a grotto a few steps away in the park.
From the bottom of the slope the five-arched Jena Bridge (Pont d'Iéna) leads across the river. It was built for Napoleon in 1813 to commemorate his victory at theBaffle of Jena in 1806. On the Left Bank rises the Eiffel Tower, an unclad metal truss tower designed by Gustave Eiffel. The tower was built for the International Exposition of 1889, against the strident opposition of national figures who thought it unsafe or ugly or both. When the exposition concession expired in 1909, the 984-foot (300-metre) tower was to have been demolished, but its value as an antenna for radio transmission saved it. Additions made for television transmission have added 56 feet to the height. From the topmost of the three platforms the view extends for more than 40 miles.
From the two-acre base of the tower the Champ-de Mars ("Field of Mars"), an immense field, stretches to the Military Academy (Ecole Militaire), which was built from 1769 to 1772 and is still used by the War College (Ecole Supérieure de Guerre). The Champ-de-Mars, which originally served as the school's parade ground, was the scene of two vast rallies during the French Revolution: that of the Federation (1790) and that of the Supreme Being (1794). From 1798 there were annual national expositions of crafts and manufactures, which were followed by world's fairs between 1855 and 1900. Behind the Military Academy stands the headquarters of the United Nations Educational, Scientific and Cultural Organization (UNESCO). The building, erected in 1958, was designed by an international trio of architects and decorated by artists of member nations.
The Invalides.
One street to the northeast is the Hotel des Invalides, founded by Louis XIV to shelter 7,000 aged or invalid veterans. The enormous range of buildings was completed in five years (1671-76). The gold-plated dome (1675-1706) that rises above the hospital buildings belongs to the church of Saint-Louis. The dome was designed by Jules Ilardouin-Mansart, who employed a style known in France as "Jesuit" because it derives from the Jesuits' first church in Rome, built in 1568. The churches of the French Academy (Académie Francaise), the Val-de-Grâce Hospital, and the Sorbonne, as well as three others in Paris, all of the 17th century, followed this style. By using the classical elements more freely than had been done in Rome, the French made it something recognizably Parisian.
In the chapels of Saint-Louis are the tombs of Napoleon's brothers Joseph and Jérôme, of his son (whose body was returned from Vienna in 1940 by Adolf Hitler), and of the marshals of France. Immediately beneath the cupola is a red porphyry sarcophagus that covers the six coffins, one inside the other, enclosing the remains of Napoleon, which were returned from St. Helena in 1840 through the efforts of King Louis Philippe. Napoleon's uniforms, personal arms, and deathbed are displayed in the Army Museum at the front of the Invalides. A portion of the Invalides still serves as a military hospital; facilities have been modernized since World War II.
The vast, tree-lined Invalides Esplanade slopes gently to the Quai d and the Alexandre III Bridge. The first stone for the bridge, which commemorates the Russian tsar Alexander III, was laid in 1897 by Alexander's son, Tsar Nicholas II. The bridge was finished in time for the International Exposition of 1900, and it leads to two other souvenirs of that year's fair, the Grand Palais and the Petit Palais. The buildings are still used for annual shows and for major visiting art exhibits.
The Louvre.
Vikings camped on the Right Bank across from the western tip of the lie de la Cite in their unsuccessful siege of Paris in 885, and in about 1200 King Philip II had a square crusader's castle built on the same site, just outside the new city wall, to buttress the western defenses. Over the following centuries many additions and renovations were made, and from the castle grew one of the world's largest palaces, completed only in 1852. From the original square, known as the Cour Carrëe ("Square Court"), two galleries extend westward for 1,640 feet, one along the river, the other along the rue de Rivoli. In 1871, only 19 years after the huge oblong was completed, its western face, the Tuileries Palace (begun 1563), was destroyed by the insurrectionists of the Commune.
Two of the facades of the Cour Carrée had strong influence on French architecture. Pierre Lescot began his inner courtyard facade in 1546, adapting the Renaissance rhythms and orders he had observed in Italy and adding purely French decoration to the classical motifs. The physician and architect Claude Perrault collaborated with Louis Le Vau, architect to the king, to design the outer east face of the palace in 1673. It, too, employs classic elements, making especially graceful use of coupled columns and a pediment.
The Louvre Museum occupies the four sides of the palace around the Cour Carrée as well as the south gallery, which stretches along the river. Among the treasures of the museum are the Victory of Samothrace, the Venus de Milo, and the Mona Lisa. The enormous collections contain works from the 7th century BC to the mid-l9th century, with a huge cultural and geographic spread. The north gallery, along the rue de Rivoli, houses a separate museum, the Museum of Decorative Arts, as well as the Ministry of Finance.
Extensive remodeling has been undertaken throughout the Louvre to increase space for art works. Construction began in the early 1980s to create a new main entrance and underground reception hail in the vast Napoleon Courtyard, between the two galleries; the 70-foot-high glass pyramid designed by I.M. Pei to cover the entrance aroused both strong support and spirited criticism.
The Arts Bridge (Pont des Arts), which crosses the Seine from the Louvre to the Left Bank, is one of the most charming of all the Parisian bridges. It was the first (1803) to be made of iron, and it has always been reserved for pedestrians: it provides an intimate view of riverside Paris and of the Seine itself.
Ile de la Cite.
Downstream and just below the bridge is the tip of the Ile de la Cite, fashioned into a triangular gravel-pathed park bordered by flowering bushes, with rustic benches under the ancient trees. It is surrounded by a wide cobbled quay that is especially popular with sunbathers and lovers. Where the steps come onto the bridge from the park there is a bronze equestrian statue of King Henry W, who insisted on completion of the Pont-Neuf The statue is an 1818 reproduction of the 1614 original, which was the first statue to stand on a public way in Paris. Opposite is the narrow entrance to the Place Dauphine (1607), named for Henry's heir, the future Louis XIII. The place was formerly a triangle of uniform red-brick houses pointed in white stone, but the row of houses along its base was ripped out in 1871 to make room for construction of part of the Palace of Justice.
The ship-shaped lie de la Cite is 10 streets long and five wide. Eight bridges link itto the riverbanks and a ninth leads to the scow-shaped lie Saint-Louis, which lies to the southeast.
The palace of the early Roman governor (now the Palace of Justice) was rebuilt on the same site by Louis IX (St. Louis) in the 13th century and enlarged 100 years later by Philip IV the Fair, who added the grim, gray turreted Conciergerie, with its impressive Gothic chambers. The Great Hail, which, under the kings, was the meeting place of the Pariement (the high court of justice), was known throughout Europe for its Gothic beauty. Fires in 1618 and 1871 destroyed much of the original room, however, and most of the rest of the palace was devastated by flames in 1776. The Great Hall now serves as a waiting room for the courts, in one of which, the adjoining first Civil Chamber, the Revolutionary Tribunal sat from 1793, condemning 2,600 persons to the guillotine. After sentencing, the victims were taken back down the stone stairs to the dungeons of the Conciergerie to await the tumbrils. The Conciergerie still stands and is open to visitors.
In the palace courtyards is found one of the great monuments of France, the 13th-century Sainte-Chapelle ('Chapel"). Built at Louis IXs direction between 1243 and 1248, it is a masterpiece of Gothic Rayonnant style. With great daring, the architect (possibly Pierre de Montreuil) poised his vaulted ceilings on a trellis of slender columns, the walls between being made of stained glass. The exquisite chapel was designed to hold the Crown of Thorns, thought to be the very one worn by Jesus at his crucifixion. Louis IX had purchased the relic from the Venetians, who held it in pawn from Baldwin, the Latin king of Byzantium. Other holy relics, such as nails and pieces of wood from the True Cross, were added to the chapel's collection, the remnants of which are now in the treasury of Notre-Dame.
Under King Louis-Philippe (1830-48), the "sanitization" of the island was begun, and it was continued for his successor, Napoleon III, by Baron Georges Haussmann. The project involved a mass clearing of antiquated structures, widening of streets and squares, and the erection of massive new government offices, including parts of the Palace of Justice. The portion of the palace that borders the Quai des Orfêvres- formerly the goldsmiths' and silversmiths' quay-became the headquarters of the Paris municipal detective force, the Police Judiciaire ("Judicial Police"), which keeps a small museum on the fourth floor.
Across the boulevard du Palais is the Police Prefecture, another 19th-century structure. On the far side of the prefecture is the Place du Parvis-Notre-Dame, an open space enlarged six times by Haussmann, who also moved the Hôtel-Dieu, the first hospital in Paris, from the riverside to the inland side of the square. Its present buildings date from 1868.
Notre-Dame de Paris.
At the east end of the square is the cathedral of Notre Dame de Paris, which is situated on a spot that Parisians have always reserved to the practice of religious rites. The Gallo-Roman boatmen of the cite erected their altar to Jupiter there (it is now in the Cluny Museum), and, when Christianity was established, a church was built on the temple site. The first bishop of Paris, St. Denis, became its patron saint. The red in the colours of Paris represents the blood of this martyr who, in popular legend, after decapitation, picked up his head and walked.
When Maurice de Sully became bishop in 1159 he decided to replace the decrepit cathedral of Saint-Etienne and the 6th-century Notre-Dame with a church in the new Gothic style. The style was conceived in France, and a new structural development, the flying buttress, which added to the beauty of the exterior and permitted interior columns to soar to new heights, was introduced in the building of Noire-Dame. Construction began in 1163 and continued until 1345.
After being damaged during the French Revolution, the church was sold at auction to a building-materials merchant. Napoleon came to power in time to annul the sale, and he ordered that the edifice be redecorated for his coronation as emperor in 1804. Louis-Philippe later initiated restoration of the neglected church. The architect Eugene Viollet-le-Duc worked from 1845 to 1864 to restore the monument. Like all cathedrals in France, Notre-Dame is the property of the state, although its operation as a religious institution is left entirely to the Roman Catholic Church.
A few 16th- and 17th-century buildings survive north of the cathedral. They are what remain of the Cloister of the Cathedral Chapter, whose school was famous long before the new cathedral was built. Early in the 12th century, one of its theologians, Peter Abelard, left the cloister with his disciples, crossed to the Left Bank, and set up an independent school in the open air in the Convent of the Paraclete near the present Place Maubert. After a prolonged struggle with the monks of Saint-Denis the followers of Abelard in 1200 won the right, from both the king and the pope, to form and govern their own community. This was the beginning of the University of Paris.
Rue de Rivoli.
The Louvre and the Tuileries Gardens take up the south side of this street, and on the other side runs an arcade more than a mile long. Opposite the middle of the Louvre, the Place du Palais-Royal leads to the palace of Cardinal de Richelieu, which he willed to the royal family. Louis XIV lived there as a child, and during the minority of Louis XV the kingdom was ruled from there by the debauched but gifted regent Philippe II, duc d'Orléans from 1715 to 1723. Late in the 18th century Louis-Philippe d'Orléans, who was popularly renamed Philippe-Egalité during the Revolution for his radical opinions, undertook extensive building around the palace garden. It was a commercial operation, and the Prince hoped to pay his debts from the property rents. Around the garden he built a beautiful oblong of colonnaded galleries and at each end of the gallery farthest from his residence a theatre. The larger playhouse has been the home of the Comédie-Française, the state theatre company, since Napoleon's reign. The princely apartments now shelter high state bodies such as the Council of State.
Just behind the courtyard is the Bibliothêque Nationale (National Library), the national library of deposit, with an enormous collection of books and prints. Haussrnann greatly enlarged the Place du Palais-Royal in 1852, and he was careful to preserve the palace when he laid out the avenue de l'Opéra. At the top of the avenue, where the Grands Boulevards crossed an enormous new place, the new opera house was built from 1825 to 1898. The Paris Opera House, a splendid monument to the Second Empire, was designed in the neo-Baroque style by Charles Gamier. It is known especially for its decorative embellishments, chief among them the Grand Staircase. Just behind the Opera House are various large department stores.
The next place along the rue de Rivoli is the Place des Pyramides. The gilded equestrian statue of Joan of Arc stands not far from where she was wounded at the Saint Honoré Gate (Porte Saint-Honoré) in her unsuccessful attack on Paris (at that time held by the English), on Sept. 8, 1429.
Farther along toward the Place de la Concorde the rue de Castiglione leads to the Place Vendôme, an elegant octagonal place, little changed from the 1698 designs of Jules Hardouin-Mansart. In the centre, the Vendôme Column bears a statue of Napoleon. It was pulled down during the Commune and put back up under the Third Republic (187 1-1940). The place and the rue de la Paix have lost none of their discreet distinction, nor have their shops.
The "Triumphal Way."
From the Arc de Triomphe du Carrousel, in the courtyard between the open arms of the Louvre, extends one of the most remarkable perspectives to be seen in any modern city. It is sometimes called la Voie Triomphale ( Triumphal Way!!). From the middle of the Carrousel arch the line of sight runs the length of the Tuileries Gardens, lines up on the obelisk in the Place de Ia Concorde, and goes up the Champs-Elysees to the centre of the Arc de Triomphe and beyond to the skyscrapers of La Defense, in the western suburbs.
The Louvr&s modest triumphal arch stands in the open
space where costumed nobles performed in an equestrian
display-- carrousel--to celebrate the Dauphin's birth in
1662. The design of the arch, an imitation of that of the
Arch of Septimius Severus in Rome, was conceived in
1808 by Charles Percier and Pierre Fontaine. The flanks of the Carrousel arch are incised with a record of Napoleon's victories.
The Tuileries Gardens, which fronted the Tuileries Palace (looted and burned in 1871 during the Commune), have not altered much since André Le Nôtre redesigned them in 1664. Le Nôtre was born and died in the gardener's cottage in the Tuileries; he succeeded his father there as master gardener. His design carried the line of the central allée beyond the gardens and out into the countryside by tracing a path straight along the wooded hill west of the palace. On this hilltop, 170 years later, the Arc de Triomphe was erected.
The Place de la Concorde was designed as a moated octagon in 1755 by Jacques-Ange Gabriel. The river end was left open, and on the inland side two matching buildings were planned. Viewed clockwise starting from the Navy Ministry (Ministère de la Marine), the statues are Lille, Strasbourg, Lyon, Marseille, Bordeaux, Nantes, Brest, and Rouen. Louis-Philippe also had the Luxor Obelisk, a gift from Egypt, installed in the centre and flanked by two fountains
Between the twin buildings on the northeastern side of the place, the broad rue Royale mounts to the Church of Sainte-Marie-Madeleine, consecrated in 1842. The church is a stern oblong, fenced with columns 60 feet high. Its design, supposedly that of a Greek temple, is actually closer to the Roman notion of Greek.
The Place de la Madeleine is the western terminus of the Grands Boulevards, which imitate the arch of the river from there north and east to the Place de la Republique and the Bastille.
To the west off the rue Royale runs the rue du Faubourg Saint-Honoré, which, in addition to the British Embassy and the Elysee Palace (residence of the French president), has on its shop windows some of the most prestigious names in the Paris fashion trade.
Along the first 2,500 feet of the Champs-Elysées, between Concorde and the Rond-Point des Champs Elysées (a roundabout, or traffic circle), little has changed for a century: the avenue is bordered with chestnut trees, behind which on both sides are gardens, usually full of children at play. The pavilions in the gardens are used as tearooms, restaurants, and theatres. From the Rond-Point up to the Arc de Triomphe, however, the avenue has changed with the times. Under the Second Empire this was a street of luxurious town houses. They were supplanted by cafés, nightclubs, luxury shops, and cinemas, but the Street retained its feeling of luxury, and the tree-shaded sidewalks (wide as a normal Street) offered promenades that were the pride of Paris. Since the 1950s, however, banks, automobile showrooms, airline offices, and fast-food eateries have taken over much of the space.
At the top of the Champs-Elysëes is a circular place from which 12 imposing avenues radiate to form a star (étoile). It was called Place de l'Etoile from 1753 until 1970, when it was renamed Place Charles de Gaulle. In the centre of the place is the Arc de Triomphe, commissioned by Napoleon in 1806. It is twice as high and as wide as the Arch of Constantine, in Rome, which inspired it. Jean Chaigrin was the architect and François Rude sculpted the frieze and the spirited group, 'The Departure of the Volunteers of 1792" (called "La Marseillaise"). On Armistice Day in 1920, the Unknown Soldier was buried under the centre of the arch, and each evening the flame of remembrance is rekindled by a different patriotic group.
The Latin Quarter (Quartier Latin).
At the Concorde Bridge the boulevard Saint-Germain begins, curving eastward to join the river again at the Sully Bridge. A little less than halfway along the boulevard is the pre-Gothic church of Saint-Germain des-Prés. The old church, which belonged to a Benedictine abbey founded in the 8th century, was sacked four times by Vikings and was rebuilt between 990 and 1201. Parts of the present church date from that time.
Beyond the boulevard Saint-Michel is the university precinct, self-governing under the kings, where, in class and out, students and teachers spoke Latin until 1789. At the junction of the boulevards Saint-Germain and Saint Michel are the remains of one of the three baths of the Roman city. These are in the grounds of the Cluny Museum, a Gothic mansion built 1485-1500, which now houses a collection of medieval works of art, including the renowned six-panel unicorn tapestry "La Dame a Ia licorne."
The wide, straight boulevard Saint-Michel is the main street of the student quarter. It is lined with bookshops, cafés, cafeterias, and movie houses. The buildings of the university are found on smaller streets. The university was built up of colleges, each founded and supported by a donor, often a prelate or a religious order. In about 1257 Robert de Sorbon, chaplain to Louis LX, established a college, known as the Sorbonne, that eventually became the centre of theological study in France. The oldest part of the Sorbonne is the chapel (1635-42), the gift of Richelieu, who is buried there. Designed by Lemercier, it was one of a number of new domed Jesuit-style churches of the period.
The Sorbonne served for centuries as the administrative seat of the University of Paris. In 1968-71 the university was divided into a number of entirely separate universities, and the Sorbonne building proper continues to serve as premises for some of these.
At the top of the hill rising from the river the boulevard skirts the Luxembourg Gardens, the remains of the park of Marie de Médicis' Luxembourg Palace (1616- 21), which now houses the French Senate. The gardens are planted with chestnuts and are enhanced with a pond for toy sailboats, a marionette theatre, and statuary.
Across the boulevard at the end of the rue Soufflot stands the Pantheon (1755-92), designed by Jacques Germain Soufflot. It was commissioned by Louis XV, after his recovery from an illness, as a votive offering to St. Genevieve and was to replace the mouldering 5th- century abbey in her name. Though intended as the principal church in Paris, it was renamed the Pantheon by the Revolutionary authorities, who made it the last resting place for heroes of the Revolution. The walling up of a number of its windows and removal of much interior decoration replaced the intended effect of light interior space with a gloomy dignity. Among those buried under the inscription "Aux grands bommes, la Patrie reconnaissante" ("To great men, [ their grateful land") are the authors Victor Hugo, Voltaire, Rousseau, and Zola and Jean Moulin, chief of the Resistance in World War II.
The Buttes.
The river valley of Paris is almost entirely circled by high ground. Upon the heights of Passy, on the Right Bank between the western city limits and the Arc de Triomphe, perch the wealthy neighbourhoods of the 16th arrondissement. The Butte-Montmartre (18th arrondissement) and the Buttes-Chaumont( 19th arrondissement), which rise along the northern rim of the city, are still working-class. The 18th arrondissement has broad avenues, but it also has winding lanes, some of which become stairways on the steeper hills, From the early 19th century until the migration in the 1920s to Montparnasse, Montmartre was the major art colony of Paris. Some sections are highly commercialized for the tourist trade; others, however, are unself-consciously picturesque. Montmartre is known for its nightclubs and entertainment.
The most noted landmark of Montmartre was built only in 1919: the Sacred Heart Basilica (Basilique du Sacrd-Coeur), paid for by national subscription after the French defeat by the Prussians in 1870. The work began in 1876 but was delayed by the death of the architect, Paul Abadie, who took inspiration from the 12th-century five-domed Romanesque church of Saint-Front in Périgueux, itself inspired by either Venetian or Byzantine churches.
Basilique du Sacré-Coeur
Foreign Tours
The Bahamas
Officially COMMONWEALTH OF THE BAHAMAS, archipelago and state on the northwestern edge of the West Indies, consisting of about 700 islands and cays and more than 2,000 low, barren rock formations, located off the southeastern coast of Florida, U.S. The archipelago is spread across the Tropic of Cancer and about 90,000 square miles (233,000 square km) of ocean in the western Atlantic. Andros (104 miles long and 40 miles wide {167 km long and 64 km wide] is the largest of the islands. The capital is Nassau on New
Providence--the most important island. Area 5,382 square miles (13,939 square km). Pop. (1993 est.) 266,000.
The land.
New Providence has the majority of the archipelago's population. The rest of the islands, chief among which are Abaco, Andros, and Eleuthera, are called the Family, or Out, Islands. All the islands of the archipelago are composed of coraline limestone, lie mostly only a few feet above sea level, and are generally flat. The highest point, Mount Alvemia (formerly Como Hill), rises 206 feet (63 m) on Cat Island. Most of the islands are long and narrow, each rising from its eastern shore to a low ridge, beyond which lie lagoons and mangrove swamps; coral reefs mark the shorelines. There are no rivers in The Bahamas.
The mild subtropical climate of The Bahamas, with two seasons (winter and summer is greatly influenced by the Gulf Stream and Atlantic Ocean breezes. The average temperature varies from 70°F (21°C) during the winter to 81° F (27° C) during the summer; average annual rainfall is about 44 inches (1,120 mm), though there is some variation between the islands. The hurricane season lasts from mid-July to mid-November.
The islands abound in tropical flora, including bougainvillea, jasmine, orchid, and oleander. Caribbean pine forests occur on some islands, such as Andros, Great Abaco, and Grand Bahama. Native trees include the black olive, cork tree, and several species of palm; mahogany, casuarina, and cedar trees have been planted on some islands. Animal life is dominated by frogs, lizards, and snakes; mosquitoes, sandflies, and termites are widespread. There are numerous species of birds, including the flamingo, the national bird. The Inagua National Park on Great Inagua Island is the home of more than 50,000 West Indian flamingos, the largest such flock in the world. Salt, aragonite, and limestone are the only commercially important minerals. Salt is produced largely by solar evaporation from salt beds on Great Inagua.
The people.
The people of The Bahamas are a blend of European and African ancestry, the latter a legacy of the slave trade. English is the official language, and almost all of the population is Christian. Baptists account for about one-third of the population, and Anglicans and Roman Catholics each constitute approximately one-fifth of the total.
Only about 30 of the islands and cays are inhabited. During the 1970s there was significant rural-to-urban interisland migration, mostly directed to the already densely populated islands of New Providence (where two-thirds of the populace lives), Grand Bahama, and Great Abaco. Long Cay, on the other hand, had only a few dozen inhabitants. Average population density for the country is relatively low.
The population growth rate of The Bahamas was relatively high during the late 1970s (a trend that continued intermittently through the 1980s), mostly because of a substantial birth rate; consequently, almost two-fifths of the populace is younger than 15 years of age. The death rate is relatively low.
The Economy.
The Bahamas has a predominantly market economy that is heavily dependent on tourism and international financial services. The gross national product (GNP) is growing much more rapidly than the population. The GNP per capita is similar to those of other developed countries.
Agriculture accounts for about one-twentieth of the GNP and employs a comparable fraction of the workforce. Only about 1 percent of the land is arable, and soils are shallow. The government has had only limited success in increasing agricultural output, and nearly all of the country's foodstuffs are imported, largely from the United States. The sunny climate favours the cultivation of tomato, pineapple, banana, mango, guava, sapodilla, soursop, grapefruit, and sea grape. Some pigs, sheep, and cattle are raised. The small fishing industry's catch is dominated by crayfish, groupers, and conchs.
Mineral industries are limited to the production of salt and cement. Grand Bahama has several petroleum transshipment terminals. Manufacturing industries centre on the production of rum and other liquors, cement, pharmaceuticals (including hormones), canned tomatoes and pineapples, and frozen crayfish. The Industries Encouragement Act offers manufacturers relief from tariffs and various taxes. Electricity is generated entirely from imported fuels.
Tourism accounts for as much as two-thirds of the GNP and employs about two-fifths of the workforce. It centres on New Providence and Grand Bahama; most tourists come from the United States. Several hundred banks and trust companies have been attracted to The Bahamas because there are no income or corporation taxes and because the secrecy of financial transactions is guaranteed. Public expenditures are constrained by the government's dependence on indirect taxes, which are levied primarily on tourism and external trade. The United States is The Bahamas' principal trading partner and exempts certain Bahamian products from duties under the generalized system of preferences. Nassau and Freeport, the latter on Grand Bahama Island, are the country's two main ports and also have international airports.
Cultural life.
Outstanding among traditional group activities is the "Junkanoo" parade on Boxing Day and New Year's Day. The main thoroughfare is given over to hundreds of gaily bedecked celebrants who, with clanging cowbells and beating drums, march and dance to a rhythm of African origin. In Nassau, amateur choral, dramatic, and dancing groups provide entertainment with much local flavour.
History.
The Bahamas were originally inhabited by a group of Arawak Indians known as Lucayan. Originally from the South American continent, some of the Arawak had been driven north into the Caribbean by the Carib Indians. Unlike their Carib neighbours, the Lucayan were generally peaceful, more involved in fishing than agriculture, and noncannibalistic.
When Columbus reached the New World in 1492, he is thought to have landed on San Salvador (also called Watling Island) or possibly Sarnana Cay, both in the Bahamas. The Spaniards made no attempt to settle but operated slave raids on the peaceful Arawak that depopulated the islands, and by the time the English arrived the Bahamas were uninhabited.
In 1629 Charles I of England granted the islands to one of his ministers, but no attempt at settlement was made. In 1648 William Sayle led a group of English Puritans from Bermuda to, it is thought, Eleuthera Island. This settlement met with extreme adversity and did not prosper, but other Bermudian migrants continued to arrive. New Providence was settled in 1656. By 1670 the Bahamas were given to the Duke of Albemarle and five others as a proprietary colony. The proprietors were mostly uninterested in the islands, and few of the settlements prospered. Piracy became a way of life for many.
The colony reverted to the crown in 1717, and serious efforts were made to end the piracy. The first royal governor, Woodes Rogers, succeeded in controlling the pirates but mostly at his own expense. Little monetary and military support came from England. Consequently, the islands remained poor and susceptible to Spanish attack.
Held for a few days by the U.S. Navy in 1776, and for almost a year by Spain in 1782-83, the islands reverted to England in 1783 and received a boost in population from loyalists and their slaves who fled the United States after the American Revolution. For a time, cotton plantations brought some prosperity to the islands, but when the soil gave out and slavery was abolished in 1834, the Bahamas' endemic poverty returned.
Two other periods of prosperity followed: the years 1861-65, when the Bahamas became a centre for blockade runners during the American Civil War, and in 1920-33, when bootlegging became big business during the years of American Prohibition. But these were economic accidents; not until the tourist industry was developed after World War II did any form of permanent prosperity come to the islands.
Some cases as Possible Entertainment
New York: Broadway
The term Broadway is applied to about 38 theatres in Manhattan, New York, which are either on the street Broadway itself or in the surrounding streets. Broadway refers more to commercial orientation and to the size of theatre than to location. Broadway theatres usually have over 1100 seats and operate for profit. Most Broadway theatres are not on the street but in the Times Square area. The Broadway area including Times Square has had a reputation in the past as being rather seedy though Mayor' Giuliani's clean-up campaigns have changed. Broadway is commercial. for-profit. theatre whereas the not-for-profit theatre is old-Broadway. There is commercial theatre old-Broadway but it is small compared with either Broadway itself or the non-profit sector. There is a particular concentration of off-Broadway theatres in the Greenwich Village area. Off -Broadway theatres are associated with newer avant-garde productions and new American productions are more likely lo be found here than on Broadway. Some productions do though move from off-Broadway to Broadway.
New York's dominance of theatre in the USA has reduced as regional theatre, especially in Chicago and Los Angeles, has become more important in the development of new productions. Many of these then go on to Broadway.
Attendances at Broadway theatres were nearly 12 million in 1998 99 compared with 7 million in 1984 85 but this has not been an uninterrupted growth. There was for instance, a decline in numbers for most of the 1980s. Playing weeks have risen from 1078 in 1984 -85 lo 1441 in 1998-99 with a low of 905 in 1991- 92. The composition of Broadway audiences is similar to that in many oilier places. Two-thirds are aged 35 or older, three-quarters are Caucasian and over half (compared with 14 per cent of the US population) have an annual income of $7.5000 or more. 'There has, however, been a doubling, between 1991 and 1997 of the number of Broadway theatre-goers under the age of 18 partly due to the number of "youth-friendly' productions. Whilst personal recommendation is the single most important reason for choosing to see a show, one in live of audiences indicated that newspaper reviews were important.
As in London's West End, new openings and existing playing weeks on Broadway have been dominated by musicals. Broadway is associated with large musical and drama productions. The name Broadway has become closely associated with a particular type of production such as the older musicals 'A Chorus Line' and "42nd Street', which ran for many years. As with main theatrical districts, there is a view that the nature of productions has changed compared with the early part of the twentieth century. Whereas New York was regarded as a place where many new productions occurred each year. Broadway theatres now concentrate on long-running plays and musicals in particular. Other productions do not get the opportunity to be seen; this criticism is levelled at London's West End also. By producing classic plays and musicals, risk is reduced especially as it is believed that many people desire the technological spectacle and diversion of musicals in particular. Broadway has become increasingly a place for 'a special event' complete with merchandising. Often productions rely on famous name film or television stars to increase ticket sales. The name Broadway has been used as a term of abuse by critics. A review. in the British Sunday Times (April 2000). of the London West End production of 'The Graduate" included the comment 'the show is like the worst of Broadway, shallow and celebrity-driven, with ghastly merchandise being sold in the foyer'.
New York is a major tourist destination including some of the most famous landmarks in the world such as the Empire State Building and the Statue of Liberty. In 1999. there were over 34 million visitors to New York city and of these, nearly 6 million were international, mostly from Canada (0.9 million) and the UK (0.8 million). Broadway is regarded as a tourist attraction of the city and the name has become universally recognized as being 'theatre in New York'. To facilitate booking, there is a charge free information and booking 'hot-line' and the Broadway Picket Center located in the busy visitor area of Times Square.
Despite this the proportion of audiences who are visitors from the rest of the USA continues to fall though there has been a slight increase in the proportion of international visitors (to one in ten of audiences). An increasing proportion of audiences are resident in New York city or the surrounding suburbs. 'The suburban element has shown the greatest growth. About 17 % of 'locals' go to a Broadway show at least once a year and there is a core of regular theatre goers 6 %, who account for over 30 % of all tickets sold.
There are shows such as "Cats" (running since 1952 making it the longest running musical in Broadway history). "Les Miserables".'Chicago'. 'Phantom of the Opera' and 'Fosse' which are being performed in New York and London (and other cities) at the same time. In recent years there has been a large number of 'imports' of productions from abroad especially from Britain. These have included a new production of "Cabaret" (1998) by Sam Mendes, later the Oscar-winning director of the film 'American Beauty' as well as in 1999, plays such as Eugene O'Neill's 'The Iceman Cometh` and David Hare's `Via Dolorosa'. 'This is partly a matter of economics, being cheaper to bring in an established play or musical instead of starting the production process from the beginning. Some originated in the more heavily subsidized theatre of Europe and, in a sense, the USA is capitalizing on that investment of public funds. The risk of new and 'straight" plays is reduced by buying in from elsewhere. 'There is an argument too that American 'classics' are limited in number compared with those from Europe. There is however, also a reverse transfer with productions such as "Chicago and 'Kent" originating in the USA and then being produced in London.
The economic impact of Broadway on New York city was estimated at $ 2724 million in 1996-97 and as seen in Chapter 8, $ 1719 million of this was due to visitor spending. The total impact was calculated by adding the initial visitor spending other than on tickets to the set-up and operating costs of Broadway companies and the spending on capital improvements to theatres. This was subject to a multiplier effect. Compared with 1991 92. there was a 37 per cent increase in impact (after allowing for inflation). The spending of locals was not included as such. In the case of visitors from outside the city, the only spending that was included was that of people who indicated dial Broadway was the main reason for the visit. In addition, a part of the spending of visitors who extended their visit in order lo go lo Broadway theatre was included. The proportions of visitors for whom Broadway was the main reason, or was a reason for extending the visit, were not estimated at the same lime as the audience surveys were undertaken ( 1996-97 ) but from the earlier Port Authority surveys in 1992.
These Port Authority surveys also estimated economic impact and included commercial off-Broadway theatre and also 'Road productions'. These are Broadway shows that are performed elsewhere but which have an economic impact in New York in the form, for instance, of royalty payments. This impact has been declining partly because of local financing, because of touring productions originating elsewhere including the rest of the USA and the influx of productions from the UK.
London: West End
London, apart from being the centre of government in the UK and a major international commercial and financial centre, is also the most important tourist destination in the country. Total tourist visits to London are over 20 million and over half of these are international. The attractions of London are mostly 'heritage' though 'pop' culture, clubs, fashion, restaurants and lifestyle are claimed to be of increasing importance. London also has a large number of theatres which act as a tourist attraction. Over a quarter of all professional theatres in the UK are in London and there is a particular concentration within London's West End. Many of the more significant theatres in London are members of the Society of London Theatre (SOLT) known, until 1994, as the Society of West End Theatre (SWET). SOLT is a trade association with a membership of about 50 of London's theatres most of which are 'West End' theatres. They are located in central London with several distinct, but close, theatre clusters contributing to the leisure zone of the city. The concentration is itself considered to have a positive influence on attracting visitors to the city. SOLT theatres range in size from the relatively small at 250 capacity through to a few larger theatres at over 2000 seats. Most are operated as commercial concerns and few are subsidized. Attendances at SOLT theatres during 1997 were about 11.5 million compared with 10.5 million on Broadway the previous year though Broadway does include fewer theatres.
It was seen in Chapter 6 how important the West End is in attracting tourists to London and how the proportion of tourists in audiences has fluctuated. The share of international tourists in audiences is currently much less than it has been during the 1980s.
One of the most noticeable recent features of the West End is the increased importance of musicals and the reduced importance of plays and this has been linked with the tourist market (domestic and international). Nearly two-thirds of all attendances in West End theatres in 1997 were at 'modern musicals'. This is markedly different from the situation outside London. Tourists are a higher proportion of musical audiences than they are for other productions. For main observers, the tourist audiences are believed not to be particularly) discerning and want little more than a 'glitzy night out". One theatre critic was disappointed, in 1997, that the stage version of Disney's 'Beauty and the Beast' at the Dominion theatre was welcomed as favourable for West End jobs and tourism, and not seen as a threat to national heritage. Another critic condemned as undesirable and a sell-out to 'West End' values, the programming (in 1998) of the musical 'Oklahoma!' at the National Theatre. This had been created as 'a radical alternative to a complacent commercial theatre .
Not only are musicals denigrated but also then impact on the rest of theatre is considered undesirable. Musicals and other 'tourist' productions have long-runs ('the Mousetrap' since 1952. 'Cats' since 1981 and "Les Miserable*' since 1985) and so-called serious plays are squeezed out and the turnover of new plays is restricted. It is not just musicals that are seen as the problem but also revivals of popular plays, and associated long runs of many of these. Access to theatres and to finance and artistic talent is restricted for the non-musical and the new play. There are several reported instances of productions, such as the award-winning "the Fate Middle Classes", being unable to find a West End venue because of the desire to produce musicals, in that case a musical about a boy band which closed after a few weeks (I999). The actor and playwright Steven Berkoff complained, alter his controversial new play 'Messiah' was turned down by the National Theatre in 2000, that theatres were too sale and were unwilling to lake risks. It is obviously less risky for large commercial theatres to produce blockbuster musicals or plays than it is to put on experimental, innovative or controversial productions that may not sell on a large scale. The tourist market is one that is large and continually turning over and renewing itself every few days or weeks, an ideal scenario for investment in large-scale spectaculars. Corporations are able to absorb early losses and to subsidize the early days of one production from the revenue of another until the break-even point is reached.
There are however, some West End theatres, usually subsidized. which are some of the most adventurous and prestigious theatres in the country: the Donmar Warehouse, the Royal Court, the Royal National Theatre and the Barbican until recently a London base for the Royal Shakespeare Company. There have been a number of successful transfers, such as "Les Miserables' and 'the Herbal Bed', from the subsidized sector to the commercial sector. In addition to these theatres many of the more innovative and limited interest productions take place off-West End in smaller theatres or in regional theatre. It is claimed that a 'significant proportion' of West End productions have originated in regional or non-SOLT theatre before transfer.
West End productions also transfer to regional theatres often as a national tour and also to other countries. In 1997, 'Phantom of the Opera' was performed in Australia, New Zealand and 17 cities in the USA and 'Buddy' in Japan, Germany, Canada, South Africa and USA. Earnings from international performances such as these were estimated at between £40 to £60 million in 1997.
The concentration of theatre ownership and of influence over productions is likely to have had a direct impact on the pattern of programming. Ownership of the commercial theatres is diverse but certain organizations and individuals appear dominant. By early 2000, there were two large corporations dominating ownership of London theatres. The Ambassador Theatre Group, which is part owned by the US corporation SFX, owned eleven after purchasing nine smaller theatres in February and the Really Useful Group owned thirteen having purchased ten from Stoll Moss the previous month. As seen in Chapter 2, SFX had already purchased the large national Apollo group in 1999, four of whose theatres are in London. The Really Useful Group is owned by the composer Andrew Lloyd Webber (Cats, Starlight Express, Phantom of the Opera and many others). The producer Cameron Mackintosh bought two theatres in 1999 to join the three that his company currently co-owned. The impresario Bill Kenwright has also been responsible for a large number of West End productions in recent years. Theatre ownership is therefore being combined in the same organization with composition, production, play and concert promotion. There is, in addition, a concentration of influence into fewer hands including, for instance, through joint Mackintosh-Webber productions. All of this could lead to significant control and influence over the programming of theatres in the West End. For the firms concerned, such integration yields economies and spreads risks.
Las Vegas
Las Vegas (Nevada. USA) is perhaps the best-known instance of a tourist centre with an 'entertainment core'. The main attraction of Las Vegas is gaming and until recently Nevada was the only stale to legalize casino gaming in the USA (legalized in 1931). Las Vegas receives over 30 million visitors a year (1998) of whom 70 percent were there for vacation, pleasure or traveling. It is also a major centre for conventions. It claims to have more hotel and motel rooms (at 109.000) than any oilier resort destination in the world and 19 of the 20 largest hotels in the world. The MGM Grand, for instance, has over 5000 rooms. At Atlantic City most gamblers are day trippers bill Las Vegas is more a destination for the staying tourists. Most visitors do not have children with them and the average age is late forties. A high proportion (three-quarters) are repeat visitors and nearly all gamble during their stay. The average stay is short or just over three nights but nearly a third of visitors are from neighboring California, half from the Western states and one in ten is international. The city has its own international airport with direct flights from countries such as the UK and Japan.
The key attraction of Vegas has been gambling but it has always been associated with live entertainment. Casinos are usually based in hotels that also provide a variety of live entertainment in order to attract and retain gaming customers. Most Las Vegas entertainment is associated with hotels rather than with separate theatres or concert halls. The musical "Starlight Express' was, for instance, staged al the Las Vegas Hilton. The entertainment ranges from musicians in bar and lounge settings through circus and illusionists to national and international stars in large purpose-built theatres and concert arenas. Some of these operations are so huge that effectively they operate as separate enterprises. Caesar's Palace (1500 rooms) has a 4500 seat indoor theatre and a 15.300 seat outdoor events stadium and MGM Grand has a similar size events centre as well as its own 33 acre theme park. At Circus Circus there is live circus in addition to a 5 acre indoor theme park.
There is a style of show, the glitzy spectacular floor-show with dancers and singers, that is referred to universally as a 'Las Vegas-type show". The 'Official Visitors Guide' to Las Vegas refers to 'other parts of the casinos (where) entertainers adorned in glittering costumes join forces in lavish stage spectaculars . . . Extravaganzas costing millions to produce surround visitors in a fantasy of shapely dancers, intricate choreographs and special effects'. Las Vegas is also a centre for many associated spectacular events including boxing".
Just under half of Las Vegas visitors attend a show during their visit though spending on shows only accounts for about 8% of expenditure per visitor compared, for instance, with 38% on food and drink and 22% on shopping. Entertainment has been regarded as an incidental attraction and has been justified by its ability to attract people to gamble. It was initially regarded as a loss-leader in order to attract high-spending gamblers. There is now, however, more emphasis on entertainment as a profit centre. This, in conjunction with rising costs, has resulted in a shift from the star-centred shows towards smaller-scale variety (or revue) shows and musicals.
The city has long had a reputation for being an adult destination with gaming associated not only with adult entertainment but also organized crime and prostitution. It has in recent years sought to re-position itself as a tourist destination. Casino gaming is now legal in more places in the USA, including Atlantic City and many Native American reservations, and Las Vegas can no longer rely on its virtual monopoly to attract visitors. It is therefore developing as a family holiday destination. In order to do this, more family-oriented entertainment has been offered in the form of virtual reality experiences, theme parks and free open-air events such as an erupting volcano outside the Mirage hotel and a pirate battle performed outside the Treasure Island hotel. The emphasis on Las Vegas as a gaming centre has been reduced but it is still the hotels that maintain a connection with entertainment, albeit in a different form.
These developments have had mixed fortunes and, whilst such entertainment has undoubtedly broadened the appeal of Las Vegas, some gaming operators have found that certain forms of entertainment compete with, rather than complement, gaming. There are several other concerns associated with this re-positioning, such as the increased number of 'non-gamblers' and 'low-roller' gamblers in the city and the loss of its distinctive character. In addition some casino executives are not skilled in providing these types of experience and there have been some noticeable failures. There has been a concern that the city has gone too far along the route of a family-friendly destination and some business people have been anxious to maintain the reputation as an adult destination. This is partly due to the lower gaming spend of tourists with children. Nonetheless some of the more recent developments, such as the New York, New York with its own rollercoaster and the Venetian Casino Resort complete with upscale shopping mall and Grand Canal, have continued the wider appeal.
Las Vegas is very much a one-industry city with just over half of the labour force in southern Nevada being employed in the city's tourist and gaming sector. It has been pointed out that this means low-skill, low-wage and un-unionized employment for many and also an excessive influence of the 'Mining and hold corporations on the political and development process. Since the l950s there arc now fewer individuals and more corporations owning and operating casinos in the city. The needs of the industry may have been prioritized over the social community and welfare needs of the local population and the sustainability of the local natural environment. There would appear lo he a coalition of interests between local hotel-casino operators, other business people, development agencies, the visitor bureau, airlines and local government that exerts a powerful influence in encouraging free- enterprise and growth.
British seaside resorts: early developments
There are features of the seaside resort in Britain in the past that have been unique features of the entertainment industry. The significance of this lies in the fact that their influence lingers on to the present-day. As seaside resorts became more popular during the kilter part of the nineteenth century there was considerable investment in theatres, pavilions, concert halls and 'pleasure palaces'. Some of these, such as the Winter Gardens in Blackpool (1878), initially represented a more serious purpose by including gardens and library. The Winter Gardens in Rhyl (North Wales) built in 1876 included a zoo, theatre, seal pond and skating rink. At this time music hall was flourishing and halls were built in resorts, firmly establishing the tradition of the variety show al the seaside.
As the seaside began lo attract the working classes there was a need to change what was on offer and from the end of the nineteenth century investment in entertainment rose dramatically. Theatres and halls existed in many resorts offering variety, melodrama and farce and more "serious" plays, drama and musicals during the season lo a predominantly middle class audience alongside a more informal, often out-door and beach entertainment. These included circuses, fairgrounds, "black-face' minstrels. Pierrots and Punch and Judy shows geared to a more working class audience. The Punch and Judy Show has been synonymous with the seaside though it had originated al inland fairs. The "black-lace' minstrels were a prominent feature of English seaside resorts, dominating popular entertainment until the "more refined' Pierrots, originating in France, appeared. Entertainment became increasingly commercial.
Some of the attractions became more bizarre and included waxworks and freak shows as well as an assortment of fortune tellers and healers and talks, lectures and lantern slides by dubious 'experts'. A major attraction in several resorts during the l930s was the "Rector of Stiffkey' who had been dismissal from the church for sexual misconduct. He earned a living in a sideshow in Blackpool which included him living in a barrel and also being "devoured in the flames of hell", lie later appeared in a show in Skegness only to he killed by one of the lions in l938.
Piers were also particularly associated with entertainment. Although most were originally intended for the arrival and departure of ships, they soon became geared towards entertainment. Holiday-makers were able to extend their walking and display from the promenade itself to a promenade over the sea. Piers often included money-generating facilities such as pavilions and concert halls, refreshment rooms, machines and mechanical devices, booths and kiosks. There was often an 'end-of-the-pier show' performed by concert parties of small groups of artists all of whom sang, danced, told jokes and performed short sketches. They were particularly popular from the l920s through to the late l930s.
Military and brass bands also played in open-air bandstands and in pier pavilions. Most resorts also had an orchestra, however small, which invariably played in pavilions on piers. Most resorts had an orchestra at some time during the late nineteenth and early twentieth centuries and the continuing existence of orchestras owes a great deal to the holiday-maker. The conductors, musicians and singers were among the most able and famous of the day. They included (Sir) Malcolm Sargent at the seaside town of Llandudno (Wales) who was later conductor of many famous orchestras and chief conductor of the annual BBC Proms festival 1948-66 and Granville Bantock (at New Brighton, a resort near Liverpool) who was later Professor of Music at Birmingham University. As employment in such orchestras was usually seasonal, musicians from non-tourist area orchestras were able to find year-round employment. In the early part of the twentieth century the Pier Orchestra at Llandudno was made up largely of members of the Halle Orchestra (Manchester), which is Britain's longest established professional symphony orchestra (founded 1858). The seaside resort of Bournemouth, on the south coast of England, had the distinction of having the first year-round permanent orchestra in England (1893) and it has since become an important touring symphony orchestra. Musical programmes were usually short and light for background or promenading, but most orchestras endeavoured to provide symphony concerts in addition and to work the 'more serious' works into their programmes.
The holiday camp is also of particular significance in the history of holidays and entertainment. All-inclusive centres for a holiday had existed for some lime. Some originated in the early twentieth century as a form of sell help, sell-improvement movement where a sense of community in a healthy environment could he fostered. These holidays, often in tents, included organized games and entertainments that were often self-entertainment. Commercial camps emerged during the 1930s and of particular significance were the holiday camps established by Bill Butlin (initially in Skegness in 1937 for 1000 campers and in Clacton in 1939). Holiday-makers did not need to leave the holiday camps during their slay as apart from the chalet-type accommodation, there were catering halls, swimming pools, games and sports areas, theatres and dance halls. Access to all of these was without further charge. In the seaside tradition, entertainment followed the variety revue pattern and also dance bands and children's entertainers. There was also an emphasis on holiday-makers making their own entertainment. Organizers variously known as Red Coats (Butlins) or Blue Coats (Pontius) organized games and competitions for campers and entertainment by campers as well pulling on shows themselves. The holiday camp was particularly popular during the l950s. They were major providers of seaside entertainment and were a significant 'breeding-ground' for new performing talent.
ENGLISH COURSE FOR ECTS AND MANAGEMENT
Marketing and merchandising
Marketing is a process whose principal function is to promote and facilitate exchange. Through marketing, individuals and groups obtain what they need and want by exchanging products and services with other parties. Such a process can occur only when there are at least two parties, each of whom has something to offer. In addition, exchange cannot occur unless the parties are able to communicate about and to deliver what they offer. Marketing is not a coercive process: all parties must be free to accept or reject what others are offering. So defined, marketing is distinguished from other modes of obtaining desired goods, such as through self-production, begging, theft, or force. Marketing is not confined to any particular type of economy, because goods must be exchanged and therefore marketed in all economies and societies except perhaps in the most primitive. Furthermore, marketing is not a function that is limited to profit-oriented business; even such institutions as hospitals, schools, and museums engage in some forms of marketing. Within the broad scope of marketing, merchandising is concerned more specifically with promoting the sale of goods and services to consumers (i.e., retailing) and hence is more characteristic of free-market economies. Based on these criteria, marketing can take a variety of forms: it can be a set of functions, a department within an organization, a managerial process, a managerial philosophy, and a social process.
THE EVOLVING DISCIPLINE OF MARKETING
The marketing discipline had its origins in the early 20th century as an offspring of economics. Economic science had neglected the role of middlemen and the role of functions other than price in the determination of demand levels and characteristics. Early marketing economists examined agricultural and industrial markets and described them in greater detail than the classical economists. This examination resulted in the development of three approaches to the analysis of marketing activity: the commodity, the institution, and the function. Commodity analysis studies the ways in which a product or product group is brought to market. A commodity analysis of milk, for example, traces the ways in which milk is collected at individual dairy farms, transported to and processed at local dairy cooperatives, and shipped to grocers and supermarkets for consumer purchase. Institutional analysis describes the types of businesses that play a prevalent role in marketing, such as wholesale or retail institutions. For instance, an institutional analysis of clothing wholesalers examines the ongoing concerns that wholesalers face in order to ensure both the correct supply for their customers and the appropriate inventory and shipping capabilities. Finally, a functional analysis examines the general tasks that marketing performs. For example, any marketing effort must ensure that the product is transported from the supplier to the customer. In some industries, this transportation function may be handled by a truck, while in others it may be done by mail, facsimile, television signal, or airline. All these institutions perform the same function.
As the study of marketing became more prevalent throughout the 20th century, large companies--particularly mass consumer manufacturers--began to recognize the importance of market research, better product design, effective distribution, and sustained communication with consumers in the success of their brands. Marketing concepts and techniques later moved into the industrial-goods sector and subsequently into the services sector. It soon became apparent that organizations and individuals market not only goods and services but also ideas (social marketing), places (location marketing), personalities (celebrity marketing), events (event marketing), and even the organizations themselves (public relations).
ROLES OF MARKETING
As marketing developed, it took a variety of forms. It was noted above that marketing can be viewed as a set of functions in the sense that certain activities are traditionally associated with the exchange process. A common but incorrect view is that selling and advertising are the only marketing activities. Yet, in addition to promotion, marketing includes a much broader set of functions, including product development, packaging, pricing, distribution, and customer service. Many organizations and businesses assign responsibility for these marketing functions to a specific group of individuals within the organization. In this respect, marketing is a unique and separate entity. Those who make up the marketing department may include brand and product managers, marketing researchers, sales representatives, advertising and promotion managers, pricing specialists, and customer service personnel.
As a managerial process, marketing is the way in which an organization determines its best opportunities in the marketplace, given its objectives and resources. The marketing process is divided into a strategic and a tactical phase. The strategic phase has three components--segmentation, targeting, and positioning (STP). The organization must distinguish among different groups of customers in the market (segmentation), choose which group(s) it can serve effectively (targeting), and communicate the central benefit it offers to that group (positioning). The marketing process includes designing and implementing various tactics, commonly referred to as the "marketing mix," or the "4 Ps": product, price, place (or distribution), and promotion. The marketing mix is followed by evaluating, controlling, and revising the marketing process to achieve the organization's objectives The managerial philosophy of marketing puts central emphasis on customer satisfaction as the means for gaining and keeping loyal customers. Marketers urge their organizations to carefully and continually gauge target customers' expectations and to consistently meet or exceed these expectations. In order to accomplish this, everyone in all areas of the organization must focus on understanding and serving customers; it will not succeed if all marketing occurs only in the marketing department. Marketing, consequently, is far too important to be done solely by the marketing department. Marketers also want their organizations to move from practicing transaction-oriented marketing, which focuses on individual exchanges, to relationship-driven marketing, which emphasizes serving the customer over the long term. Simply getting new customers and losing old ones will not help the organization achieve its objectives. Finally, marketing is a social process that occurs in all economies, regardless of their political structure and orientation. It is the process by which a society organizes and distributes its resources to meet the material needs of its citizens. However, marketing activity is more pronounced under conditions of goods surpluses than goods shortages. When goods are in short supply, consumers are usually so desirous of goods that the exchange process does not require significant promotion or facilitation. In contrast, when there are more goods and services than consumers need or want, companies must work harder to convince customers to exchange with them.
THE MARKETING PROCESS
The marketing process consists of four elements: strategic marketing analysis, marketing-mix planning, marketing implementation, and marketing control.
Strategic marketing analysis
MARKET SEGMENTS
The aim of marketing in profit-oriented organizations is to meet needs profitably. Companies must therefore first define which needs--and whose needs--they can satisfy. For example, the personal transportation market consists of people who put different values on an automobile's cost, speed, safety, status, and styling. No single automobile can satisfy all these needs in a superior fashion; compromises have to be made. Furthermore, some individuals may wish to meet their personal transportation needs with something other than an automobile, such as a motorcycle, a bicycle, or a bus or other form of public transportation. Because of such variables, an automobile company must identify the different preference groups, or segments, of customers and decide which group(s) they can target profitably.
MARKET NICHES
Segments can be divided into even smaller groups, called subsegments or niches. A niche is defined as a small target group that has special requirements. For example, a bank may specialize in serving the investment needs of not only senior citizens but also senior citizens with high incomes and perhaps even those with particular investment preferences. It is more likely that larger organizations will serve the larger market segments (mass marketing) and ignore niches. As a result, smaller companies typically emerge that are intimately familiar with a particular niche and specialize in serving its needs.
MARKETING TO INDIVIDUALS
A growing number of companies are now trying to serve "segments of one." They attempt to adapt their offer and communication to each individual customer. This is understandable, for instance, with large industrial companies that have only a few major customers. For example, The Boeing Company (United States) designs its 747 planes differently for each major customer, such as United Airlines, Inc., or American Airlines, Inc. Serving individual customers is increasingly possible with the advent of database marketing, through which individual customer characteristics and purchase histories are retained in company information systems. Even mass-marketing companies, particularly large retailers and catalog houses, compile comprehensive data on individual customers and are able to customize their offerings and communications.
POSITIONING
A key step in marketing strategy, known as positioning, involves creating and communicating a message that clearly establishes the company or brand in relation to competitors. Thus, Volvo Aktiebolaget (Sweden) has positioned its automobile as the "safest," and Daimler-Benz AG (Germany), manufacturer of Mercedes-Benz vehicles, has positioned its car as the best "engineered." Some products may be positioned as "outstanding" in two or more ways. However, claiming superiority along several dimensions may hurt a company's credibility because consumers will not believe that any one offering can excel in all dimensions. Furthermore, although the company may communicate a particular position, customers may perceive a different image of the company as a result of their actual experiences with the company's product or through word of mouth.
Marketing-mix planning
Having developed a strategy, a company must then decide which tactics will be most effective in achieving strategy goals. Tactical marketing involves creating a marketing mix of four components--product, price, place, promotion--that fulfills the strategy for the targeted set of customer needs.
PRODUCT
Product development.
The first marketing-mix element is the product, which refers to the offering or group of offerings that will be made available to customers. In the case of a physical product, such as a car, a company will gather information about the features and benefits desired by a target market. Before assembling a product, the marketer's role is to communicate customer desires to the engineers who design the product or service. This is in contrast to past practice, when engineers designed a product based on their own preferences, interests, or expertise and then expected marketers to find as many customers as possible to buy this product. Contemporary thinking calls for products to be designed based on customer input and not solely on engineers' ideas.
In traditional economies, the goods produced and consumed often remain the same from one generation to the next--including food, clothing, and housing. As economies develop, the range of products available tends to expand, and the products themselves change. In contemporary industrialized societies, products, like people, go through life cycles: birth, growth, maturity, and decline. This constant replacement of existing products with new or altered products has significant consequences for professional marketers. The development of new products involves all aspects of a business--production, finance, research and development, and even personnel administration and public relations.
Packaging and branding.
Packaging and branding are also substantial components in the marketing of a product. Packaging in some instances may be as simple as customers in France carrying long loaves of unwrapped bread or small produce dealers in Italy wrapping vegetables in newspapers or placing them in customers' string bags. In most industrialized countries, however, the packaging of merchandise has become a major part of the selling effort, as marketers now specify exactly the types of packaging that will be most appealing to prospective customers. The importance of packaging in the distribution of the product has increased with the spread of self-service purchases--in wholesaling as well as in retailing. Packaging is sometimes designed to facilitate the use of the product, as with aerosol containers for room deodorants. In Europe such condiments as mustard, mayonnaise, and ketchup are often packaged in tubes. Some packages are reusable, making them attractive to customers in poorer countries where metal containers, for instance, are often highly prized.
Marketing a service product.
The same general marketing approach about the product applies to the development of service offerings as well. For example, a health maintenance organization (HMO) must design a contract for its members that describes which medical procedures will be covered, how much physician choice will be available, how out-of-town medical costs will be handled, and so forth. In creating a successful service mix, the HMO must choose features that are preferred and expected by target customers, or the service will not be valued in the marketplace.
PRICE
The second marketing-mix element is price. Ordinarily companies determine a price by gauging the quality or performance level of the offer and then selecting a price that reflects how the market values its level of quality. However, marketers also are aware that price can send a message to a customer about the product's presumed quality level. A Mercedes-Benz vehicle is generally considered to be a high-quality automobile, and it therefore can command a high price in the marketplace. But, even if the manufacturer could price its cars competitively with economy cars, it might not do so, knowing that the lower price might communicate lower quality. On the other hand, in order to gain market share, some companies have moved to "more for the same" or "the same for less" pricing, which means offering prices that are consistently lower than those of their competitors. This kind of discount pricing has caused firms in such industries as airlines and pharmaceuticals (which used to charge a price premium based on their past brand strength and reputation) to significantly reevaluate their marketing strategies.
PLACE
Place, or where the product is made available, is the third element of the marketing mix and is most commonly referred to as distribution. When a product moves along its path from producer to consumer, it is said to be following a channel of distribution. For example, the channel of distribution for many food products includes food-processing plants, warehouses, wholesalers, and supermarkets. By using this channel, a food manufacturer makes its products easily accessible by ensuring that they are in stores that are frequented by those in the target market. In another example, a mutual funds organization makes its investment products available by enlisting the assistance of brokerage houses and banks, which in turn establish relationships with particular customers. However, each channel participant can handle only a certain number of products: space at supermarkets is limited, and investment brokers can keep abreast of only a limited number of mutual funds. Because of this, some marketers may decide to skip steps in the channel and instead market directly to buyers through direct mail, telemarketing, door-to-door selling, shopping via television (a growing trend in the late 20th century), or factory outlets.
PROMOTION
Promotion, the fourth marketing-mix element, consists of several methods of communicating with and influencing customers. The major tools are sales force, advertising, sales promotion, and public relations.
Sales force.
Sales representatives are the most expensive means of promotion, because they require income, expenses, and supplementary benefits. Their ability to personalize the promotion process makes salespeople most effective at selling complex goods, big-ticket items, and highly personal goods--for example, those related to religion or insurance. Salespeople are trained to make presentations, answer objections, gain commitments to purchase, and manage account growth. Some companies have successfully reduced their sales-force costs by replacing certain functions (for example, finding new customers) with less expensive methods (such as direct mail and telemarketing).
Advertising.
Advertising includes all forms of paid, nonpersonal communication and promotion of products, services, or ideas by a specified sponsor. Advertising appears in such media as print (newspapers, magazines, billboards, flyers) or broadcast (radio, television). Print advertisements typically consist of a picture, a headline, information about the product, and occasionally a response coupon. Broadcast advertisements consist of an audio or video narrative that can range from short 15-second spots to longer segments known as infomercials, which generally last 30 or 60 minutes.
Sales promotion.
While advertising presents a reason to buy a product, sales promotion offers a short-term incentive to purchase. Sales promotions often attract brand switchers (those who are not loyal to a specific brand) who are looking primarily for low price and good value. Thus, especially in markets where brands are highly similar, sales promotions can cause a short-term increase in sales but little permanent gain in market share. Alternatively, in markets where brands are quite dissimilar, sales promotions can alter market shares more permanently. The use of promotions has risen considerably during the late 20th century. This is due to a number of factors within companies, including an increased sophistication in sales promotion techniques and greater pressure to increase sales. Several market factors also have fostered this increase, including a rise in the number of brands (especially similar ones) and a decrease in the efficiency of traditional advertising due to increasingly fractionated consumer markets.
Public relations.
Public relations, in contrast to advertising and sales promotion, generally involves less commercialized modes of communication. Its primary purpose is to disseminate information and opinion to groups and individuals who have an actual or potential impact on a company's ability to achieve its objectives. In addition, public relations specialists are responsible for monitoring these individuals and groups and for maintaining good relationships with them. One of their key activities is to work with news and information media to ensure
appropriate coverage of the company's activities and products. Public relations specialists create publicity by arranging press conferences, contests, meetings, and other events that will draw attention to a company's products or services. Another public relations responsibility is crisis management--that is, handling situations in which public awareness of a particular issue may dramatically and negatively impact the company's ability to achieve its goals. For example, when it was discovered that some bottles of Perrier sparkling water might have been tainted by a harmful chemical, Source Perrier, SA's public relations team had to ensure that the general consuming public did not thereafter automatically associate Perrier with tainted water. Other public relations activities include lobbying, advising management about public issues, and planning community events. Because public relations does not always seek to impact sales or profitability directly, it is sometimes seen as serving a function that is separate from marketing. However, some companies recognize that public relations can work in conjunction with other marketing activities to facilitate the exchange process directly and indirectly. These organizations have established marketing public relations departments to directly support corporate and product promotion and image management.
Marketing implementation.
Companies have typically hired different agencies to help in the development of advertising, sales promotion, and publicity ideas. However, this often results in a lack of coordination between elements of the promotion mix. When components of the mix are not all in harmony, a confusing message may be sent to consumers. For example, a print advertisement for an automobile may emphasize the car's exclusivity and luxury, while a television advertisement may stress rebates and sales, clashing with this image of exclusivity. Alternatively, by integrating the marketing elements, a company can more efficiently utilize its resources. Instead of individually managing four or five different promotion processes, the company manages only one. In addition, promotion expenditures are likely to be better allocated, because differences among promotion tools become more explicit. This reasoning has led to integrated marketing communications, in which all promotional tools are considered to be part of the same effort, and each tool receives full consideration in terms of its cost and effectiveness.
Marketing evaluation and control
No marketing process, even the most carefully developed, is guaranteed to result in maximum benefit for a company. In addition, because every market is changing constantly, a strategy that is effective today may not be effective in the future. It is important to evaluate a marketing program periodically to be sure that it is achieving its objectives.
MARKETING CONTROL
There are four types of marketing control, each of which has a different purpose: annual-plan control, profitability control, efficiency control, and strategic control.
Annual-plan control.
The basis of annual-plan control is managerial objectives--that is to say, specific goals, such as sales and profitability, that are established on a monthly or quarterly basis. Organizations use five tools to monitor plan performance. The first is sales analysis, in which sales goals are compared with actual sales and discrepancies are explained or accounted for. A second tool is market-share analysis, which compares a company's sales with those of its competitors. Companies can express their market share in a number of ways, by comparing their own sales to total market sales, sales within the market segment, or sales of the segment's top competitors. Third, marketing expense-to-sales analysis gauges how much a company spends to achieve its sales goals. The ratio of marketing expenses to sales is expected to fluctuate, and companies usually establish an acceptable range for this ratio. In contrast, financial analysis estimates such expenses (along with others) from a corporate perspective. This includes a comparison of profits to sales (profit margin), sales to assets (asset turnover), profits to assets (return on assets), assets to worth (financial leverage), and, finally, profits to worth (return on net worth). Finally, companies measure customer satisfaction as a means of tracking goal achievement. Analyses of this kind are generally less quantitative than those described above and may include complaint and suggestion systems, customer satisfaction surveys, and careful analysis of reasons why customers switch to a competitor's product.
Profitability control.
Profitability control and efficiency control allow a company to closely monitor its sales, profits, and expenditures. Profitability control demonstrates the relative profit-earning capacity of a company's different products and consumer groups. Companies are frequently surprised to find that a small percentage of their products and customers contribute to a large percentage of their profits. This knowledge helps a company allocate its resources and effort.
Efficiency control.
Efficiency control involves micro-level analysis of the various elements of the marketing mix, including sales force, advertising, sales promotion, and distribution. For example, to understand its sales-force efficiency, a company may keep track of how many sales calls a representative makes each day, how long each call lasts, and how much each call costs and generates in revenue. This type of analysis highlights areas in which companies can manage their marketing efforts in a more productive and cost-effective manner.
Strategic control.
Strategic control processes allow managers to evaluate a company's marketing program from a critical long-term perspective. This involves a detailed and objective analysis of a company's organization and its ability to maximize its strengths and market opportunities. Companies can use two types of strategic control tools. The first, which a company uses to evaluate itself, is called a marketing-effectiveness rating review. In order to rate its own marketing effectiveness, a company examines its customer philosophy, the adequacy of its marketing information, and the efficiency of its marketing operations. It will also closely evaluate the strength of its marketing strategy and the integration of its marketing tactics.
MARKETING AUDIT
The second evaluation tool is known as a marketing audit. This is a comprehensive, systematic, independent, and periodic analysis that a company uses to examine its strengths in relation to its current and potential market(s). Such an analysis is comprehensive because it covers all aspects of the marketing climate (unlike a functional audit, which analyzes one marketing activity), looking at both macro-environment factors (demographic, economic, ecological, technological, political, and cultural) and micro- or task-environment factors (markets, customers, competitors, distributors, dealers, suppliers, facilitators, and publics). The audit includes analyses of the company's marketing strategy, marketing organization, marketing systems, and marketing productivity. It must be systematic in order to provide concrete conclusions based on these analyses. To ensure objectivity, a marketing audit is best done by a person, department, or organization that is independent of the company or marketing program. Marketing audits should be done not only when the value of a company's current marketing plan is in question; they must be done periodically in order to isolate and solve problems before they arise.
THE MARKETING ACTORS
The elements that play a role in the marketing process can be divided into three groups: customers, distributors, and facilitators. In addition to interacting with one another, these groups must interact within a business environment that is affected by a variety of forces, including governmental, economic, and social influences.
Customers
In order to understand target customers, certain questions must be answered: Who constitutes the market segment? What do they buy and why? And how, when, and where do they buy? Knowing who constitutes the market segment is not simply a matter of knowing who uses a product. Often, individuals other than the user may participate in or influence a purchasing decision. Several individuals may play various roles in the decision-making process. For instance, in the decision to purchase an automobile for a small family business, the son may be the initiator, the daughter may be an influencer, the wife may be the decider, the purchasing manager may be the buyer, and the husband may be the user. In other words, the son may read in a magazine that businesses can save money and decrease tax liability by owning or leasing company transportation. He may therefore initiate the product search process by raising this issue at a weekly business meeting. However, the son may not be the best-qualified to gather and process information about automobiles, because the daughter worked for several years in the auto industry before joining the family business. Although the daughter's expertise and research efforts may influence the process, she may not be the key decision maker. The mother, by virtue of her position in the business and in the family, may make the final decision about which car to purchase. However, the family uncle may have good negotiation skills, and he may be the purchasing agent. Thus, he will go to different car dealerships in order to buy the chosen car at the best possible price. Finally, despite the involvement of all these individuals in the purchase process, none of them may actually drive the car. It may be purchased so that the father may use it for his frequent sales calls. In other instances, an individual may handle more than one of these purchasing functions and may even be responsible for all of them. The key is that a marketer must recognize that different people have different influences on the purchase decision, and these factors must be taken into account in crafting a marketing strategy.
In addition to knowing to whom the marketing efforts are targeted, it is important to know which products target customers tend to purchase and why they do so. Customers do not purchase "things" as much as they purchase services or benefits to satisfy needs. For instance, a conventional oven allows users to cook and heat food. Microwave oven manufacturers recognized that this need could be fulfilled--and done so more quickly--with a technology other than conventional heating. By focusing on needs rather than on products, these companies were able to gain a significant share in the food cooking and heating market. Knowledge of when, where, and how purchases are made is also useful. A furniture store whose target customers tend to
make major purchases in the spring may send its mailings at the beginning of this season. A food vendor may set up a stand near the door of a busy office complex so that employees must pass the stand on their way to lunch. And a jeweler who knows that customers prefer to pay with credit cards may ensure that all major credit cards are accepted at the store. In other cases, marketers who understand specifics about buying habits and preferences also may try to alter them. Thus, a remotely situated wholesale store may use deeply discounted prices to lure customers away from the more conveniently located shopping malls.
Customers can be divided into two categories: consumer customers, who purchase goods and services for use by themselves and by those with whom they live; and business customers, who purchase goods and services for use by the organization for which they work. Although there are a number of similarities between the purchasing approaches of each type of customer, there are important differences as well.
CONSUMER CUSTOMERS
Factors influencing consumers.
Four major types of factors influence consumer buying behaviour: cultural, social, personal, and psychological.
Cultural factors.
Cultural factors have the broadest influence, because they constitute a stable set of values, perceptions, preferences, and behaviours that have been learned by the consumer throughout life. For example, in Western cultures consumption is often driven by a consumer's need to express individuality, while in Eastern cultures consumers are more interested in conforming to group norms. In addition to the influence of a dominant culture, consumers may also be influenced by several subcultures. In Quebec the dominant culture is French-speaking, but one influential subculture is English-speaking. Social class is also a subcultural factor: members of any given social class tend to share similar values, interests, and behaviours.
Social factors.
A consumer may interact with several individuals on a daily basis, and the influence of these people constitutes the social factors that impact the buying process. Social factors include reference groups--that is, the formal or informal social groups against which consumers compare themselves. Consumers may be influenced not only by their own membership groups but also by reference groups of which they wish to be a part. Thus, a consumer who wishes to be considered a successful white-collar professional may buy a particular kind of clothing because the people in this reference group tend to wear that style. Typically, the most influential reference group is the family. In this case, family includes the people who raised the consumer (the "family of orientation") as well as the consumer's spouse and children (the "family of procreation"). Within each group, a consumer will be expected to play a specific role or set of roles dictated by the norms of the group. Roles in each group generally are tied closely to status.
Personal factors.
Personal factors include individual characteristics that, when taken in aggregate, distinguish the individual from others of the same social group and culture. These include age, life-cycle stage, occupation, economic circumstances, and lifestyle. A consumer's personality and self-conception will also influence his or her buying behaviour.
Psychological factors.
Finally, psychological factors are the ways in which human thinking and thought patterns influence buying decisions. Consumers are influenced, for example, by their motivation to fulfill a need. In addition, the ways in which an individual acquires and retains information will affect the buying process significantly. Consumers also make their decisions based on past experiences--both positive and negative.
Consumer buying tasks.
A consumer's buying task is affected significantly by the level of purchase involvement. The level of involvement describes how important the decision is to the consumer; high involvement is usually associated with purchases that are expensive, infrequent, or risky. Buying also is affected by the degree of difference between brands in the product category. The buying task can be grouped into four categories based on whether involvement is high or low and whether brand differences are great or small.
High-involvement purchases.
Complex buying behaviour occurs when the consumer is highly involved with the purchase and when there are significant differences between brands. This behaviour can be associated with the purchase of a new home or of an advanced computer. Such tasks are complex because the risk is high (significant financial commitment), and the large differences among brands or products require gathering a substantial amount of information prior to purchase. Marketers who wish to influence this buying task must help the consumer process the information as readily as possible. This may include informing the consumer about the product category and its important attributes, providing detailed information about product benefits, and motivating sales personnel to influence final brand choice. For instance, realtors may offer consumers a book or a video featuring photographs and descriptions of each available home. And a computer salesperson is likely to spend
time in the retail store providing information to customers who have questions. Dissonance-reducing buying behaviour occurs when the consumer is highly involved but sees little difference between brands. This is likely to be the case with the purchase of a lawn mower or a diamond ring. After making a purchase under such circumstances, a consumer is likely to experience the dissonance that comes from noticing that other brands would have been just as good, if not slightly better, in some dimensions. A consumer in such a buying situation will seek information or ideas that justify the original purchase.
Low-involvement purchases.
There are two types of low-involvement purchases. Habitual buying behaviour occurs when involvement is low and differences between brands are small. Consumers in this case usually do not form a strong attitude toward a brand but select it because it is familiar. In these markets, promotions tend to be simple and repetitive so that the consumer can, without much effort, learn the association between a brand and a product class. Marketers may also try to make their product more involving. For instance, toothpaste was at one time purchased primarily out of habit, but Proctor and Gamble Co. introduced a brand, Crest toothpaste, that increased consumer involvement by raising awareness about the importance of good dental hygiene.
Brand differences.
Variety-seeking buying behaviour occurs when the consumer is not involved with the purchase, yet there are significant brand differences. In this case, the cost of switching products is low, and so the consumer may, perhaps simply out of boredom, move from one brand to another. Such is often the case with frozen desserts, breakfast cereals, and soft drinks. Dominant firms in such a market situation will attempt to encourage habitual buying and will try to keep other brands from being considered by the consumer. These strategies reduce customer switching behaviour. Challenger firms, on the other hand, want consumers to switch from the market leader, so they will offer promotions, free samples, and advertising that encourage consumers to try something new.
The consumer buying process.
The purchase process is initiated when a consumer becomes aware of a need. This awareness may come from an internal source such as hunger or an external source such as marketing communications. Awareness of such a need motivates the consumer to search for information about options with which to fulfill the need. This information can come from personal sources, commercial sources, public or government sources, or the consumer's own experience. Once alternatives have been identified through these sources, consumers evaluate the options, paying particular attention to those attributes the consumer considers most important. Evaluation culminates with a purchase decision, but the buying process does not end here. In fact, marketers point out that a purchase represents the beginning, not the end, of a consumer's relationship with a company. After a purchase has been made, a satisfied consumer is more likely to purchase another company product and to say positive things about the company or its product to other potential purchasers. The opposite is true for dissatisfied consumers. Because of this fact, many companies continue to communicate with their customers after a purchase in an effort to influence post-purchase satisfaction and behaviour.
For example, a plumber may be motivated to consider buying a new set of tools because his old set of tools is getting rusty. To gather information about what kind of new tool set to buy, this plumber may examine the tools of a colleague who just bought a new set, read advertisements in plumbing trade magazines, and visit different stores to examine the sets available. The plumber then processes all the information collected, focusing perhaps on durability as one of the most important attributes. In making a particular purchase, the plumber initiates a relationship with a particular tool company. This company may try to enhance post-purchase loyalty and satisfaction by sending the plumber promotions about new tools.
BUSINESS CUSTOMERS
Business customers, also known as industrial customers, purchase products or services to use in the production of other products. Such industries include agriculture, manufacturing, construction, transportation, and communication, among others. They differ from consumer markets in several respects. Because the customers are organizations, the market tends to have fewer and larger buyers than consumer markets. This often results in closer buyer-seller relationships, because those who operate in a market must depend more significantly on one another for supply and revenue. Business customers also are more concentrated; for instance, in the United States more than half of the country's business buyers are concentrated in only seven states. Demand for business goods is derived demand, which means it is driven by a demand for consumer goods. Therefore, demand for business goods is more volatile, because variations in consumer demand can have a significant impact on business-goods demand. Business markets are also distinctive in that buyers are professional purchasers who are highly skilled in negotiating contracts and maximizing efficiency. In addition, several individuals within the business usually have direct or indirect influence on the purchasing process.
Factors influencing business customers.
Although business customers are affected by the same cultural, social, personal, and psychological factors that influence consumer customers, the business arena imposes other factors that can be even more influential. First, there is the economic environment, which is characterized by such factors as primary demand, economic forecast, political and regulatory developments, and the type of competition in the market. In a highly competitive market such as airline travel, firms may be concerned about price and therefore make purchases with a focus on saving money. In markets where there is more differentiation among competitors--e.g., in the hotel industry--many firms may make purchases with a focus on quality rather than on price.
Second, there are organizational factors, which include the objectives, policies, procedures, structures, and systems that characterize any particular company. Some companies are structured in such a way that purchases must pass through a complex system of checks and balances, while other companies allow purchasing managers to make more individual decisions. Interpersonal factors are more salient among business customers, because the participants in the buying process--perhaps representing several departments within a company--often have different interests, authority, and persuasiveness. Furthermore, the factors that affect an individual in the business buying process are related to the participant's role in the organization. These factors include job position, risk attitudes, and income.
The business buying process.
The business buying process mirrors the consumer buying process, with a few notable exceptions. Business buying is not generally need-driven and is instead problem-driven. A business buying process is usually initiated when someone in the company sees a problem that needs to be solved or recognizes a way in which the company can increase profitability or efficiency. The ensuing process follows the same pattern as that of consumers, including information search, evaluation of alternatives, purchase decision, and post-purchase evaluation. However, in part because business purchase decisions require accountability and are often closely analyzed according to cost and efficiency, the process is more systematic than consumer buying and often involves significant documentation. Typically, a purchasing agent for a business buyer will generate documentation regarding product specifications, preferred supplier lists, requests for bids from suppliers, and performance reviews.
Marketing intermediaries:the distribution channel
Many producers do not sell products or services directly to consumers and instead use marketing intermediaries to execute an assortment of necessary functions to get the product to the final user. These intermediaries, such as middlemen (wholesalers, retailers, agents, and brokers), distributors, or financial intermediaries, typically enter into longer-term commitments with the producer and make up what is known as the marketing channel, or the channel of distribution. Manufacturers use raw materials to produce finished products, which in turn may be sent directly to the retailer, or, less often, to the consumer. However, as a general rule, finished goods flow from the manufacturer to one or more wholesalers before they reach the retailer and, finally, the consumer. Each party in the distribution channel usually acquires legal possession of goods during their physical transfer, but this is not always the case. For instance, in consignment selling, the producer retains full legal ownership even though the goods may be in the hands of the wholesaler or retailer--that is, until the merchandise reaches the final user or consumer. Channels of distribution tend to be more direct--that is, shorter and simpler--in the less industrialized nations. There are notable exceptions, however. For instance, the Ghana Cocoa Marketing Board collects cacao beans in Ghana and licenses trading firms to process the commodity. Similar marketing processes are used in other West African nations. Because of the vast number of small-scale producers, these agents operate through middlemen who, in turn, enlist sub-buyers to find runners to transport the products from remote areas. Japan's marketing organization was, until the late 20th century, characterized by long and complex channels of distribution and a variety of wholesalers. It was possible for a product to pass through a minimum of five separate wholesalers before it reached a retailer. Companies have a wide range of distribution channels available to them, and structuring the right channel may be one of the company's most critical marketing decisions. Businesses may sell products directly to the final customer, as Land's End, Inc., does with its mail-order goods and as is the case with most industrial capital goods. Or they may use one or more intermediaries to move their goods to the final user. The design and structure of consumer marketing channels and industrial marketing channels can be quite similar or vary widely. The channel design is based on the level of service desired by the target consumer. There are five primary service components that facilitate the marketer's understanding of what, where, why, when, and how target customers buy certain products. The service variables are quantity or lot size (the number of units a customer purchases on any given purchase occasion), waiting time (the amount of time customers are willing to wait for receipt of goods), proximity or spatial convenience (accessibility of the product), product variety (the breadth of assortment of the product offering), and service backup (add-on services such as delivery or installation provided by the channel). It is essential for the designer of the marketing channel--typically the manufacturer--to recognize the level of each service point that the target customer desires. A single manufacturer may service several target customer groups through separate channels, and therefore each set of service outputs for these groups could vary. One group of target customers may want elevated levels of service (that is, fast delivery, high product availability, large product assortment, and installation). Their demand for such increased service translates into higher costs for the channel and higher prices for customers. However, the prosperity of discount and warehouse stores demonstrates that customers are willing to accept lower service outputs if this leads to lower prices.
Channel functions and flows.
In order to deliver the optimal level of service outputs to their target consumers, manufacturers are willing to allocate some of their tasks, or marketing flows, to intermediaries. As any marketing channel moves goods from producers to consumers, the marketing intermediaries perform, or participate in, a number of marketing flows, or activities. The typical marketing flows, listed in the usual sequence in which they arise, are collection and distribution of marketing research information (information), development and dissemination of persuasive communications (promotion), agreement on terms for transfer of ownership or possession (negotiation),
intentions to buy (ordering), acquisition and allocation of funds (financing), assumption of risks (risk taking), storage and movement of product (physical possession), buyers paying sellers (payment), and transfer of ownership (title). Each of these flows must be performed by a marketing intermediary for any channel to deliver the goods to the final consumer. Thus, each producer must decide who will perform which of these functions in order to deliver the service output levels that the target consumers desire. Producers delegate these flows for a variety of reasons. First, they may lack the financial resources to carry out the intermediary activities themselves. Second, many producers can earn a superior return on their capital by investing profits back into their core business rather than into the distribution of their products. Finally, intermediaries, or middlemen, offer superior efficiency in making goods and services widely available and accessible to final users. For instance, in overseas markets it may be difficult for an exporter to establish contact with end users, and various kinds of agents must therefore be employed. Because an intermediary typically focuses on only a small handful of specialized tasks within the marketing channel, each intermediary, through specialization, experience, or scale of operation, can offer a producer greater distribution benefits.
Management of channel systems.
Although middlemen can offer greater distribution economy to producers, gaining cooperation from these middlemen can be problematic. Middlemen must continuously be motivated and stimulated to perform at the highest level. In order to gain such a high level of performance, manufacturers need some sort of leverage. Researchers have distinguished five bases of power: coercive (threats if the middlemen do not comply), reward (extra benefits for compliance), legitimate (power by position--rank or contract), expert (special knowledge), and referent (manufacturer is highly respected by the middlemen). As new institutions emerge or products enter different life-cycle phases, distribution channels change and evolve. With these types of changes, no matter how well the channel is designed and managed, conflict is inevitable. Often this conflict develops because the interests of the independent businesses do not coincide. For example, franchisers, because they receive a percentage of sales, typically want their franchisees to maximize sales, while the franchisees want to maximize their profits, not sales. The conflict that arises may be vertical, horizontal, or multichannel in nature. When General Motors Corporation comes into conflict with its dealers, this is a vertical channel conflict. Horizontal channel conflict arises when a franchisee in a neighbouring town feels a fellow franchisee has infringed on its territory. Finally, multichannel conflict occurs when a manufacturer has established two or more channels that compete against each other in selling to the same market. For example, a major tire manufacturer may begin selling its tires through mass merchandisers, much to the dismay of its independent tire dealers.
WHOLESALERS
Wholesaling includes all activities required to sell goods or services to other firms, either for resale or for business use, usually in bulk quantities and at lower-than-retail prices. Wholesalers, also called distributors, are independent merchants operating any number of wholesale establishments. Wholesalers are typically classified into one of three groups: merchant wholesalers, brokers and agents, and manufacturers' and retailers' branches and offices.
Merchant wholesalers.
Merchant wholesalers, also known as jobbers, distributors, or supply houses, are independently owned and operated organizations that acquire title ownership of the goods that they handle. There are two types of merchant wholesalers: full-service and limited-service.
Full-service wholesalers.
Full-service wholesalers usually handle larger sales volumes; they may perform a broad range of services for their customers, such as stocking inventories, operating warehouses, supplying credit, employing salespeople to assist customers, and delivering goods to customers. General-line wholesalers carry a wide variety of merchandise, such as groceries; specialty wholesalers, on the other hand, deal with a narrow line of goods, such as coffee and tea, cigarettes, or seafood.
Limited-service wholesalers.
Limited-service wholesalers, who offer fewer services to their customers and suppliers, emerged in order to reduce the costs of service. There are several types of limited-service wholesalers. Cash-and-carry wholesalers usually handle a limited line of fast-moving merchandise, selling to smaller retailers on a cash-only basis and not delivering goods. Truck wholesalers or jobbers sell and deliver directly from their vehicles, often for cash. They carry a limited line of semiperishables such as milk, bread, and snack foods. Drop shippers do not carry inventory or handle the merchandise. Operating primarily in bulk industries such as lumber, coal, and heavy equipment, they take orders but have manufacturers ship merchandise directly to final consumers. Rack jobbers, who handle nonfood lines such as housewares or personal goods, primarily serve drug and grocery retailers. Rack jobbers typically perform such functions as delivery, shelving, inventory stacking, and financing. Producers' cooperatives--owned by their members, who are farmers--assemble farm produce to be sold in local markets and share profits at the end of the year.
In less-developed countries, wholesalers are often the sole or primary means of trade; they are the main elements in the distribution systems of many countries in Latin America, East Asia, and Africa. In such countries the business activities of wholesalers may expand to include manufacturing and retailing, or they may branch out into nondistributive ventures such as real estate, finance, or transportation. Until the late 1950s, Japan was dominated by wholesaling. Even relatively large manufacturers and retailers relied principally on wholesalers as their intermediaries. However, in the late 20th century, Japanese wholesalers have declined in importance. Even in the most highly industrialized nations, however, wholesalers remain essential to the operations of significant numbers of small retailers.
Brokers and agents.
Manufacturers may use brokers and agents, who do not take title possession of the goods, in marketing their products. Brokers and agents typically perform only a few of the marketing flows, and their main function is to ease buying and selling--that is, to bring buyers and sellers together and negotiate between them. Brokers, most commonly found in the food, real estate, and insurance industries, may represent either a buyer or a seller and are paid by the party who hires them. Brokers often can represent several manufacturers of noncompeting products on a commission basis. They do not carry inventory or assume risk. Unlike merchant wholesalers, agent middlemen do not take legal ownership of the goods they sell; nor do they generally take physical possession of them. The three principal types of agent middlemen are manufacturers' agents, selling agents, and purchasing agents. Manufacturers' agents, who represent two or more manufacturers' complementary lines on a continuous basis, are usually compensated by commission. As a rule, they carry only part of a manufacturer's output, perhaps in areas where the manufacturer cannot maintain full-time salespeople. Many manufacturers' agents are businesses of only a few employees and are most commonly found in the furniture, electric, and apparel industries. Sales agents are given contractual authority to sell all of a manufacturer's output and generally have considerable autonomy to set prices, terms, and conditions of sale. Sometimes they perform the duties of a manufacturer's marketing department, although they work on a commission basis. Sales agents often provide market feedback and product information to the manufacturers and play an important role in product development. They are found in such product areas as chemicals, metals, and industrial machinery and equipment. Purchasing agents, who routinely have long-term relationships with buyers, typically receive, inspect, store, and ship goods to their buyers.
Manufacturers' and retailers' branches and offices.
Wholesaling operations conducted by the sellers or buyers themselves rather than by independent wholesalers comprise the third major type of wholesaling. Manufacturers may engage in wholesaling through their sales branches and offices. This allows manufacturers to improve the inventory control, selling, and promotion flows. Numerous retailers also establish purchasing offices in major market centres such as Chicago and New York City that play a role similar to that of brokers and agents. The major difference is that they are part of the buyer's own organization.
RETAILERS
Retailing, the merchandising aspect of marketing, includes all activities required to sell directly to consumers for their personal, nonbusiness use. The firm that performs this consumer selling--whether it is a manufacturer, wholesaler, or retailer--is engaged in retailing. Retailing can take many forms: goods or services may be sold in person, by mail, telephone, television, or computer, or even through vending machines. These products can be sold on the street, in a store, or in the consumer's home. However, businesses that are classified as retailers secure the vast majority of their sales volume from store-based retailing.
The history of retailing.
For centuries most merchandise was sold in marketplaces or by peddlers. In many countries, hawkers still sell their wares while traveling from one village to the next. Marketplaces are still the primary form of retail selling in these villages. This was also true in Europe until the Renaissance, when market stalls in certain localities became permanent and eventually grew into stores and business districts. Retail chains are known to have existed in China several centuries before the Christian era and in some European cities in the 16th and 17th centuries. However, the birth of the modern chain store can be traced to 1859, with the inauguration of what is now the Great Atlantic & Pacific Tea Company, Inc. (A&P), in New York City. During the 15th and 16th centuries the Fugger family of Germany was the first to carry out mercantile operations of a chain-store variety. In 1670 the Hudson's Bay Company chartered its chain of outposts in Canada.
Department stores also were seen in Europe and Asia as early as the 17th century. The famous Bon Marché in Paris grew from a large specialty store into a full-fledged department store in the mid-1800s. By the middle of the 20th century, department stores existed in major U.S. cities, although small independent merchants still constitute the majority of retailers. Shopping malls, a late 20th-century development in retail practices, were created to provide for a consumer's every need in a single, self-contained shopping area. Although they were first created for the convenience of suburban populations, they can now also be found on main city thoroughfares. A large branch of a well-known retail chain usually serves as a mall's retail flagship, which is the primary attraction for customers. In fact, few malls can be financed and built without a flagship establishment already in place. Other mall proprietors have used recreation and entertainment to attract customers. Movie theatres, holiday displays, and live musical performances are often found in shopping malls. In Asian countries, malls also have been known to house swimming pools, arcades, and amusement parks. Hong Kong's City Plaza shopping mall includes one of the territory's two ice rinks. Some malls, such as the Mall of America in Bloomington, Minn., U.S., may offer exhibitions, sideshows, and other diversions. Although there is a great variety of retail enterprises, with new types constantly emerging, they can be classified into three main types: store retailers, nonstore retailers, and retail organizations.
Store retailers.
Several different types of stores participate in retail merchandising. The following is a brief description of the most important store retailers.
Specialty stores.
A specialty store carries a deep assortment within a narrow line of goods. Furniture stores, florists, sporting-goods stores, and bookstores are all specialty stores. Stores such as Athlete's Foot (sports shoes only) and Tall Men (clothing for tall men) are considered superspecialty stores because they carry a very narrow product line.
Department stores.
Department stores carry a wider variety of merchandise than most stores but offer these items in separate departments within the store. These departments usually include home furnishings and household goods, as well as clothing, which may be divided into departments according to gender and age. Department stores in western Europe and Asia also have large food departments, such as the renowned food court at Harrods in the United Kingdom. Departments within each store are usually operated as separate entities, each with its own buyers, promotions, and service personnel. Some departments, such as restaurants and beauty parlours, are leased to external providers. Department stores generally account for less than 10 percent of a country's total retail sales, but they draw large numbers of customers in urban areas. The most influential of the department stores may even be trendsetters in various fields, such as fashion. Department stores such as Sears, Roebuck and Company have also spawned chain organizations. Others may do this through mergers or by opening branch units within a region or by expanding to other countries.
Supermarkets.
Supermarkets are characterized by large facilities (15,000 to 25,000 square feet [1,394 to 2,323 square metres] with more than 12,000 items), low profit margins (earning about 1 percent operating profit on sales), high volume, and operations that serve the consumer's total needs for items such as food (groceries, meats, produce, dairy products, baked goods) and household sundries. They are organized according to product departments and operate primarily on a self-service basis. Supermarkets also may sell wines and other alcoholic beverages (depending on local licensing laws) and clothing. The first true supermarket was opened in the United States by Michael Cullin in 1930. His King Kullen chain of large-volume food stores was so successful that it encouraged the major food-store chains to convert their specialty stores into supermarkets. When compared with the conventional independent grocer, supermarkets generally offered greater variety and convenience and often better prices as well. Consequently, in the two decades after World War II, the supermarket drove many small food retailers out of business, not only in the United States but throughout the world. In France, for example, the number of larger food stores grew from about 50 in 1960 to 4,700 in 1982, while the number of small food retailers fell from 130,000 to 60,000.
Convenience stores.
Located primarily near residential areas, convenience stores are relatively small outlets that are open long hours and carry a limited line of high-turnover convenience products at high prices. Although many have added food services, consumers use them mainly for "fill-in" purchases, such as bread, milk, or miscellaneous goods.
Superstores.
Superstores, hypermarkets, and combination stores are unique retail merchandisers. With facilities averaging 35,000 square feet, superstores meet many of the consumer's needs for food and nonfood items by housing a full-service grocery store as well as such services as dry cleaning, laundry, shoe repair, and cafeterias. Combination stores typically combine a grocery store and a drug store in one facility, utilizing approximately 55,000 square feet of selling space. Hypermarkets combine supermarket, discount, and warehousing retailing principles by going beyond routinely purchased goods to include furniture, clothing, appliances, and other items. Ranging in size from 80,000 to 220,000 square feet, hypermarkets display products in bulk quantities that require minimum handling by store personnel.
Discount stores.
Selling merchandise below the manufacturer's list price is known as discounting. The discount store has become an increasingly popular means of retailing. Following World War II, a number of retail establishments in the United States began to pursue a high-volume, low-profit strategy designed to attract price-conscious consumers. A key strategy for keeping operating costs (and therefore prices) low was to locate in low-rent shopping districts and to offer minimal service assistance. This no-frills approach was used at first only with hard goods, or consumer durables, such as electrical household appliances, but it has since been shown to be successful with soft goods, such as clothing. This practice has been adopted for a wide variety of products, so that discount stores have essentially become department stores with reduced prices and fewer services. In the late 20th century, discount stores began to operate outlet malls. These groups of discount stores are usually located some distance away from major metropolitan areas and have facilities that make them indistinguishable from standard shopping malls. As they gained popularity, many discount stores improved their facilities and appearances, added new lines and services, and opened suburban branches. Coupled with attempts by traditional department stores to reduce prices in order to compete with discounters, the distinction between many department and discount stores has become blurred. Specialty discount operations have grown significantly in electronics, sporting goods, and books.
Off-price retailers.
Off-price retailers offer a different approach to discount retailing. As discount houses tried to increase services and offerings in order to upgrade, off-price retailers invaded this low-price, high-volume sector. Off-price retailers purchase at below-wholesale prices and charge less than retail prices. This practice is quite different from that of ordinary discounters, who buy at the market wholesale price and simply accept lower margins by pricing their products below retail costs. Off-price retailers carry a constantly changing collection of overruns, irregulars, and leftover goods and have made their biggest forays in the clothing, footwear, and accessories industries. The three primary examples of off-price retailers are factory outlets, independent carriers, and warehouse clubs. Stocking manufacturers' surplus, discontinued, or irregular products, factory outlets are owned and operated by the manufacturer. Independent off-price retailers carry a rapidly changing collection of higher-quality merchandise and are typically owned and operated by entrepreneurs or divisions of larger retail companies. Warehouse (or wholesale) clubs operate out of enormous, low-cost facilities and charge patrons an annual membership fee. They sell a limited selection of brand-name grocery items, appliances, clothing, and miscellaneous items at a deep discount. These warehouse stores, such as Wal-Mart-owned Sam's, Price Club, and Costco (in the United States), maintain low costs because they buy products at huge quantity discounts, use less labour in stocking, and typically do not make home deliveries or accept credit cards.
Nonstore retailers.
Some retailers do not operate stores, and these nonstore businesses have grown much faster than store retailers. With some market observers predicting that by the year 2000 nonstore retailing will handle 30 percent of all general merchandise sold, nonstore channels may become a powerful force in the retailing industry. The major types of nonstore retailing are direct selling, direct marketing, and automatic vending.
Direct selling.
This form of retailing originated several centuries ago and has mushroomed into a $9 billion industry consisting of about 600 companies selling door-to-door, office-to-office, or at private-home sales meetings. The forerunners in the direct-selling industry include The Fuller Brush Company (brushes, brooms, etc.), Electrolux (vacuum cleaners), and Avon (cosmetics). In addition, Tupperware pioneered the home-sales approach, in which friends and neighbours gather in a home where Tupperware products are demonstrated and sold. Network marketing, a direct-selling approach similar to home sales, is also gaining prevalence in markets worldwide. Network marketing companies such as Amway and Shaklee reward their distributors not only for selling products but also for recruiting others to become distributors.
Direct marketing.
Direct marketing is direct contact between a seller (manufacturer or retailer) and a consumer. Generally speaking, a seller can measure response to an offer because of its direct addressability. Although direct marketing gained wide popularity as a marketing strategy only in the late 20th century, it has been successfully utilized for more than a hundred years. The world's largest catalog houses--Sears, Roebuck and Company and Montgomery Ward & Co.--began as direct marketers in the late 1880s, selling their products solely by mail order. A century later, however, both companies were conducting most of their business in retail stores. Some department stores and specialty stores may supplement their store operations with direct-marketing transactions by mail or telephone. Mail-order firms grew rapidly in the 1950s and '60s in continental Europe, Great Britain, and certain other highly industrialized nations. Modern direct marketing is generally supported by advanced database technologies that track each customer's purchase behaviour. These technologies are used by established retail firms, such as Quelle and Neckermann in Germany, and are the foundation of mail-order businesses such as J. Crew, The Sharper Image, and L.L. Bean (all in the United States). Direct marketing is not a worldwide business phenomenon, however, because mail-order operations require infrastructure elements that are still lacking in many countries, such as efficient transportation networks and secure methods for transmitting payments. Direct marketing has expanded from its early forms, among them direct mail and catalog mailings, to include such vehicles as telemarketing, direct-response radio and television, and electronic shopping. Unlike many other forms of promotion, a direct-marketing campaign is quantitatively measurable.
Automatic vending.
Automatic vending is a unique area in nonstore merchandising because the variety of merchandise offered through automatic vending machines continues to grow. Initially, impulse goods with high convenience value such as cigarettes, soft drinks, candy, newspapers, and hot beverages were offered. However, a wide array of products such as hosiery, cosmetics, food snacks, postage stamps, paperback books, record albums, camera film, and even fishing worms are becoming available through machines. Vending-machine operations are usually offered in sites owned by other businesses, institutions, and transportation agencies. They can be found in offices, gasoline stations, large retail stores, hotels, restaurants, and many other locales. In Japan, vending machines now dispense frozen beef, fresh flowers, whiskey, jewelry, and even names of prospective dating partners. In Sweden, vending machines have developed as a supplementary channel to retail stores, where hours of business are restricted by law. High costs of manufacturing, installation, and operation have somewhat limited the expansion of vending-machine retailing. In addition, consumers typically pay a high premium for vended merchandise.
Retail organizations.
While merchants can sell their wares through a store or nonstore retailing format, retail organizations can also structure themselves in several different ways. The major types of retail organizations are corporate chains, voluntary chains and retailer cooperatives, consumer cooperatives, franchise organizations, and merchandising conglomerates.
Corporate chains.
Two or more outlets that have common ownership and control, centralized buying and merchandising operations, and similar lines of merchandise are considered corporate chain stores. Corporate chain stores appear to be strongest in the food, drug, shoe, variety, and women's clothing industries. Managed chain stores have a number of advantages over independently managed stores. Because managed chains buy large volumes of products, suppliers are willing to offer cost advantages that are not usually available to other stores. These savings can be passed on to consumers in the form of lower prices and better sales. In addition, because managed chains operate on such a large scale, they can hire more specialized and experienced personnel, who may be better able to take full advantage of purchasing and promotion opportunities. Chain stores also have the opportunity to take advantage of economies of scale in the areas of advertising, store design, and inventory control. However, a corporate chain may have disadvantages as well. Its size and bureaucracy often weaken staff members' personal interest, drive, creativity, and customer-service motivation.
Voluntary chains and retailer cooperatives.
These are associations of independent retailers, unlike corporate chains. Wholesaler-sponsored voluntary chains of retailers who engage in bulk buying and collective merchandising are prevalent in many countries. True Value hardware stores represent this type of arrangement in the United States. In western Europe in the 1980s there were several large wholesaler-sponsored chains of retailers, each including more than 15,000 stores. These retail stores were located across 18 countries, each store using the same name and, as a rule, offering the same brands of products but remaining an independent enterprise. Wholesaler-sponsored chains offer the same types of services for their clients as do the financially integrated retail chains. Retailer cooperatives, such as ACE hardware stores, are grouped as independent retailers who establish a central buying organization and conduct joint promotion efforts.
Consumer cooperatives.
Consumer cooperatives, or co-ops, are retail outlets that are owned and operated by consumers for their mutual benefit. The first consumer cooperative store was established in Rochdale, Eng., in 1844, and most co-ops are modeled after the same, original principles. They are based on open consumer membership, equal voting among members, limited customer services, and shared profits among members in the form of rebates generally related to the amounts of their purchases. Consumer cooperatives have gained widespread popularity throughout western and northern Europe, particularly in Denmark, Finland, Iceland, Norway, Sweden, and Great Britain. Co-ops typically emerge because community residents believe that local retailers' prices are too high or service is substandard.
Franchise organizations.
Franchise arrangements are characterized by a contractual relationship between a franchiser (a manufacturer, wholesaler, or service organization) and franchisees (independent entrepreneurs who purchase the right to own and operate any number of units in the franchise systems). Typified by a unique product, service, business method, trade name, or patent, franchises have been prominent in many industries, including fast foods, video stores, health and fitness centres, hair salons, auto rentals, motels, and travel agencies. McDonald's Corporation is a prominent example of a franchise retail organization, with franchises all over the world.
Merchandising conglomerates.
Merchandising conglomerates combine several diversified retailing lines and forms under central ownership, as well as integrate distribution and management of functions. Merchandising conglomerates are relatively free-form corporations. In the United States, Woolworth Corporation is considered a merchandising conglomerate because it operates Kinney shoe stores, Herald Square Stationers, Frame Scene, and Kids Mart.
Marketing facilitators
Because marketing functions require significant expertise, it is often both efficient and effective for an organization to use the assistance of independent marketing facilitators. These are organizations and consultants whose sole or primary responsibility is to handle marketing functions. In many larger companies, all or some of these functions are performed internally. However, this is not necessary or justifiable in most companies, which usually require only part-time or periodic assistance from marketing facilitators. Also, most companies cannot afford to support the salaries and operating expenses required to maintain marketing facilitators as a permanent part of their staff. Furthermore, independent marketing contractors can be more effective than an internal department because nonemployee facilitators can have broader expertise and more objective perspectives. In addition, independent contractors often are more motivated to perform at high standards, because competition in the facilitator market is usually aggressive, and poor performance could mean lost business. There are four major types of marketing facilitators: advertising agencies, market research firms, transportation firms, and warehousing firms.
ADVERTISING AGENCIES
Advertising agencies are responsible for initiating, managing, and implementing paid marketing communications. In addition, some agencies have diversified into other types of marketing communications, including public relations, sales promotion, interactive media, and direct marketing. Agencies typically consist of four departments: account management, a creative division, a research group, and a media planning department. Those in account management act as liaisons between the client and the agency, ensuring that client needs are communicated to the agency and that agency recommendations are clearly understood by the client. Account managers also manage the flow of work within the agency, making sure that projects proceed according to schedule. The creative department is where advertisements are conceived, developed, and produced. Artists, writers, and producers work together to craft a message that meets agency and client objectives. In this department, slogans, jingles, and logos are developed. The research department gathers and processes data about the target market and consumers. This information provides a foundation for the work of the creative department and account management. Media planning personnel specialize in selecting and placing advertisements in print and broadcast media.
MARKET RESEARCH FIRMS
Market research firms gather and analyze data about customers, competitors, distributors, and other actors and forces in the marketplace. A large portion of the work performed by most market research firms is commissioned by specific companies for particular purposes. However, some firms also routinely collect a wide spectrum of data and then attempt to sell some or all of it to companies that may benefit from such information. For example, the A.C. Nielsen Co. in the United States specializes in supplying marketing data about consumer television viewing habits, and Information Resources, Inc. (IRI), has an extensive database regarding consumer supermarket purchases. Marketing research may be quantitative, qualitative, or a combination of both. Quantitative research is numerically oriented, requires significant attention to the measurement of market phenomena, and often involves statistical analysis. For example, when a restaurant asks its customers to rate different aspects of its service on a scale from 1 (good) to 10 (poor), this provides quantitative information that may be analyzed statistically. Qualitative research focuses on descriptive words and symbols and usually involves observing consumers in a marketing setting or questioning them about their product or service consumption experiences. For example, a marketing researcher may stop a consumer who has purchased a particular type of detergent and ask him why that detergent was chosen. Qualitative and quantitative research each provides different insights into consumer behaviour, and research results are ordinarily more useful when the two methods are combined. Market research can be thought of as the application of scientific method to the solution of marketing problems. It involves studying people as buyers, sellers, and consumers, examining their attitudes, preferences, habits, and purchasing power. Market research is also concerned with the channels of distribution, with promotion and pricing, and with the design of the products and services to be marketed.
TRANSPORTATION FIRMS
As a product moves from producer to consumer, it must often travel long distances. Many products consumed in the United States have been manufactured in another area of the world, such as Asia or Mexico. In addition, if the channel of distribution includes several firms, the product must be moved a number of times before it becomes accessible to consumers. A basic home appliance begins as a raw material (iron ore at a steel mill, for example) that is transported from a processing plant to a manufacturing facility. Transportation firms assist marketers in moving products from one point in a channel to the next. An important matter of negotiation between companies working together in a channel is whether the sender or receiver of goods is responsible for transportation. Movement of products usually involves significant cost, risk, and time management. Thus, when firms consider a transportation option, they carefully weigh its dependability and price, frequency of operation, and accessibility. A firm that has its own transportation capabilities is known as a private carrier. There are also contract carriers, which are independent transportation firms that can be hired by companies on a long- or short-term basis. A common carrier provides services to any and all companies between predetermined points on a scheduled basis. The U.S. Postal Service is a common carrier, as are Federal Express and the Amtrak railway system.
WAREHOUSING FIRMS
Because products are not usually sold or shipped as soon as they are produced or delivered, firms require storage facilities. Two types of warehouses meet this need: storage warehouses hold goods for longer periods of time, and distribution warehouses serve as way stations for goods as they pass from one location to the next. Like the other marketing functions, warehouses can be wholly owned by firms, or space can be rented as needed. Although companies have more control over wholly owned facilities, warehouses of this sort can tie up capital and firm resources. Operations within warehouses usually require inspecting goods, tracking inventories, repackaging goods, shipping, and invoicing.
MARKETING IN DIFFERENT SECTORS
Although the basic principles of marketing apply to all industries, the ways in which these principles are best applied can differ considerably based on the kind of product or service sold, the kind of buying behaviour associated with the purchase, and the sector (government, consumer goods, services, etc.).
The government market
This market consists of federal, state, and local governmental units that purchase or rent goods to fulfill their functions and responsibilities for the public. Government agencies purchase a wide range of products and services, including helicopters, paintings, office furniture, clothing, alcohol, and fuel. Most of the agencies manage a significant portion of their own purchasing.
THE CIVILIAN ESTABLISHMENT
One prominent sector of the government market is the federal civilian buying establishment. In the United States this establishment consists of six categories: departments (e.g., the Department of Commerce), administration (e.g., the General Services Administration), agencies (e.g., the Federal Aviation Administration), boards (e.g., the Railroad Retirement Board), commissions (e.g., the Federal Communications Commission), and the executive office (e.g., the Office of Management and Budget). In addition there are several miscellaneous civilian buying establishments, such as, for example, the Tennessee Valley Authority.
THE MILITARY ESTABLISHMENT
Another governmental purchasing sector is the federal military buying establishment, represented in the United States by the Department of Defense, which purchases primarily through the Defense Supply Agency and the army, navy, and air force. The Defense Supply Agency operates six supply centres, which specialize in construction, electronics, fuel, personnel support, and industrial and general supplies.
PURCHASING PROCEDURES
Government purchasing procedures fall into two categories: the open bid and the negotiated contract. Under open-bid buying, the government disseminates very specific information about the products and services required and requests bids from suppliers. Contracts generally are awarded to the lowest bidder. In negotiated-contract buying, a government agency negotiates directly with one or more companies regarding a specific project or supply need. In most cases, contracts are negotiated for complex projects that involve major research-and-development costs and in matters where there is little effective competition.
Consumer-goods marketing
Consumer goods can be classified according to consumer shopping habits.
CONVENIENCE GOODS
Convenience goods are those that the customer purchases frequently, immediately, and with minimum effort. Tobacco products, soaps, and newspapers are all considered convenience goods, as are common staples like ketchup or pasta. Convenience-goods purchasing is usually based on habitual behaviour, where the consumer will routinely purchase a particular product. Some convenience goods, however, may be purchased impulsively, involving no habit, planning, or search effort. These goods, usually displayed near the cash register in a store in order to encourage quick choice and purchase, include candy, razors, and batteries. A slightly different type of convenience product is the emergency good, which is purchased when there is an urgent need. Such goods include umbrellas and snow shovels, and these are usually distributed at a wide variety of outlets so that they will be readily available when necessary.
SHOPPING GOODS
A second type of product is the shopping good, which usually requires a more involved selection process than convenience goods. A consumer usually compares a variety of attributes, including suitability, quality, price, and style. Homogeneous shopping goods are those that are similar in quality but different enough in other attributes (such as price, brand image, or style) to justify a search process. These products might include automobile tires or a stereo or television system. Homogeneous shopping goods are often sold strongly on price. With heterogeneous shopping goods, product features become more important to the consumer than price. Such is often the case with the purchase of major appliances, clothing, furniture, and high-tech equipment. In this situation, the item purchased must be a certain size or colour and must perform very specific functions that cannot be fulfilled by all items offered by every supplier. With goods of this sort, the seller has to carry a wide assortment to satisfy individual tastes and must have well-trained salespeople to provide both information and advice to consumers.
SPECIALTY GOODS
Specialty goods have particularly unique characteristics and brand identifications for which a significant group of buyers is willing to make a special purchasing effort. Examples include specific brands of fancy products, luxury cars, professional photographic equipment, and high- fashion clothing. For instance, consumers who favour merchandise produced by a certain shoe manufacturer or furniture maker will, if necessary, travel considerable distances in order to purchase that particular brand. In specialty-goods markets, sellers do not encourage comparisons between options; buyers invest time to reach dealers carrying the product desired, and these dealers therefore do not necessarily need to be conveniently located.
UNSOUGHT GOODS
Finally, an unsought good is one that a consumer does not know about--or knows about but does not normally think of buying. New products, such as new frozen-food concepts or new communications equipment, are unsought until consumers learn about them through word-of-mouth influence or advertising. In addition, the need for unsought goods may not seem urgent to the consumer, and purchase is often deferred. This is frequently the case with life insurance, preventive car maintenance, and cemetery plots. Because of this, unsought goods require significant marketing efforts, and some of the more sophisticated selling techniques have been developed from the challenge to sell unsought goods.
Services marketing
A service is an act of labour or a performance that does not produce a tangible commodity and does not result in the customer's ownership of anything. Its production may or may not be tied to a physical product. Thus, there are pure services that involve no tangible product (as with psychotherapy), tangible goods with accompanying services (such as a computer software package with free software support), and hybrid product-services that consist of parts of each (for instance, restaurants are usually patronized for both their food and their service). Services can be distinguished from products because they are intangible, inseparable from the production process, variable, and perishable. Services are intangible because they can often not be seen, tasted, felt, heard, or smelled before they are purchased. A person purchasing plastic surgery cannot see the results before the purchase, and a lawyer's client cannot anticipate the outcome of a case before the lawyer's work is presented in court. To reduce the uncertainty that results from this intangibility, marketers may strive to make their service tangible by emphasizing the place, people, equipment, communications, symbols, or price of the service. For example, consider the insurance slogans "You're in good hands with Allstate" or Prudential's "Get a piece of the Rock."
Services are inseparable from their production because they are typically produced and consumed simultaneously. This is not true of physical products, which are often consumed long after the product has been manufactured, inventoried, distributed, and placed in a retail store. Inseparability is especially evident in entertainment services or professional services. In many cases, inseparability limits the production of services because they are so directly tied to the individuals who perform them. This problem can be alleviated if a service provider learns to work faster or if the service expertise can be standardized and performed by a number of individuals (as H&R Block, Inc., has done with its network of trained tax consultants throughout the United States).
The variability of services comes from their significant human component. Not only do humans differ from one another, but their performance at any given time may differ from their performance at another time. The mechanics at a particular auto service garage, for example, may differ in terms of their knowledge and expertise, and each mechanic will have "good" days and "bad" days. Variability can be reduced by quality-control measures. These measures can include good selection and training of personnel and allowing customers to communicate dissatisfaction (e.g., through customer suggestion and complaint systems) so that poor service can be detected and. corrected Finally, services are perishable because they cannot be stored. Because of this, it is difficult for service providers to manage anything other than steady demand. When demand increases dramatically, service organizations face the problem of producing enough output to meet customer needs. When a large tour bus unexpectedly arrives at a restaurant, its staff must rush to meet the demand, because the food services (taking orders, making food, taking money, etc.) cannot be "warehoused" for such an occasion. To manage such instances, companies may hire part-time employees, develop efficiency routines for peak demand occasions, or ask consumers to participate in the service-delivery process. On the other hand, when demand drops off precipitously, service organizations are often burdened with a staff of service providers who are not performing. Organizations can maintain steady demand by offering differential pricing during off-peak times, anticipating off-peak hours by requiring reservations, and giving employees more flexible work shifts.
Business marketing
Business marketing, sometimes called business-to-business marketing or industrial marketing, involves those marketing activities and functions that are targeted toward organizational customers. This type of marketing involves selling goods (and services) to organizations (public and private) to be used directly or indirectly in their own production or service-delivery operations. Some of the major industries that comprise the business market are construction, manufacturing, mining, transportation, public utilities, communications, and distribution. One of the key points that differentiates business from consumer marketing is the magnitude of the transactions. For example, in the mid-1990s, a Boeing 747 airliner, selling for about $155 million, could take up to four years to manufacture and deliver once the order was placed. Often, a major airline company will order several aircraft at one time, making the purchase price as high as a billion dollars. Customers for industrial goods can be divided into three groups: user customers, original-equipment manufacturers, and resellers. User customers make use of the goods they purchase in their own businesses. An automobile manufacturer, for example, might purchase a metal-stamping press to produce parts for its vehicles. Original-equipment manufacturers incorporate the purchased goods into their final products, which are then sold to final consumers (e.g., the manufacturer of television receivers buys tubes and transistors). Industrial resellers are middlemen--essentially wholesalers but in some cases retailers--who distribute goods to user customers, to original-equipment manufacturers, and to other middlemen. Industrial-goods wholesalers include mill-supply houses, steel warehouses, machine-tool dealers, paper jobbers, and chemical distributors.
Nonprofit marketing
Marketing scholars began exploring the application of marketing to nonprofit organizations in 1969. Since then, nonprofit organizations have increasingly turned to marketing for growth, funding, and prosperity. Although it is difficult to define "nonprofit" organizations because of the existence of a number of quasi-governmental organizations, a study in the mid-1990s found more than one million private, nonprofit organizations in the United States. Some experts believe that the way to distinguish between organizations is according to their sources of funding. The three major sources are profits, government revenues (such as grants or taxes), and voluntary donations. In addition, a legally defined nonprofit organization is one that has been granted tax-exempt status by the Internal Revenue Service. However, while nonprofit groups can be defined legally, it is more helpful to focus on the specific marketing activities that need to be performed within the organization's environment. Museums, hospitals, universities, and churches are all examples of nonprofit organizations. Although many individuals may believe that nonprofit organizations have only a small impact on the economy, the operating expenditures of private nonprofit organizations now represent a significant percentage of the U.S. gross national product. In addition, many of these are substantial enterprises. For example, Girl Scout cookies, sold by Girl Scouts of America, constitute 10 percent of all cookies sold in the United States.
Social marketing
Social marketing employs marketing principles and techniques to advance a social cause, idea, or behaviour. It entails the design, implementation, and control of programs aimed at increasing the acceptability of a social idea or practice that would benefit the adoptors or society. Social ideas can take the form of beliefs, attitudes, and values, such as human rights. Whether social marketers are promoting ideas or social practices, their ultimate goal is to alter behaviour. In order to accomplish this behaviour change, social marketers set measurable objectives, research their target group's needs, target their "products" to these particular "consumers," and effectively communicate their benefits. In addition, social-marketing organizations have to be constantly aware of changes in their environments and must be able to adapt to these changes.
Place marketing
Place marketing employs marketing principles and techniques to advance the appeal and viability of a place (town, city, state, region, or nation) to tourists, businesses, investors, and residents. Among the "place sellers" are economic development agencies, tourist promotion agencies, and mayors' offices. Place sellers must gain a deep understanding of how place buyers make their purchasing decisions. Place-marketing activities can be found in both the private and public sectors at the local, regional, national, and international levels. They can range from activities involving downtrodden cities trying to attract businesses to vacation spots seeking to attract tourists. In implementing these marketing activities, each locale must adapt to external shocks and forces beyond its control (intergovernmental power shifts, increasing global competition, and rapid technological change) as well as to internal forces and decline cycles.
ECONOMIC AND SOCIAL ASPECTS OF MARKETING
Sometimes criticized for its impact on personal economic and social well-being, marketing has been said to affect not only individual consumers but also society as a whole. This section briefly examines some of the criticisms raised and how governments, individuals, and marketers have addressed them.
Marketing and individual welfare
Criticisms have been leveled against marketers, claiming that some of their practices may damage individual welfare. While this may be true in certain circumstances, it is important to recognize that, if a business damages individual welfare, it cannot hope to continue in the marketplace for long. As a consequence, most unfavourable views of marketing are criticisms of poor marketing, not of strategically sound marketing practices. Others have raised concerns about marketing by saying that it increases prices by encouraging excessive markups. Marketers recognize that consumers may be willing to pay more for a product--such as a necklace from Tiffany and Co.--simply because of the associated prestige. This not only results in greater costs for promotion and distribution, but it allows marketers to earn profit margins that may be significantly higher than industry norms. Marketers counter these concerns by pointing out that products provide not only functional benefits but symbolic ones as well. By creating a symbol of prestige and luxury, Tiffany's offers a symbolic benefit that, according to some consumers, justifies the price. In addition, brands may symbolize not only prestige but also quality and functionality, which gives consumers greater confidence when they purchase a branded product. Finally, advertising and promotions are often very cost-effective methods of informing the general public about items and services that are available in the marketplace. A few marketers have been accused of using deceptive practices, such as misleading promotional activities or high-pressure selling. These deceptive practices have given rise to legislative and administrative remedies, including guidelines offered by the Federal Trade Commission (FTC) regarding advertising practices, automatic 30-day guarantee policies by some manufacturers, and "cooling off" periods during which a consumer may cancel any contract signed. In addition, professional marketing associations, such as the Direct Marketing Association, have promulgated a set of professional standards for their industry.
Marketing and societal welfare
Concern also has been raised that some marketing practices may encourage excessive interest in material possessions, create "false wants," or promote the purchase of nonessential goods. For example, in the United States, children's Saturday morning television programming came under fire for promoting materialistic values. The Federal Communications Commission (FCC) responded in the early 1990s by regulating the amount of commercial time per hour. In many of these cases, however, the criticisms overstate the power of marketing communications to influence individuals and portray members of the public as individuals unable to distinguish between a good decision and a bad one. In addition, such charges cast marketing as a cause of social problems when often the problems have much deeper societal roots. Marketing activity also has been sometimes criticized because of its control by strong private interests and its neglect of social and public concern. While companies in the cigarette, oil, and alcohol industries may have significant influence on legislation, media, and individual behaviour, organizations that focus on environmental, health, or education concerns are not able to wield such influence and often fail to receive appropriate recognition for their efforts. While there is clearly an imbalance of power between private interests and public ones, in the late 20th century, private companies have received more praise for their marketing efforts for social causes.
Marketing's contribution to individuals and society
Although some have questioned the appropriateness of the marketing philosophy in an age of environmental deterioration, resource shortages, world hunger and poverty, and neglected social services, numerous firms are commendably satisfying individual consumer demands as well as acting in the long-term interests of the consumer and society. These dual objectives of many of today's companies have led to a broadening of the "marketing concept" to become the "societal marketing concept." Generating customer satisfaction while at the same time attending to consumer and societal well-being in the long run are the core concepts of societal marketing.
In practicing societal marketing, marketers try to balance company profits, consumer satisfaction, and public interest in their marketing policies. Many companies have achieved success in adopting societal marketing. Two prominent examples are The Body Shop International PLC, based in England, and Ben & Jerry's Homemade Inc., which produces ice cream and is based in Vermont. Body Shop's cosmetics and personal hygiene products, based on natural ingredients, are sold in recycled packaging. The products are formulated without animal testing, and a percentage of profits each year is donated to animal rights groups, homeless shelters, Amnesty International, rain-forest preservation groups, and other social causes. Ben & Jerry's donates a percentage of its profits to help alleviate social and environmental problems. The company's corporate concept focuses on "caring capitalism," which involves the product as well as social and economic missions. Marketing has had many other positive benefits for individuals and society. It has helped accelerate economic development and create new jobs. It has also contributed to technological progress and enhanced consumers'
TOURISM
Tourism - The Worlds Biggest Industry
Against the background. of unparalleled growth in the latter half of the twentieth century, tourism now finds itself at a crossroads in its development. On the one hand, it is heralded as 'the world's biggest industry' by a number of global organisations including the World Travel and Tourism Council (WTTC) and the World Tourism Organisation (WTO), which highlights the fact that tourism overtook both crude petroleum and motor vehicles to become the world's number one export earner in 1994. Its economic significance is also illustrated by the fact that tourism receipts were greater than the world's exports of other selected product groups, including electronic equipment, clothing, textiles and raw materials.
In addition, receipts from international tourism have achieved growth rates in excess of exports of commercial services and merchandise exports during the period 1984 to 1994. For the period 1985 to 1995 the trend is similar, with the following average annual percentage growth rates:
* Tourism l2per cent
* Commercial services 12 per cent
* Merchandise exports 10 per cent
WTO data also indicate rapid and sustained growth in international tourist arrivals and receipts from tourism over the last 30 years. Today, tourism is seen as a major contributor to global economic development, creating employment and generating wealth on a truly international scale. An increasing number of countries rely heavily on receipts from tourism for their economic and social well-being.
In direct contrast to this very positive outlook for the industry, many national governments are reluctant to invest public funds in tourism development and promotion, with tourism spending often being cut when more pressing social and economic needs arise. The decisions, in 1997, by the governments of Canada, the United States of America and Belgium to transfer responsibility, for tourism to private sector enterprises or regional authorities serve to illustrate this point well. In Britain, the funding of the English Tourist Board has been cut drastically since the early 1990s, the decision of a government that considered the industry to he sufficiently mature and able to fund its own expansion with diminishing public financial support. At a time of increasing corrcern for the environment and the retention of cultural identities, tourism is also viewed by governments and consumers alike as a potentially destructive force, causing harmful environmental and socio-cultural impacts in destination areas and on host communities. Paradoxically, it is not difficult to argue that the withdrawal of public funding and control from tourism development may well accelerate the industry's harmful environmental and socio-cultural effects.
It is against this background of a complex and rapidly expanding industry seeking to maintain its credibility and promote its economic benefits, often in the face of declining governmental and host community support.
The Business of Hotels
I The Importance of Hotels
Hotels play an important role in most countries in providing facilities for the transaction of business, for meetings and conferences, for recreation and entertainment. In that sense hotels are as essential to economies and societies as are adequate transport, communication and retail distribution systems for various goods and services. Through their facilities hotels contribute to the total output of goods and services, which makes up the material well-being of nations and communities.
In many areas hotels are important attractions for visitors who bring to them spending power and who tend to spend at a higher rate than they do when they are at home. Through visitor spending hotels thus often contribute significantly to local economies both directly, and indirectly through the subsequent diffusion of the visitor expenditure to other recipients in the community.
In areas receiving foreign visitors, hotels are often important foreign currency earners and in this way may contribute significantly to their countries' balance of payments. Particularly in countries with limited export possibilities, hotels may be one of the few sources of foreign currency earnings.
Hotels are important employers of labour. Thousands of jobs are provided by hotels in the many occupations that make up the hotel industries in most countries; many others in the industry are self-employed and proprietors of smaller hotels. The role of hotels as employers is particularly important in areas with few alternative sources of employment, where they contribute to regional development.
Hotels are also important outlets .for the products of other industries. In the building and modernization of hotels business is provided for the construction industry and related trades. Equipment, furniture and furnishings are supplied to hotels by a wide range of manufacturers. Food, drink and other consumables are among the most significant daily hotel purchases from farmers, fishermen, food and drink suppliers, and from gas, electricity and water undertakings. In addition to those engaged directly in hotels, much indirect employment is, therefore, generated by hotels for those employed in industries supplying them.
Last but not least, hotels are an important source of amenities .for local residents. Their restaurants, bars and other facilities often attract much local custom and many hotels have become social centres of their communities.
Travel and Hotels
Staying away from home is a function of travel and three main phases may be distinguished in the development of travel in the northern hemisphere.
Until about the middle of the nineteenth cenruiy the bulk of journeys were undertaken for business and vocational reasons, by road, by people travelling mainly in their own countries. The volume of travel was relatively small, confined to a small fraction of the population in any country, and most of those who did travel, did so by coach. Inns and similar hostelries along the highways and in the principal towns provided the means of accommodation well into the nineteenth century.
Between about 1850 and about 1950 a growing proportion of travellers went away from home for other than business reasons and holidays came to represent gradually an important reason for a journey. For a hundred years or so, the railway and the steamship dominated passenger transportation, and the new means of transport gave an impetus to travel between countries and between continents. Although the first hotels date from the eighteenth century, their growth on any scale occurred only in the nineteenth century, when first the railway and later the steamship created sufficiently large markets to make the larger hotel possible. Hotels together with guest houses and boarding houses dominated the accommodation market in this period.
By about the middle of the twentieth century in most developed countries of the world (a little earlier in North America and a little later in Europe) a whole cycle was completed and most traffic returned to the road, with the motor car increasingly providing the main means of passenger transportation. Almost concurrently the aircraft took over unmistakably both from the railways and from shipping as the principal means of long-distance passenger transport. On many routes holiday traffic came to match and often greatly exceed other traffic. A growing volume of travel away from home became international. Hotels entered into competition with new forms of accommodation - holiday centres and holiday villages in Europe, motels in North America, and various self-catering facilities for those on holiday.
Two Centuries of Hotelkeeping
Hotels are some two hundred years old. The word 'hotel' itself came into use in England with the introduction in London, after 1760 , of the kind of establishment then common in Paris, called 'hotel garni', or a large house, in which apartments were let by the day, week or trench. Its appearance signified a departure from the customary method of accommodating guests in inns and similar hostelries, into something more luxurious and even ostentatious. Hotels with managers, receptionists and uniformed staff arrived generally only at the beginning of the nineteenth century and until the middle of that century their development was relatively slow. The absence of good inns in Scotland to someextent accelerated the arrival of the hotel there; by the end of the eighteenth century Edinburgh, for example, had several hotels where the traveller could get elegant and comfortable rooms. Hotels are also known to have made much progress in other parts of Europe in the closing years of the eighteenth and early years of the nineteenth century, where at the time originated the idea of a resort hotel.
In North America early accommodation for travellers followed a similar pattern as in England, with most inns originating in converted houses, but by the turn of the eighteenth century several cities on the eastern seaboard had purpose-built hotels and in the first half of the nineteenth century hotel building spread across America to the Pacific Coast. The evolution from innkeeping to hotelkeeping, therefore, proceeded almost in parallel in the Old and in the New Worlds and the rise of the hotel industries on both sides of the Atlantic had probably more in common than is generally recognized. What America might have lacked in history and tradition, it more than made up in pioneering spirit, in intense rivalry between cities and entrepreneurs, and in the sheer size and growth of the travel market.
In the last century hotels became firmly established not only as centres commercial hospitality for travellers, but often also as important social centres of their communities. Their building, management and operation became specialized activities, with their own styles and methods. The present century brought about growing specialization and increased sophistication in the hotel industries of most countries, as well as their growth and expansion. But the growth and the diversity of hotel operations has been also matched by the growth and diversity of competition in the total accommodation
market.
Information about accommodation facilities in individual countries essentially reflects the designations used for them by the countries concerned and the coverage of various types in the available statistics. Only very broad inter-country comparisons are possible. One source is the annual report of the Tourism Committee of the Organisation for Economic Co-operation and Development (OECD), which distinguishes between beds available in hotels and similar establishments, and in what is described as supplementary accommodation.
The ratio of beds in hotels and similar establishments to beds in supplementary accommodation gives an indication of the relative importance of the hotel sector in the total accommodation market of individual countries. In most countries the accommodation profile tends to reflect the relative importance of foreign and domestic users, of leisure and business travel, and of other influences. In many countries hotels and similar establishments appear to be minority providers of accommodation.
Hotel Location
Hotel services are supplied to their buyers direct in person; they are consumed at the point of sale, and they are also produced there.
Hotel services must be, therefore, provided where the demand exists and the market is the dominant influence on hotel location. In fact, location is part of the hotel product. In turn, location is the key influence on the viability of the business, so much so that a prominent entrepreneur could have said with conviction and with much justification that there are only three rules for success in the hotel business: location, location, location.
We have seen earlier that from the early days all accommodation units followed transport modes, Inns and other hostelries were situated along the roads and at destinations, serving transit and terminal traffic. The rapid spread of railways marked the emergence of railway hotels in the nineteenth century. In the twentieth century motor transport created a new demand for accommodation along the highways and the modern motel and motor hotel have been distinctive responses to the new impetus of the motor car. A similar but les pronounced influence was passenger shipping, which stimulated hotel development in ports, and more recently air transport, which brought about a major growth of hotels in the vicinity of airports and air terminals.
Secondly, although this is closely related to transport, many hotels are located to serve first and foremost holiday markets. In their areas of highest concentration, holiday visitors are accommodated in hotels in localities whcre the resident population may represent only a small proportion of those present at the time, as is the case in many resorts.
The third major influence on hotel location is the location of economic activity and of industry and commerce in particular. Whilst again not separable from transport development, industrial and commercial activities create demand for transit and termInal accommodation in industrial and commercial centres, in locations not frequented by holiday visitors.
Different segments of the travel market give rise to distinctive patterns of demand for hotel accommodation and often distinctive types of hotels. In business and industrial centres hotels normally achieve their highest occupancies on weekdays and in resorts in the main holiday seasons; their facilities and services reflect the requirements of businessmen and of holiday visitors respectively. Between these clearly defined segments come other towns and areas, such as busy commercial centres with historical or other attractions for visitors, which may achieve a more even weekly and annual pattern of business.
Types of Hotels
The rich variety of hotels can be seen from the many terms in use to denote particular types. Hotels are referred to as luxury, resort, commercial, residential, transit, and in many other ways. Each of these terms may give an indication of standard or location, or particular type of guest who makes up most of the market of a particular hotel, but it does not describe adequately its main characteristics. These can be only seen when a combination of terms is applied to an hotel, each of which describes a particular hotel according to certain criteria. It is helpful to appreciate at this stage what the main types of hotels are, by adopting particular criteria for classifying them, without necessarily attaching precise meanings to them.
• Thus according to location hotels are in cities and in large and small towns, in inland, coastal and mountain resorts, and in the country.
• According to the actual position of the hotel in its location it may be in the city or town centre or in the suburbs, along the beach of a coastal resort, along the highway.
• By reference to its relationship with particular means of transport_there are motels and motor hotels, railway hotels, airport hotels (the terms also indicating location).
• According to the purpose of visit and the main reason for their guests' stay, hotels may become known as business hotels, holiday hotels, convention hotels, tourist hotels.
• Where there is a pronounced tendency to a short or long duration of guests' stay it may be an important hotel characteristic, so that the hotel becomes a transit or a residential hotel.
• According to the range of its facilities and services a hotel may be open to residents and non-residents, or it may restrict itself to providing overnight accommodation and at most offering breakfast to its guests, and be a hotel garni or apartment hotel.
• Whether a hotel holds a licence for the sale of alcoholic liquor or not, is an important dimension in the range of available hotel services, and the distinction between licensed and unlicensed hotels is, therefore, of relevance in describing a hotel in most countries.
• There is no universal agreement on how hotels should he described according to size, but by reference to their room or bed capacities we normally apply the term small hotel to one with a small amount of sleeping accommodation, the term large hotel to one with several hundred beds or bedrooms, and the term medium size hotel to one somewhere between the two, according to the size structure of the hotel industry in a particular country.
• Whatever the criteria used in hotel guides and in classification and grading systems in existence in many countries, normally at least four or five classes or grades have been found necessary to distinguish adequately in the standards of hotels and these have found some currency among hotel users. The extremes of luxury and basic standards, sometimes denoted by five stars and one star respectively are not difficult concepts; the mid point on any such scale denotes the average without any particular claims to merit. The intervening points are then standards above average but falling short of luxury (quality hotels) and standards above basic (economy).
Last but not least comes the ownership and management. Individually owned independent hotels, which may he managed by the proprietor or by a salaried manager, have to he distinguished from chain or group hotels, invariably owned by a company. Independent hotels may belong to a hotel consortium or cooperative. A company may operate its hotels under direct management or under a franchise agreement.
The above distinctions then enable us to describe a particular hotel in broad terms, concisely, comprehensively and meaningfully, e.g.:
• Terminus Hotel is a medium-sized economy town centre unlicensed hotel, owned and managed by a small company, catering mainly for tourists visiting the historic town and the surrounding countryside.
• Hotel Excelsior is a large independent luxury hotel on the main promenade of the coastal resort, with holiday visitors as its main market.
• The Crossroads Hotel is a small licensed quality transit motor hotel, operated as a franchise, on the outskirts of the city, which serves mainly traveling
F Hotel Products and Markets
The aim of this subject is to outline the facilities and services provided by hotels, who are the people who use hotels, why they use hotels, and what influences their choice of particular hotels. In providing answers to these questions, we can formulate a conceptual model of a hotel, which attempts to explain in simple terms how particular hotel products meet the needs of particular hotel markets, and establish a basis for a more detailed examination of the hotel business.
The Hotel as a Total Market Concept
From the point of view of its users, a hotel is an institution of commercial hospitality, which offers its facilities and services for sale, individually or in various combinations, and this concept is made up of several elements.
Its location places the hotel geographically in or near a particular city, town or village; within a given area location denotes accessibility and the convenience this represents, attractiveness of surroundings and the appeal this represents, freedom from noise and other nuisances, or otherwise.
Its facilities which include bedrooms, restaurants, bars, function rooms, meeting rooms and recreation facilities such as tennis courts and swimming pools represent a repertoire of facilities for the use of its customers, and these may be differentiated in type, size, and in other ways.
I ts service comprises the availability and extent of particular hotel services provided through its facilities, the style and quality of all these in such terms as formality and informality, degree of personal attention, and speed and efficiency.
Its image may he defined as the way in which the hotel portrays itself to people and the way in which it is perceived as portraying itself by them. It is a byproduct of its location, facilities and service, but it is enhanced by such factors as its name, appearance; its associations by who stays there and who eats there; by what it says about itself and what other people say about it.
Its price expresses the value given by the hotel through its location, facilities, service and image, and the satisfaction derived by its users from these elements of the hotel concept. The individual elements assume greater or lesser importance for different people. One person may put location as paramount and be prepared to accept basic facilities and service for an overnight day, ignoring the image, as long as the price is within a limit, to which he is willing to go. Another may be more concerned with the image of the hotel, its facilities and service. However, all the five elements are related to each other, and in a situation of choice most hotel users tend either to accept or reject as a whole, that is the total concept.
There are varying degrees of adaptability and flexibility in the hotel concept, ranging from the complete fixity of its location to the relative flexibility of price, with facilities, service and image lending themselves to some adaptation in particular circumstances with time.
Hotel Facilities and Services as Products
In the early days of innkeeping the traveller often had to bring his own food to places where he stayed the night-bed for the night was the only product offered But soon most establishments extended their hospitality to providing at least some food and refreshments. Today many apartment hotels, hotels gami, and motels confine their facilities to sleeping accommodation, with little or no catering provision. But the typical hotel as we know it today, normally provides not only accommodation, but also food and drink, and sometimes other facilities and services, and makes them available not only to its residents but also to non-residents.
Although the range of hotel facilities and services may extend as far as to cater for all or most needs of their customers, however long their stay, and for a hotel to become a self-contained community with its own shops, entertainments and recreation facilities, it is helpful at this stage to describe the hotel concept in a simpler form, by including only the main customer needs typically met by most hotels.
The main customer demand in most hotels is for sleeping accommodation, food and drink, and for food and drink for organized groups. These four requirements then relate to accommodation, restaurants, bars and functions, as the principal hotel products.
Sleeping accommodation is provided for hotel residents alone. Restaurants and bars meet the requirements of hotel residents and non-residents alike, even though separate facilities may be sometimes provided for them. Functions are best seen as a separate hotel product bought by organized groups; these groups may be resident in the hotel as, for example, participants in a residential conference, or be non-residents, such as a local club or society, or the group may combine the two. The total hotel concept - of location, facilities, service, image and price - can he, therefore, sub-divided according to the needs of the customer and the particular facilities brought into play to meet them. The cluster of elements of the total hotel concept is then related to each particular hotel product. Each hotel product contains the elements of the location, facilities, services, image and price, to meet a particular customer need or set of needs. The first approach to the segmentation of the hotel market is, therefore, taken by dividing hotel users according to the products bought.
Corresponding to each hotel product there are the buyers of that product who constitute a market for it.
Hotel Accommodation Markets
Hotel users who are buyers of overnight accommodation may be classified according to the main purpose of their visit to a particular location into three main categories as holiday, business and other users.
Holiday users include a variety of leisure travel as the main reason for their stay in hotels, ranging from short stays in a particular location on the way to somewhere else to weekend and longer stays when the location represents the end of a journey. Their demand for hotel accommodation tends to be resort oriented, seasonal and sensitive to price.
Business users are employees and others travelling in
the course of their work, people visiting exhibitions, trade fairs, or coming together as members of professional and commercial organizations for meetings and conferences. Their demand for hotel accommodation tends to be town- and city-oriented, non-seasonal and less price-sensitive, except in the case of some event attractions such as conferences and exhibitions, which may he usefully regarded as a separate category.
Other hotel users comprise visitors to a particular location for a variety of reasons other than holiday or business, e.g. those attending such family occasions as weddings, parents visiting educational institutions, visitors to special events, and common interest groups meeting for other than business and vocational reasons, re-locating families and individuals seeking permanent accommodation in an area and staying temporarily in an hotel, people living in an hotel permanently. The characteristics of this type of demand are more varied than those of the first and second group, and it is, therefore, often desirable to sub-divide it further for practical purposes.
Within and between the three main groups, which comprise the total market for hotel accommodation, there are several distinctions important to individual hotels. We have noted already that some hotel users give rise to demand for transit and short-stay accommodation; others are terminal visitors with a longer average stay. Also, for example, much business demand is generated by a relatively small number of travellers who are frequent hotel users; most holiday and other demand comes from a very large number of people who use hotels only occasionally. Moreover, business users often book accommodation at short notice, whilst holiday and other users tend to do so longcr in advance. And in allthree groups some people are individual hotel users, and others stay in hotels in groups.
Hotel Catering Markets
Hotel restaurants, bars and function rooms may be conveniently grouped together as its food and beverage or catering facilities, and the meals and refreshments they provide as the hotel food and beverage or catering products. Corresponding to them there are again buyers of these products who constitute the hotel catering markets and who may be classified in various ways. For our purposes there is a basic distinction between the demand exercised by hotel residents, by non-residents, and by organized groups.
The first category of users of hotel restaurants and bars is related to the basic function of the hotel in providing overnight sleeping accommodation, and consists of hotel residents, whom we have classified earlier as holiday, business and other users Their use of hotel catering facilities tends to be influenced by the reason for their hotel stay and by the terms on which they stay. Breakfast is their common hotel purchase, but otherwise a hotel resident may have his meals in his hotel or elsewhere, and he is more likely to be a hotel restaurant or bar customer in the evenings than at midday.
The second category is non-residents, individually or in small groups, when eating out. They may, in fact, be staying at other hotels or accommodation establishments or with friends or relative or be day visitors to the area, for holiday, business or other reasons Alternatively they are local residents, for whom the hotel restaurants and bars represent outlets for meals and refreshments, as a leisure activity or as part of their business activities. This category tends to represent important hotel users at midday as well as in the evenings, particularly at weekends.
The third category of users of hotel catering facilities is organized groups who make advance arrangements for functions at the hotel, which may call for separate facilities and organizational arrangements. They include local clubs, societies, business and professional groups, as well as participants in meetings and conferences originating from outside the area.
Hotel catering products represent a greater diversity than its accommodation products and it is often correspondingly more difficult to classify them and the markets for them in practice. Moreover, hotels are not alone in supplying them. In the market for meals and refreshments for individuals and groups a hotel competes not only with other hotels, but also with restaurants outside hotels, pubs and clubs, to name but a few other types of outlet.
Therefore, catering in hotels is a separate hotel function, with its own objectives, policies and strategies, and with its own organization.
Hotel Demand Generating Sources
For most people the use of hotels represents what is known as derived demand because few stay or eat in hotels for its own sake; their primary reasons for doing so lie in their reasons for visiting an area or for spending their time there in particular ways. When describing hotel accommodation and catering markets we have seen that hotel users have different degrees of freedom and choice as to whether they buy hotel services or not. Some have
few or no alternatives; for them only hotels provide the facilities and services which they require in a particular area in pursuit of their business, vocational and other interests; the incidence of their hotel usage arises to a great extent from their working circumstances. For many others the use of hotels is a matter of choice; they do so in their pursuit of leisure and recreation; for them hotel usage involves a discretionary use of their time and money. This distinction helps us identify the demand generating sources for hotels in a given area, which are of three main types-institutional, recreational and transit.
Institutional sources include industrial and commercial enterprises, educational institutions, government establishments and other organizations in the private and public sector, whose activities are involved in the economic life of the community and in its administration. These institutions generate demand for hotels through their own visitors and their other requirements for hotel facilities and services.
Recreational sources include historical, scenic and other site attractions and event attractions, which generate demand for hotels from tourists; local events and activities in the social and cultural life of the community, which generate demand from clubs, societies and other organizations; happenings of significance to individuals and families.
The third source of demand stems from individuals and groups with no intrinsic reason for spending time in a particular locality, other than being on the way somewhere else and the need to break a journey. This source of demand is closely related to particular forms of transport; it expresses itself on highways, at ports and at airports, and may be described as transit.
It will be readily apparent that this view of demand generating sources for hotels is closely related to several aspects of the hotel business considered earlier - for example, to the three-fold classification of the hotel accommodation market into holiday, business and other users; to the three main influences on hotel location - travel, holidays and economic activity; and to the types of hotel. By adopting in each case a somewhat different viewpoint, it is possible to highlight the interdependence between the location, markets and products of hotels.
Hotel Market Areas
We can define a hotel market in several ways by reference to the people who buy hotel services, as a network of dealings between the hotel and its users, or as an area which a hotel serves. In the first two approaches hotel users may come from within the area, from various parts of the country, and from abroad; we then refer to the local, domestic and foreign markets, and subdivide them in appropriate ways. In the third approach described below we view the hotel market area as a physical area served by the hotel.
For hotel accommodation it is necessary to identify all the institutional and recreational sources of demand, which may be served by a particular hotel. The area drawn in this way round the hotel may extend from its immediate vicinity to a radius of several miles or more. How far it does extend depends on the geographical distribution of the demand generating sources, the mode of transport used by the hotel users of each source, and the availability of other facilities in the area. The head office of a large firm, a university, a historic castle, and a town which is a festival centre, may be all within a market area of a hotel, if the hotel is reasonably accessible from these points, and if its location at least matches the location of other hotels. The market area may coincide for a number of hotels within close proximity of each other, which offer a similar concept in terms of facilities, service, image and price. On the periphery the market area for a hotel may overlap with the market areas of other hotels some distance away. At periods of peak demand it may extend further than at times of low demand. For transit the accommodation market area is related to the journeys undertaken through the area - their origin and destination, the method of transportation, the time of day, the time of year and other circumstances of the journeys.
For hotel catering services the market area depends on market density - the availability of spending power within an area, as well as on the accessibility of the hotel to the different sources of demand, and on the availability of other catering services in the area. In this there is a close analogy with the concept of a catchment area for other retail outlets, as far as the resident population is concerned. How far do people go from where they live to do their shopping? The distance may vary according to the purchase they are to make. Similarly there may be a smaller market area for hotel lunches than for hotel dinners and functions, because close proximity to the hotel may he a more important consideration for a midday meal than for an evening out.
Hotel Market Segmentation
The market for hotel products may be divided into several components or segments and this enables individual hotels to identify their actual and potential users according to various criteria. Segmentation then provides a basis for the marketing of hotel products, for paying close attention to the requirements of different users, and for monitoring the performance in the markets chosen by a hotel.
We divided hotel users, according to the product bought by them, into buyers of accommodation, food, drink and functions. We divided the accommodation market, according to the reasons for the users' stay, into holiday, business and other users, and the hotel catering market into hotel residents, non-residents and functions. According to the origin of demand we also identified institutional, recreational and transit sources of demand.
Another basis for segmentation is the needs of hotel users and the means_they have to pay for their satisfaction, by dividing them according to their socio economic characteristics. Socio-economic classifications seek to group people according to their occupation and employment status. For example, the British Joint Industry Committee for National Readership Surveys (JICNARS) defines social grades as shown in the following table:
Social Grade Definitions
Social grade
Social status
Occupation
A
Upper middle
class
Higher
managerial,
administrative
or professional
B
Middle class
Intermediate
managerial,
adminisniative or
professional
C 1
Lower middle
class
Supervisory or
clerical, and
juniormanagerial,
administrative or
professional
C2
Skilled working
class
Skilled manual
workers
D
Working class
Semi- and
unskilled manual
E
Those at the
lowest level of
subsistence
State pensioners
or widows (no
other earner),
casual or lowest
grade workers
Social grade A might be expected to stay in luxury and quality hotels, B in medium hotels, C in economy hotels. However, this is an oversimplification, because the same people may interchange between segments according to the circumstances in which they find themselves. A businessman on an expense account may stay in a quality hotel, but travelling for pleasure with his family he may stay in a lower grade hotel. Moreover, the incidence of hotel usage among DE groups is minimal. Nevertheless, segmentation by socio-economic criteria is an important approach to market segmentation. For some purposes age, family composition, life cycle stage, or other criteria may be more appropriate.
A concomitant of market segmentation is product branding, with a view to differentiating an hotel from others in the minds of buyers, long established in other consumer industries. Some hotel groups have focused on branded segments distinguished by levels of service; examples include Holiday Inn upmarket Crowne Plaza, core brand Holiday Inn and limited service Garden Court.
Other brands have been created by grouping like operations, such as Forte Posthouses and Whitbread Lanshury Hotels, or by acquisition, such as Porte Crest and Mount Charlotte Thistle.
We anticipate that product segmentation will assume even greater significance in the future development of hotel companies. It is an effective method for hotel companies to maintain or expand market share and in some instances create new markets.
Product branding will become more focussed and will reflect increasing levels of segmentation.
In the light of this, the future of the 'all purpose hotel' is doubtful in terms of its competitiveness in the market place.
Buying and Paying for Hotel Services
It is important to understand how a buying decision is made, who makes it, and who pays for the hotel services bought.
The buying decision itself may be basically of two kinds -deliberate or impulsive. Before embarking on journeys, business people may ask secretaries to reserve hotel rooms in the towns they are to visit for specified nights. A family may arrive at their choice of holiday hotel after a scrutiny of hotel guides. A society may make several inquiries before choosing the venue for their annual dinner dance. These are deliberate buying decisions made with some _advance planning and with advance reservations. A tourist looking for somewhere to stay when travelling by car, or on arrival at the railway station or airport, is likely to make an impulse decision, in much the same way as a couple walking through the streets of a town and 'discovering' a restaurant which appears to be to their liking. Purchases of hotel products are both deliberate and impulse purchases and most hotels respond to both, although different operational policies and procedures normally apply to each.
Many people make their own arrangements for travelling and for staying in hotels. However, many hotel bookings are made by people who do it for others: the secretary for the boss, the travel agent for the client, the business travel department of a large company for its employees. In these circumstances it is important to know who the buying agent is and where that person is located, if the knowledge derived from the analysis of the hotel demand generating sources is to be applied to bringing about sales. Most hotels can no longer hope to fill their beds, restaurants and bars by simply waiting for the guest.
According to the source of payment for hotel services, hotel users are also of two basic kinds - those who pay themselves and those whose hotel bills are covered or reimbursed for them. Most leisure use of hotels represents personal expenditure out of disposable incomes, the bulk of business use of hotels in the wide sense is paid for directly or indirectly by third parties - employers and other agencies on behalf of the guest. Although many business users have no fixed limits as to the charges they incur in hotels, many tend to observe what they and their organizations regard as acceptable. The understanding of these practices is important to hotels too. The decision on the market segments to be catered for is closely related to decisions on pricing and we have seen that price is an integral element of each hotel's total concept.
Hotel Marketing Orientation
Hotels serve people and their success depends on how well they serve them in places where they wish to be served. This is only a way of stating in the simplest of tenns the application to hotel operations of the marketing concept, which is concerned with the consumer as a starting point in the conduct of business.
The marketing concept is beginning to be understood by hoteliers. Although some continue to regard sales andmarketing as synonymous, most hotels no longer operate in the seller's market and even massive sales effort is not likely to generate a sustained high volume of business, if consumer needs are not genuinely met in the planning, design and subsequent operation of an hotel.
The basic hotel concept stresses the view of the hotel, as it is seen by the hotel user rather than the hotel operator, as a business to meet the needs of hotel users. Some of these needs are basic and physical, such as sleeping in clean beds or eating wholesome meals; others such as those met by the image of the hotel are acquired needs, which reflect what a person aims to be as an individual. A successful hotel must seek to meet both sets of needs. So that an hotel can meet the needs of hotel users, individual hotel services have to be seen as hotel products sold to particular markets. A hotel cannot be all things to all people. Each hotel has to achieve a match between its particular products and particular market segments, i.e. groups of people with more or less similar characteristics and requirements for hotel services. In this there is a difference between the hotel accommodation and catering products, in that each may to some extent cater for different markets. But this difference only reinforces the need for harmony in the total hotel concept. In order to achieve the match between hotel products and markets, there is a need for a careful analysis of the sources of demand for hotel services in the market area served by the hotel and an understanding of how hotel services are bought and paid for.
From this model of a hotel a translation can be made to particular operations. This takes the form of hotel policies, philosophies and strategies.
Special Features of Hotel Marketing
Marketing is first and foremost about matching products and markets and in this sense the marketing of hotel services is in principle no different from the marketing of other consumer products. But there are special features of hotel products and markets and hence of hotel marketing.
For most users hotel rooms are a means to an end and not an end in itself and the demand for them is what is known as derived demand - the reason for their use may be a business visit or a holiday or something else but rarely the room itself, and the same applies to some extent to other hotel services.
The availability of the most important hotel product, the hotel room, is fixed in time and place. In the short term the number of rooms or beds on offer cannot be significantly changed and location is part of the highly perishable product, which cannot be stored for future sale or follow the customer. The demand for hotel accommodation and other services fluctuates from day to day, from week to week and from one part of the year to another. A waste occurs when demand falls and there is a definite upper limit to the volume of business in a period of peak demand.
Hotel investment is primarily an investment in land and buildings and interior assets. The bulk of the capital invested in the fixed assets of the hotel, combined with the continuity of hotel activity, gives risc to high fixed costs, which have to be covered irrespective of the volume of business. Three key factors are, therefore, critical to a successful hotel operation - the right location, correct capacity, and a high level of utilization, all of them imply marketing decisions - first in the conception of the hotel and in its operation subsequently.
In the conception of the hotel, marketing can contribute first through a market feasibility study to assess the demand. A study may identify the best market opportunity for a hotel, a gap in the market, a location or choice between alternative locations, for a particular hotel concept; or, given a particular location, a study can determine the most appropriate hotel concept. The translation of the concept into an operational facility then takes place through product formulation and development. In the operation of the hotel, marketing can contribute through a continuous process of market research, product development, promotion, selling, monitoring and review - the stages of a marketing cycle.
In the planning of a new hotel, there is full scope for the adherence to the marketing concept from the outset. In an existing hotel, there is often an important distinction between the short-and long-term marketing tasks. In the short term the marketing task may be to adjust customers' wants to available facilities and services, but the long-term task is to modify the facilities and services to the customers' wants.
In the short run our existing facilities and services are given within narrow limits. We may research the market to see which market segments are or could be attracted to them, make such adjustments to our products as are possible, but the main effort is likely to focus on promotion and selling. With low occupancies and low utilization of restaurants, bars and function rooms, in the short run the sales effort becomes dominant. But it is no excuse for doing just that; it is both necessary and possible to proceed with changing the products: toestablish who our customers could be and what their needs are (market research), and to formulate and develop products meeting their needs (product formulation and development). This approach ultimately calls for less sales effort, which is then designed to demonstrate to people that their needs can be met; it is of particular importance in hotels.
Marketed commodities and articles are concrete, physical and capable of measurement; most of them can be inspected and many of them even tried out before purchase. Services are less tangible and hotel services particularly so. Hotel services cannot be easily defined and described in terms of clearly measurable products and their qualities. They are often bought individually or as part of a package, and they may be bought directly by the user or through an intermediary, for example, a travel agent. In hotels, as in other walks of life, it is necessary to make it easy to buy only more so.
Property Ownership
An investment in hotels is first and foremost an investment in land and buildings, which represent the dominant assets of hotels. Other fixed assets are:
• plant and equipment, including such major items as air conditioning, boilers, lifts, and heavy kitchen equipment;
• furniture, furnishings, and small equipment;
• china, glass, linen and cutlery.
Accordingly there is a dual nature of investment in hotels - as an investment in land and buildings and an investment in interior assets. This distinction has been recognized in three principal ways in recent years.
First, the building shell may be owned by a developer, sometimes as part of some larger project, and leascd to anhotel operator on a rental basis. This is also implied by some hotel groups, which apply internal rentals to hotels owned by them; in this way the hotel profits are assessed after taking into account the notional rental of the land and building.
Secondly, hotel companies make use of sale-and-lease- back arrangements as a means of financing the investment, which reduces the capital requirement for the hotel operator.
Thirdly, interior assets may be also leased by the hotel operator rather than bought, thereby also reducing the capital requirement.
There are, therefore, various arrangements as to who is involved in property ownership and in hotel management. A hotel operator may invest in the property represented by land and buildings or enter into a leasing arrangement and invest only in the interior assets, or an operator may enter into a management contract without any direct capital investment.
Property Operation and Maintenance
In large hotels and in hotel groups normally a senior person is ultimately responsible for technical services who may be variously described as the technical services, buildings and services, or works director, officer, or superintendent, or simply as chief engineer, or by some such title. In large organizations the technical services may be subdivided between those responsible for buildings, for engineering, and for other services.
Although technical considerations may be the direct concern of hotel management in smaller hotels, they arespecialist activities normally entrusted to specialist staff and sometimes 'contracted out'.
Property operation, maintenance and energy costs are costs of hotel operation, as distinct from the capital investment outlay on the assets. They are, therefore, appropriately included in hotel profit and loss statements.
In the Uniform System of Accounts for Hotels property operation and maintenance includes costs of repairs and maintenance of buildings, plant and equipment, furniture and furnishings, as well as the maintenance of grounds, related wages and salaries, and work let out on contract. The costs incurred by hotels contributing to Horwath International reports in the early 1990.
III.Hotel Organization
Organization is the framework in which various activities operate. It is concerned with such matters as the division of tasks within firms and establishments, positions of responsibility and authority, and relationships between them. It introduces such concepts as the span of control (the number of subordinates supervised directly by an individual), levels of management (the number of tiers through which management operates), delegation (the allocation of responsibility and authority to designated individuals in the line of 'command').
Until not so long ago - about the middle of this century and even later than that the typical hotel of almost any size was characterized by a large number of individuals and departments directly responsible to the hotel manager who was closely concerned with his guests and with all or most aspects of the hotel operation. Theremight have been one or more assistant managers who had little or no authority over such key individuals as the chef, the head waiter or the housekeeper. The hotel manager usually combined the 'mine host' concept of hotel keeping with a close involvement in the operation. He normally had all or most of the technical skills that enter into the business of accommodating and catering for guests. Although he might have given more attention to departments in which he felt confident about his expertise, and less to those in which his knowledge and skills might have been lacking, his approach was essentially that of a technician rather than the manager of a business. Hotels served those who chose to use them. The financial control was exercised by the owners or by accountants on their behalf. Personnel management rarely extended beyond the 'hiring and firing' of staff. Hotel buildings and interiors were not often viewed as business assets required to produce a return comparable to other commercial investments; maintenance and energy were cheap.
Several influences have tended to change this profile generally and the approach to hotel organization in particular in the second half of the twentieth century. The market for hotels, the number of hotels, and the size of individual operations have grown, against the background of economic and social conditions in most parts of the world. Business and management thought and practice have found their way into hotels, with the entry into the hotel business of firms engaged in other industries, development of hotel education and training, and higher quality of management. Innovation in hotel organization, at first largely confined to a few firms in North America, has spread to others in other countries. These and other influences have brought about changesin the ways in which hotels organize their activities today.
Three particular developments illustrate the changes in hotel organization in post-war Britain. One relates to the grouping of functions. In the early I 950s hotel reception, uniformed services and housekeeping were invariably regarded as separate departments, each reporting directly to the hotel manager; twenty years later many large hotels had front hall managers, rooms managers, or assistant managers with specific responsibilities in this area. Similarly, over the same period in most large hotels food and beverage managers came to be appointed, responsible for all the hotel activities previously organized in restaurants, bars and kitchens under the direct control of the hotel manager. Secondly, there has been a growth in specialists. In the early 1950s only a few large hotels had a staff manager, a public relations officer or a buyer; by the early 1970s personnel, sales and marketing, and purchasing departments were common features of the large hotels and of hotel groups. Thirdly, where each hotel used to be more or less self-sufficient in the provision of its various guest services and supporting requirements, many of these are now provided through internal rentals and concessions and through specialist suppliers and operators such as outside bakeries, butcheries and laundries.
The accommodation function may be described in terms of reception, uniformed services and housekeeping. Several typical organizational approaches may be identified in respect of these activities in practice:
- all three activities operate as separate departments with their own heads of department;
-reception and uniformed services are grouped together as the front hail or front house of the hotel under an assistant manager for whom this is the sole or main responsibility;
- reception and uniformed services are grouped together as a front hail or front house department with its own head of department.
- all three activities are grouped together as the rooms department under an assistant manager for whom this is the sole or main responsibility;
- all three activities are grouped together as the rooms department with its own head of department.
The first approach provides for a direct line of responsibility and authority between each separate head
Rooms
The accommodation function may be described in terms of reception,uniformed services and housekeeping. Several typical organizational approaches may be identified in respect of these activities in practice:
- all three activities operate as separate departments with their own heads of department;
-reception and uniformed services are grouped together as the front hail or front house of the hotel under an assistant manager for whom this is the sole or main responsibility;
- reception and uniformed services are grouped together as a front hail or front house department with its own head of department.
- all three activities are grouped together as the rooms department under an assistant manager for whom this is the sole or main responsibility;
- all three activities are grouped together as the rooms department with its own head of department.
The first approach provides for a direct line of responsibility and authority between each separate head of department and the hotel manager and hence for a close contact between the two levels of management; however, it extends the hotel manager's span of control and he is required to coordinate the separate departments. The other four approaches are designed to reduce the hotel manager's span of control and provide for a coordination of related activities at an intermediate level but increase the number of levels through which management has to operate, and reduce the amount of direct contact between the hotel manager and the departments concerned.
Several activities were described in connection with rooms, which may be arranged differently in large hotels:
In most hotels advance reservations form an integral part of hotel reception and the same employees deal with them and with other reception tasks. But advance reservations may be dealt with in a separate section of the reception office or in a separate department, to enable employees to concentrate on the respective tasks without conflicting demands on their time and attention. Sometimes all advance reservations are concentrated in the sales department, which has a responsibility for maximizing hotel occupancy.
In smaller hotels guest accounts are normally handled by book-keeper/receptionists, but strictly speaking guest accounts represent an extension of the accounting function of the hotel. Therefore, where guest accounting is handled by bill office clerks and cashiers, they normally form a part of the accounts department.
• In some hotels room service is provided by housekeeping staff, but room service is clearly part of the food and beverage function of the hotel.
Food and Beverage
Several typical organizational approaches identified in respect of this function in practice:
? may be each sales outlet and supporting service operates as a separate department with its own head of department;
• several departments are grouped together under an assistant manager for whom they represent the sole or main responsibility, e.g. purchasing and storage, bars and cellars, the 'back-of-the-house' activities including the kitchen, and so on;
• several of these departments are grouped together as one department under its own head of department;
• all food and beverage activities are grouped together under an assistant manager for whom they represent the sole or main responsibility; • all food and beverage activities are grouped together as a food and beverage department with its own head of department.
The same observations apply to these approaches as are made above in relation to rooms, regarding lines of responsibility and authority, span of control and levels of management; the size of the span of control and the number of management levels are conflicting considerations.
Several aspects of the food and beverage function are closely related to each other but also to other parts of the hotel operation:
• Most hotels have facilities serving both food and beverages, although in some of them food or beverages may predominate. Whilst it is usually relatively easy to separate the revenue from each, it is often impractical to separate accurately all the costs of operation other than the cost of sales, because the same employees may handle both products, and because other goods and services provided in the same outlet may not be readily identifiable as either food or beverages. In these circumstances food and beverages are treated together, analysed by sales outlet, and the related responsibilities are reflected in the organization structure.
• Food and beverage control based on the food and beverage cycles may be appropriately seen as part of the total accounting function of the hotel. In these circumstances such employees as restaurant cashiers and cost control clerks are included on the staff of the hotel accountant. • 'Where there is a separate sales department, food and beverage sales are usually closely monitored by that department, and such arrangements as reservations for functions may form part of the responsibilities of the sales department.
Miscellaneous Guest Services
Miscellaneous guest services are illustrated in terms of such activities as telephones and laundry and the typical organizational approaches for most of term are shown to be of two main kinds:
• the services are operated under direct management of the hotel as minor operated departments;
• the services are operated under rental and concession arrangements with the hotel by another firm.
The alternative arrangements may apply in the provision of the following main services to guests:
beauty shop and hairdressing
secretarial services
florist
squash courts and
tennis courts
garage
gifts and souvenirs
laundry and dry cleaning
swimming pool
newspapers and magazines
tobacconist
Direct management of these services normally provides for a closer direct control and supervision by the hotel and for greater flexibility in operation. In many hotels the services are merely grouped as residuary hotel activities for accounting and control purposes and are in practice provided as part of the services of other hotel departments, e.g. reception, uniformed services, housekeeping or general administration, and are not separate departments in the organizational sense. Only when the volume of a particular service is sufficiently large, it may be organized as a separate department. And it is only then that the option arises for the service to be provided for the guests by another operator, because it warrants his involvement, under a rental or concession arrangement. Such arrangement then relieves the hotel from operating what is often to the hotel operator an unfamiliar service and allows it to concentrate on its primary activities.
Therefore, major deciding factors are the size of the operation, the availability of suitable operators of particular services, and the operational philosophies of the hotel or hotel group, as well as the quality of service and the financial return to the hotel, which may result from one or the other approach.
Hotel Support Services
In practice the non-revenue service activities are organized in one of three main ways:
• retained among the hotel manager's own responsibilities;
• assigned to an assistant manager as one of his or her responsibilities;
• assigned to a separate department with its own head of department.
To a greater or lesser extent each of these activities may also draw for its performance on external specialist advice and assistance.
The main specialist activities, which may be organized in one of these ways, and examples of the external sources of advice and assistance available to the hotel in respect of each, can be summarized as follows:
Accounting and finance
Hotel accountants and consultants
Public accountants and auditors
Professional stock-takers
Personnel services
Personnel recruitment and selection specialists
Work study, personnel and industrial relations advisers
Training boards and other agencies
Purchasing
Hotel accountants and consultants
Furniture and equipment
specialists
Various suppliers
Sales and marketing
Market research agencies
Advertising agencies
Public relations consultants
Property operation,
maintenance, energy
Architects, builders, designers
Consulting engineers
Utility undertakings
Advisory services are also sometimes provided by professional bodies, trade associations for their members, the technical press and other agencies.
Apart from any operational philosophies, the adoption of the organizational approaches, in respect of a particular activity, is largely determined by the size of operation: the first is normally associated with a small hotel; the second with medium size; and the third with large operations, but no hard and fast rules apply. Each of these activities comprises specialist knowledge and skills, as distinct from normal operational know-how inherent in the primary operating activities.
The Management Structure
Following the discussion of the division and grouping of operated and service activities into departments, it is next necessary to consider the total management structure of the hotel; this comprises all positions of responsibility and authority below top management, which is represented in a hotel company by the board of directors. The management team consists of the hotel manager, one or more deputy or assistant managers, and the heads of departments. A discussion of the management structure is concerned with these posts and with the relationships between them.
According to the size of the hotel and the particular arrangement in operation, the hotel chief executive may be variously designated as managing director, general manager or simply hotel manager. He or she may to agreater or lesser extent participate in the formulation of the hotel policies and strategies, and will invariably be responsible for their implementation and for the hotel performance. In larger hotels this level may be subdivided betweena managing director or general manager and the hotel manager or a resident manager. The former then reports to the board and normally coordinates the work of the specialist departments and of the hotel or resident manager, who is in turn responsible for the day-to-day management of the hotel activities.
The complexity and continuity of the hotel activities normally give rise to the need for one or more deputy or assistant managers. A deputy hotel manager normally has authority over the heads of departments. But there is much variation in the role, authority and responsibilities of hotel assistant managers.
In some instances they are the hotel manager's deputies in all but name, in respect of the whole operation or some parts of it, e.g. food and beverages, front hall, 'back of the house', and so on; in other cases they have these specific responsibilities in addition to their general role as the manager's deputies. But many so-called assistant managers perform roles, which are more appropriately described as those of general assistants (assisting where required throughout the hotel) or of personal assistants to the manager (acting on his behalf as he directs them to do). Yet in other cases their main role is guest contact.
All the roles described above may be appropriate in particular circumstances, but effective hotel management calls for a clear definition of responsibility and authority. The relationships with heads of departments are especially important in this context. Titles, which describe the particular roles, can be helpful in this direction.
In order to provide clear-cut lines of responsibility and authority and an effective coordination of related activities, some hotels function without assistant managers as such: those who would normally be in such positions are allocated specific responsibilities and appropriate titles to describe them.
Those in positions of heads of departments fall into two distinct categories. Heads of operated departments are known as line managers, with direct lines of responsibility and authority to their superiors and to their subordinates in respect of each operated department. Heads of service departments are specialists who provide advice and service to line management, and relieve them of such specialist tasks as are considered to be more effectively discharged through the appointment of specialists; they have no direct authority over employees other than those of their own departments. Line management includes, for example, head receptionists, head housekeepers, head chefs and restaurant managers. Specialists include accountants, buyers, personnel and purchasing officers and similar posts. In order to draw a distinction between the two, it is helpful to confine the designation 'manager' to operated departments.
It is also relevant to refer in this context to a confusion, which often arises with various trainee positions. It is difficult to justilt such titles as 'trainee manager' unless its holder has been designated to fill a specific post, for which he is training. A person who is undergoing training with a view to an ultimate unspecified position of responsibility is more appropriately described as a management trainee.
IVHotel Services
Rooms and Beds
The primary function of a hotel is to accommodate those away from home and sleeping accommodation is the most distinctive hotel product. In most hotels room sales are the largest single source of hotel revenue and in many, more sales are generated by rooms than by all the other services combined. Room sales are invariably also the most profitable source of hotel revenue, which yield the highest profit margins and contribute the main share of the hotel operating profit.
Hotels contributing to annual reports of Horwath International earned on average the proportions of their total revenue shown in the following from room sales in the early 1990s.
Room Sales as a Ratio of Hotel Revenue in Main Regions
1990
1991
1992
(%)
(%)
(%)
Africa and the Middle East
46.0
43.6
45.2
Asia mid Australia
54.1
56.0
57.9
Europe
49.2
49.1
47.0
North America
63.9
62.9
71.6
Latin ArnericalCaribbean
53.8
58.5
56.
Three main hotel activities are earning the room revenue: hotel reception, uniformed services and Room Sales
A large proportion of hotel guests reserve their rooms from a few hours to several weeks or months before they actually arrive at the hotel. They do so in person, by telephone, telegram, Telex or Fax, by mail, through travel agents, and in a growing number of cases through central reservations systems. Hotel reservations create a multitude of contractual relationships between the hotel and its guests, which begin at the time each reservation is made and continue until the departure of the guests or until their accounts are settled after their stay. Advance reservations are an important responsibility on the part of the hotel, both in the legal and in the business sense, and call for a system which enables room reservations to be converted into room revenue. When guests arrive in hotels, they are asked to register by providing the receptionist with certain particulars about themselves. The hotel register, in which the particulars are entered, has two main functions; one is to satisfy the law, which makes hotel registration of guests a legal requirement in most countries. The second function is to provide an internal record of guests, from which data are obtained for other hotel records.
In most hotels room allocations of accommodation reserved in advance are made before the guests' arrival and only guests registering without a previous reservation are allocated rooms on arrival, but in some hotels all room allocations are made only when guests arrive. The registration and room allocation are then the starting point for guests' stay and a signal for the opening of their accounts, as well as for notifying uniformed staff, the housekeeping department, telephonists, and others, of arrivals.
Several main records document the room sale in the reception office:
• reservation form or card standardizes the details of each booking, forms the top sheet of any documents relating to it, and enables a speedy reference to any individual case;
• reservation diamy or daily arrival list records all bookings by date of arrival and shows all arrivals for a particular day at a glance;
• reservation chart provides a visual record of all reservations for a period and shows at a glance rooms reserved and those remaining to he sold;
• hotel register records all arrivals as they occur and gives details of all current and past guests;
• reception or room status board shows all rooms by room number and floor and gives the current and projected status of all rooms on a particular day, with details of occupation;
• guest index lists all current guests in alphabetical order with their room numbers and provides an additional quick point of reference in larger hotels.
Mall and Other Guest Services
A combined key and mail rack is a standard feature of most hotel reception offices and reflects two typical responsibilities of the office room keys and guest mail, Arranged by room number and floor, it corresponds in layout to the reception or room status board and is complementary to it.
In the course of a day's business room keys arc issued from the rack to arriving guests and to residents who call for them; keys are returned to the rack by guests going out of the hotel or departing at the end of their stay. The rack is a point of reference regarding the occupation of rooms and the whereabouts of guests.
Mail may arrive for guests before, during and after their stay at the hotel, and may consist ç.f ordinary or registered mail, packets and parcels, cables and' telegrams, Telex messages, Fax transmissions, express mail and personal messages left for guests. Mail awaiting guests' arrival should be handed to them when they are registering; mail arriving after a guest has left the hotel, should be forwarded. During the guest's stay speed is the essence of Fax transmissions, security is the essence of registered mail, bulkiness is the essence of parcels; each calls for standard procedures of their own. But the key and mail rack is the focus; it accommodates much of the mail the guest collects when collecting the room key; it can serve to alert the receptionist to items such as parcels or registered mail, stored elsewhere.
Three basic aids are, therefore, related and complementary in the provision of key, mail and other guest services:
• guest index shows whether a particular person is resident and that person's room number;
• reception or room status board shows who is occupying a particular room;
• key and mail rack indicates whether the guest is in the hotel and whether there is any mail for that person.
In many hotels the reception office or a separate section of it also acts as a source of information to guests
- about hotel facilities and services, about the locality, about transport and other matters. In other hotels the keys, mail and information to guests are provided by uniformed staff, and there are usually good reasons for one or the other arrangement. But who does what and to whom the guest can turn, should be made clear to the guest in terms of individual needs and requirements rather than in terms of the hotel organization structure, particularly in larger hotels. Such notices as 'Reception' and 'Hall Porter'have different connotations in different hotels and are not necessarily self-explanatory even for experienced hotel users. Counters and sections of the front hall of the hotel clearly labelled 'Registration', 'Keys', 'Mail', 'information', 'Guest Accounts', and so on, are more meaningful to guests.
Uniformed Services
The second component of the accommodation function is uniformed services, which form an integral part of the front hail ftmnctions of the hotel and provide a variety of personal services to guests.
Servicing arrivals and departures are the most common uniformed services. The meeting and greeting of arriving guests, their luggage and the parking of their ears, are the first responsibilities, which extend from the hotel entrance and car park to the hotel bedrooms. On departure, guests, luggage and transportation are again their primary responsibilities. In an hotel with a hundred departing guests in the morning, followed by a similar volume of arrivals in the afternoon and evening, uniformed staff attend in a day's business to some two hundred people, handle several hundred pieces of luggage, park several doPzen cars, and arrange several dozen taxis. The guests, their luggage, and their vehicles, therefore, play a major part in the provision of uniformed services.
During the guest's stay uniformed staff are often the main source of informatinn about the hotel and the locality, and the guest's main source of such arrangements as theatre tickets, tours, car hire and other services. The hail porter's desk or an enquiry counter in the front hail are then the information centres of hotels, which contribute much to the range of guest services and to their integration.
In some hotels other guest services may be provided by uniformed staff. Newspapers, as well as other small articles, may be supplied to guests by uniformed staff who may also act as messengers, lift operators and men's cloakroom attendants. In many hotels uniformed staff are the only people on duty during the night and particularly in smaller hotels maintain a whole range of hotel services provided by other departments in day time: to receive and register late arrivals, to serve light refreshments, to operate the hotel switchboard, to arrange early morning calls, as well as to clean public rooms and to ensure the security of the hotel.
The provision of uniformed services varies greatly between hotels of different sizes, types and standards, and their organization tends to be influenced by all these factors, as well as by established practices, As mentioned earlier, information to guests may he provided by the reception office or as part of uniformed services or by both. The cleanliness of public rooms may be the responsibility of uniformed staff, the housekeeping department, or outside contractors. What hotel services are available during the night and by whom they are provided, is another source of variation. These differences are legitimate, as long as they reflect the particular requirements of guests and the particular circumstances of each hotel, and as long as the respective functions are defined and understood by staff and made clear to guests where they affect them.
Hotel Housekeeping
The basic housekeeping function of the hotel is the servicing of guest rooms. In its scope, guest bedrooms may be the sole or main responsibility of the hotel housekeeping department, but it may extend to other areas of the hotel.
Normally hotel guests spend at least one-third of their stay in their room. The design, layout, decor, furniture and furnishings of the hotel bedroom are fundamental to meeting their needs and in creating customer satisfaction, and these may be significantly influenced by the housekeeping department. The cleanliness and good order, the linen and other room supplies, and the smooth functioning of the room are the focus of the department. This may include other guest services, such as early morning teas, guest laundry, baby sitting and other personal services. The main housekeeping records are made up of arrival and departure lists and notifications received from the reception office and the housekeeping own room status report, together with separate records in respect of additional services provided by the department.
The extension of the housekeeping function outside the hotel bedroom normally includes the cleaning of bedroom floors and may include staircases, public cloakrooms and other public areas of the hotel. However, it is quite common for such public rooms as hotel lounges to be cleaned by uniformed staff, for the responsibility for the men's and women's cloakrooms to be divided between uniformed staff and the housekeeping department, and for restaurants and bars to be cleaned by the staff of those departments. More recently, hotels have been engaging outside contract firms for the cleaning of public rooms.
Other housekeeping services often include the provision of first aid to guests and staff, dealing with lost property, and floral arrangements throughout the hotel. When staff accommodation is provided by the hotel, it may be included as part of the head housekeeper's responsibilities. Although in many countries hotels increasingly use outside laundries and dry cleaning firms for their requirements, many hotels operate their own dry cleaning and laundry facilities. These 'in-house' facilities may be then organized as separate departments of the hotel or as sections of the housekeeping department.
This outline of the hotel housekeeping function illustrates three organizational approaches. One seeks to integrate a number of related functions within a major housekeeping department. The second assigns certain functions to the housekeeping department and others to other departments of the hotel, largely on the basis of physical areas. The third consists of 'buying in' certain services from outside suppliers rather than operating them directly as hotel facilities. Food and Drink
The food and drink service is the second major activity of most hotels and in many of them it accounts for a larger proportion of employees than the provision of sleeping accommodation and related services. This is due to two main factors:
• in contrast to hotel rooms, meals and refreshments in hotels may be supplied to non-residents as well as to resident guests and include substantial functions sales;
• the provision of meals and refreshments is relatively labour intensive.
The provision of sleeping accommodation is a service activity, in which there is a negligible use of materials, and there is no cost of sales. The provision of meals and refreshments results in composite products made up of commodities and of service, and the use of materials represent the cost of sales. Food and drink enter into meals and refreshments served in hotels in several stages from their purchase by the hotel to their sale in the same or altered form to the hotel customer. According to the size and diversity of the hotel markets there may be more than one restaurant and bar and also food and drink service in rooms and through functions.
Restaurants
Restaurants establishment where refreshments or meals may be procured by the public. The public dining room that came ultimately to be known as the restaurant originated in France, and the French have continued to make major contributions to the restaurant's development.
The first restaurant proprietor is believed to have been one A. Boulanger, a soup vendor, who opened his business in Paris in 1765. The sign above his door advertised restoratives, or restaurants, referring to the soups and broths available within. The institution took its name from that sign, and "restaurant" now denotes a public eating place in English, French, Dutch, Danish, Norwegian, Romanian, and many other languages, with some variations. For example, in Spanish and Portuguese the word becomes restaurante, in Italian it is ristorante; in Swedish, restaurang; in Russian, restoran; and in Polish, restauracia. Although inns and hostelries often served paying guests meals from the host's table, or table d'hôte, and beverages were sold in cafés, Boulanger's restaurant was probably the first public place where any diner might order a meal from a menu offering a choice of dishes.
Boulanger operated a modest establishment; it was not until 1782 that La Grande Taverne de Londres, the first luxury restaurant, was founded in Paris. The owner, Antoine Beauvilliers, a leading culinary writer and gastronomic authority, later wrote L 'Art du cuisinier (1814), a cookbook that became a standard work on French culinary art.
The most illustrious of all 19th-century Paris restaurants was the Café Anglais, on the Boulevard des Italiens at the corner of the rue Marivaux, where the chef, Adoiphe Dugléré, created classic dishes such as sole Dugléré (filets poached with tomatoes and served with a cream sauce having a fish stock base) and the famous sorrel soup potage Germiny. On June 7, 1867, the Café Anglais served the now-famous "Three Emperors Dinner" for three royal guests visiting Paris to attend the Universal Exposition. The diners included Tsar Alexander 11 of Russia; his son the tsarevich (later the tsar Alexander III); and King William I of Prussia, later the first emperor of Germany. The meal included souffles with creamed chicken (a Ia reine), fillets of sole, escalloped turbot, chicken a la portugaise (cooked with tomatoes, onions, and garlic), lobster a la parisienne (round, flat medallions glazed with a gelatin-mayonnaise mixture and elaborately decorated), ducklings a Ia rouennaise (the carcasses stuffed with liver and pressed, presented on a platter with boned slices of the breast and the grilled legs, and served with a red wine sauce containing pureed liver), ortolans (small game birds) ontoast, and eight different wines.
Toward the end of the 19th century, in the gaudy and extravagant era known as ia belie époque, the luxurious Maxim's, on the rue Royale, became the social and culinary centre of Paris. The restaurant temporarily declined after World War I but recovered under new management, to become an outstanding gastronomic shrine.
France produced many of the world's finest chefs, including Georges-Auguste Escoffier, who organized the kitchens for the luxury hotels owned by César Ritz, developing the so-called brigade de cuisine, or kitchen team, consisting of highly trained experts each with clearly defined duties. These teams included a chef, or gros bonnet, in charge of the kitchen; a sauce chef, or deputy; an entremettier, in charge of preparation of soups, vegetables, and sweet courses; a rótisseur to prepare roasts and fried or grilled meats; and the garde manger, in charge of all supplies and cold dishes. In Escoffier's time, the duties and responsibilities of each functionary were sharply defined, but in modern times, rising labour costs and the need for faster service have broken down such rigidly defined duties. In the kitchens of even the leading modern restaurants, duties at the peak of the dinner-hour preparations are likely to overlap widely, with efficiency maintained amid seeming chaos and confusion.
I n the 20th century, with the development of the automobile, country dining became popular in France, and a number of fine provincial restaurants were established. The Restaurant de la Pyramide, in Vienne, regarded by many as the world's finest restaurant, wasfounded by Fernand Point and after his death, in 1955, retained its high standing under the direction of his widow, Madame "Mado" Point. Other leading French provincial restaurants have included the Troisgros in Roanne; the Paul Bocuse Restaurant near Lyon; the Auberge de 1'Ill in Illhaeusern, Alsace; and the hotel Côte d'Or, at Saulieu.
French restaurants today are usually in one of three categories: the bistro, or brasserie, a simple, informal, and inexpensive establishment; the medium-priced restaurant; and the more elegant grand restaurant, where the most intricate dishes are executed and served in luxurious surroundings.
Other nations have also made many significant contributions to the development of the restaurant.
In Italy the botteghe (coffee shop) of Venice originated in the 16th century, at first serving coffee only, later adding snacks. The modern trattorie, or taverns, feature local specialities. The osterie, or hostelries, are informal restaurants offering home-style cooking. In Florence small restaurants below street level, known as the buca, serve whatever foods the host may choose to cook on a particular day.
Austrian coffeehouses offer leisurely, complete meals, and the diner may linger to sip coffee, read a newspaper, or even to write an article. Many Austrians frequent their own "steady restaurants," known as Stain,nbe
In Hungary the csárda, a country highway restaurant, offers menus usually limited to meat courses and fish stews.
The beer halls of the Czech Republic, especially in Prague, are similar to coffeehouses elsewhere. Food is served, with beer replacing coffee.
The German Weinstube is an informal restaurant featuring a large wine selection, and the Weinhaus, a food and wine shop where customers may also dine, offers a selection of foods ranging from delicatessen fare to full restaurant menus. The Schenke is an estate-tavern or cottage pub serving wine and food. In the cities a similar establishment is called the Stadischenke.
In Spain the bars and cafés of Madrid offer widely varied appetizers, called tapas, including such items as shrimp cooked in olive oil with garlic, meatballs with gravy and peas, salt cod, eels, squid, mushrooms, and tuna fish. The tapas are taken with sherry, and it is a popular custom to go on a chateo, or tour of bars, consuming large quantities of tapas and sheny at each bar. Spain also features the marisco bar, or marEs querIa, a seafood bar; the asadoro, a Catalan rotisserie; and the tasca, or pub-wineshop.
In Portugal, cervejarias are popular beer parlours also offering shellfish. Fado taverns serve grilled sausages and wine, accompanied by the plaintive Portuguese songs called fados (meaning "fate").
In Scandinavia sandwich shops offer open-faced, artfully garnished sandwiches called smorrebrod. Swedish restaurants feature the smorgasbord, which literally means "bread and butter table" but actually is a lavish, beautifully arranged feast of herring, shrimp, pickles, meatballs, fish, salads, cold cuts, and hot dishes, served with aquavit or beer.
The Netherlands has broodjeswinkels, serving sandwich open-faced shops, called sandwiches, seafoods, hot and cold dishes, and cheeses from a huge table.
English city and country pubs have three kinds of bars: the public bar, the saloon, and the private bar. Everyone is welcome in the public bar or saloon, but the private bar is restricted to habituës of the pub. Pub food varies widely through England, ranging from sandwiches and soups to pork pies, veal and ham pies, steak and kidney pies, bangers (sausages) and a pint (beer), bangers and mash (potatoes), toad in the hole (sausage in a Yorkshire pudding crust), and Cornish pasties, or pies filled with meat and vegetables.
In the tavérnas of Greece, customers are served such beverages as retsina, a resinated wine, and ouzo, an anise-flavoured aperitif, while they listen to the music of the bou:ouki. Like other Mediterranean countries, Greece has the groceiy-tavérna where one can buy food or eat.
The Turkish iskembeci is a restaurant featuring tripe soup and other tripe dishes; muhalleb icE shops serve boiled chicken and rice in a soup and milk pudding.
Characteristic of Japan are sushi bars that serve sashimi (raw fish slices) and sushi (fish or other ingredients with vinegared rice) at a counter. Other food bars serve such dishes as noodles and tempura (deep- fried shrimp and vegetables). Yudofu restaurants build their meals around varieties of tofu (bean curd), and the elegant tea houses serve formal Kaiseki table d'hôte meals.
In China, restaurants serving the local cuisine are found, and noodle shops offer a wide variety of noodles and soups. The dim-sum shops provide a never-ending supply of assorted steamed, stuffed dumplings and othersteamed or fried delicacies.
A common sight in most parts of Asia is a kind of portable restaurant, operated by a single person or family from a wagon or litter set up at a particular street location, where specialties are cooked on the spot. Food and cooking utensils vary widely in Asia.
The cafeteria, an American contribution to the restauranfs development, originated in San Francisco during the 1849 gold rush. Featuring self-service, it offers a wide variety of foods displayed on counters. The customer makes his selections, paying for each item as he chooses it or paying for the entire meal at the end of the line. Other types of quick-eating places originating in the United States are the drugstore counter, serving sandwiches or other snacks; the lunch counter, where the diner is served a limited quick-order menu at the counter; and the drive-in, "drive-thru," or drive-up restaurant, where patrons are served in their automobiles. So-called fast-food restaurants, usually operated in chains or as franchises and heavily advertised, offer limited menus-- typically comprising hamburgers, hot dogs, fried chicken, or pizza and their complements--and also offer speed, convenience, and familiarity to diners who may eat in the restaurant or take their food home. Among fast-food names that have become widely known are White Castle (one of the first, originating in Wichita, Kan., in 1921), McDonald's (which grew from one establishment in Des Flames, Ill., in 1955 to more than 15,000 internationally within 40 years), Kentucky Fried Chicken (founded in 1956), and Pizza Hut (1958). Many school, work, and institutional facilities provide space for coin-operated vending machines that offer snacks and beverages. The specialty restaurant, serving one or two special kinds of food, such as seafood or steak, is another distinctive American establishment.
The Pullman car diner, serving full-course meals to long distance railroad passengers, and the riverboat steamers, renowned as floating gourmet palaces, were original American conceptions. They belong to an earlier age, when dining out was a principal social diversion, and restaurants tended to become increasingly lavish in food preparation, decor, and service. In many modern restaurants, customers now prefer informal but pleasant atmosphere and fast service. The number of dishes available, and the elaborateness of their preparation, has been increasingly curtailed as labour costs have risen and the availability of skilled labour decreased. The trend is toward such efficient operations as fast-food restaurants, snack bars, and coffee shops. The trend in elegant and expensive restaurants is toward smaller rooms and intimate atmosphere, with authentic, highly specialized and limited menus.
Miscelaneous Guest Services
Accommodation, food and drink services are the major activities of hotels, which generate all or most hotel revenue, account for all or most of their employees, and represent the principal products provided by the major hotel departments.
But the present-day hotel guest normally also expects other facilities and services. In addition to a comfortable room, and meals and refreshments in a restaurant or bar or in the room, a guest may want to use the telephone or have clothes laundered or dry cleaned. In a large modern hotel a guest may anticipate to be able to buynewspapers, magazines and souvenirs, have a haircut, obtain theatre tickets, and book an airline ticket for the next stage of a trip.
The hotel services other than accommodation, food and drink may be provided to the guest by the hotel or by other operators on the hotel premises. The revenue- earning activities provided directly by the hotel are variously described as ancillary or subsidiary revenue- earning, and are grouped for accounting and control purposes in what are known as minor operated departments, to distinguish them from major operated departments concerned with rooms, food and beverages. Both are distinguished from rental and concession arrangements, under which some of these and other services may be provided to guests by outside firms operating in the hotel.
The three basic components of the accommodation function are present in most hotels and are normally organized in separate departments. But their organization and staffmg often differ in hotels of different sizes, types and standards. In smaller hotels only a few people may be engaged in each and cover a wide range of duties; as the hotel increases in size, each activity may be subdivided into separate departments or sections, in which those engaged in them perform more specialized tasks.
A transit city hotel with a short average length of stay calls for a somewhat different approach from that of a resort hotel, which accommodates guests for longer and often such regular periods as one or two weeks. There is also a relationship between prices, the range and quality of facilities and services provided, and the way they are organized. For all these and other reasons it is possible to describe the hotel activities related to the accommodation of guests only in broad and general terms.
V. Tourist Attractions
Tourist attractions have an important role to play in world tourism since they often provide the motivating force for travel, thereby energising the many components of the tourist industry. The scope of the attractions sector is immense; logically anything that has the power to draw visitors to it can be considered an attraction. Moreover an attraction may not be a readily identifiable place or feature, but a visitor's overall perception of a destination as an attractive place to visit, distilled from a variety of surces and images. London's current popularity as a tourist destination with young visitors from around the world is a good case; they are not attracted primarily by the traditional Big Ben, Buckingham Palace, Houses of Parliament but rather by the image of the capital as a "cool" place to hear good music and have an enjoyable time.
Touristic attractions occur at a variety of scales. Many internationally famous attractions such as:
San Francisco's Golden Gate Bridge
Red Square in Moscow
The Ponipidou Centre in Paris are household names on many tourists' "must see" lists.
Domestic tourists travel within their own countries to a variety of attractions, some of which are provided free of charge while others charge admission. These may be day visits or a part of a long holiday or short break.
Tourist attraction are provided by both commercial and non-commercial organizations. Many historic buildings, areas of landscape or wildlife interest, museums and ancient monuments are in the care of public bodies and voluntary groups which aim to preserve or conserve vital parts of a country's heritage while at the same time making facilities available to tourists.
Types of tourist attractions
Tourist attractions are generally classified into one of
two categories:
Natural attractions
Man made attractions such as:
Heritage attractions (e.g. Williamsburg)
Museums and ancient monuments ('e.g Louvre in Paris)
Theme parks (e.g. Walt Disney World in Florida)
Entertainments (e.g The Sydney Opera House)
Sport facilities (e.g Winter Olimpic Gaines)
Leisure shopping venues ('e.gThe Metro Center in Englanc
Wildlife areas (e.g Busch Garden in Florida)
Tourism today
The mass tourism that exists in the world today is a phenomenon of the post-industrial society of the latter half of the twentieth century. Tourism has become an integral part of the move away from economies based on heavy engineering and manufacturing to a rapidly expanding service sector. The growth in international and domestic tourism since the 1950s has been nothing short of dramatic, with international tourist arrivals climbingfrom 25 million in 1950 to a record 592 million in 1996 (World Tourism Organisation, 1997). When we add to this the fact that the volume of domestic tourism worldwide is estimated by the World Tourism Organisation to be approximately ten times greater than that of international tourism (World Tourism Organisation. 1983), the scale of the tourism phenomenon can begin to be appreciated. Greater wealth, higher educational standards, increased mobility and more leisure time have all contributed to unparalleled demand for holidays and excursions at home and abroad. Overseas travel is no longer the preserve of the privileged few, but is available to the majority, as developments in transportation, increased competition and global communications technology have reduced the real cost of holidays. Private and public sector organisations have responded to the increased demand by providing a wide range of facilities and products to meet the needs of an increasingly discerning travelling public. It must be remembered, however, that tourism is a very recent phenotnenon that has hitherto been allowed to grow in a business environment relatively free of regulation and trade restrictions. Such an unrestricted environment is unlikely to continue in years to come.
The current scale and scope of the international tourism industry is illustrated in recent data from the World Travel and Tourism Council (1996), which indicate that in 1996 the world travel and tourism industry is estimated to have:
* Gmployed 255 million people
* Generated an output of US $3.6 trillion
* Contributed 10.7 per cent of global gross domestic product (.GDP) o invested US $766 billion in capital projects
* Generated( US $761 billion in world exports
* Paid US $653 billion in taxes worldwide
Such figures demonstrate the economic significance of the tourism industry on a global scale and confirm that the age of mass tourism has truly arrived in spectacular fashion.
Local Tours
Paris
Paris is the capital of France and one of Europe's largest conurbations. The city was founded more than 2,000 years ago on an island in the Seine River, some
233 miles (375 kilometres) upstream from the river's mouth on the English Channel. The modern city has spread from the island (the lie de la Cite) and far beyond both banks of the Seine. The City of Paris itself covers an area of 41 square miles (105 square kilometres); the Greater Paris conurbation, formed of suburbs and other built-up areas, extends around it in all directions to cover approximately 890 square miles. Paris occupies a central position in the rich agricultural region known as the Paris Basin, and it constitutes one of eight départements of theIle-de-France administrative region. It is by far the nation's most important centre of commerce and culture.
NEIGHBOUR FlOODS AND SIGHTS
Paris' many old buildings, monuments, gardens, plazas, boulevards, and bridges compose one of the world's grandest cityscapes. An impressive spot from which to view the city is the Chaillot Palace, which stands on a rise on the Right Bank of the Seine to the west, where the river begins its southwestward curve.
The Chaillot Palace.
The Chaillot Palace dates from the International Exposition of 1937. It replaced the Trocadéro Palace, a structure left over from the 1878 International Exposition. The Chaillot Palace is made up of two separate pavilions, from each of which extends a curved wing. The Musée de I'Homme, the Naval Museum, the Museum of French Monuments, and the Cinema Museum are located there. Under the terrace that separates the two sections are two theatres, the National Theatre of Chaillot and a small hall that serves as one of the two motion- picture houses of the national film library.
The terrace, which is lined by statues, gives a splendid view across Paris. The slope descending to the river has been made into a terraced park, the centre of which is alive with fountains, cascades, and pools. The Trocadéro Aquarium is in a grotto a few steps away in the park.
From the bottom of the slope the five-arched Jena Bridge (Pont d'Iéna) leads across the river. It was built for Napoleon in 1813 to commemorate his victory at theBaffle of Jena in 1806. On the Left Bank rises the Eiffel Tower, an unclad metal truss tower designed by Gustave Eiffel. The tower was built for the International Exposition of 1889, against the strident opposition of national figures who thought it unsafe or ugly or both. When the exposition concession expired in 1909, the 984-foot (300-metre) tower was to have been demolished, but its value as an antenna for radio transmission saved it. Additions made for television transmission have added 56 feet to the height. From the topmost of the three platforms the view extends for more than 40 miles.
From the two-acre base of the tower the Champ-de Mars ("Field of Mars"), an immense field, stretches to the Military Academy (Ecole Militaire), which was built from 1769 to 1772 and is still used by the War College (Ecole Supérieure de Guerre). The Champ-de-Mars, which originally served as the school's parade ground, was the scene of two vast rallies during the French Revolution: that of the Federation (1790) and that of the Supreme Being (1794). From 1798 there were annual national expositions of crafts and manufactures, which were followed by world's fairs between 1855 and 1900. Behind the Military Academy stands the headquarters of the United Nations Educational, Scientific and Cultural Organization (UNESCO). The building, erected in 1958, was designed by an international trio of architects and decorated by artists of member nations.
The Invalides.
One street to the northeast is the Hotel des Invalides, founded by Louis XIV to shelter 7,000 aged or invalid veterans. The enormous range of buildings was completed in five years (1671-76). The gold-plated dome (1675-1706) that rises above the hospital buildings belongs to the church of Saint-Louis. The dome was designed by Jules Ilardouin-Mansart, who employed a style known in France as "Jesuit" because it derives from the Jesuits' first church in Rome, built in 1568. The churches of the French Academy (Académie Francaise), the Val-de-Grâce Hospital, and the Sorbonne, as well as three others in Paris, all of the 17th century, followed this style. By using the classical elements more freely than had been done in Rome, the French made it something recognizably Parisian.
In the chapels of Saint-Louis are the tombs of Napoleon's brothers Joseph and Jérôme, of his son (whose body was returned from Vienna in 1940 by Adolf Hitler), and of the marshals of France. Immediately beneath the cupola is a red porphyry sarcophagus that covers the six coffins, one inside the other, enclosing the remains of Napoleon, which were returned from St. Helena in 1840 through the efforts of King Louis Philippe. Napoleon's uniforms, personal arms, and deathbed are displayed in the Army Museum at the front of the Invalides. A portion of the Invalides still serves as a military hospital; facilities have been modernized since World War II.
The vast, tree-lined Invalides Esplanade slopes gently to the Quai d and the Alexandre III Bridge. The first stone for the bridge, which commemorates the Russian tsar Alexander III, was laid in 1897 by Alexander's son, Tsar Nicholas II. The bridge was finished in time for the International Exposition of 1900, and it leads to two other souvenirs of that year's fair, the Grand Palais and the Petit Palais. The buildings are still used for annual shows and for major visiting art exhibits.
The Louvre.
Vikings camped on the Right Bank across from the western tip of the lie de la Cite in their unsuccessful siege of Paris in 885, and in about 1200 King Philip II had a square crusader's castle built on the same site, just outside the new city wall, to buttress the western defenses. Over the following centuries many additions and renovations were made, and from the castle grew one of the world's largest palaces, completed only in 1852. From the original square, known as the Cour Carrëe ("Square Court"), two galleries extend westward for 1,640 feet, one along the river, the other along the rue de Rivoli. In 1871, only 19 years after the huge oblong was completed, its western face, the Tuileries Palace (begun 1563), was destroyed by the insurrectionists of the Commune.
Two of the facades of the Cour Carrée had strong influence on French architecture. Pierre Lescot began his inner courtyard facade in 1546, adapting the Renaissance rhythms and orders he had observed in Italy and adding purely French decoration to the classical motifs. The physician and architect Claude Perrault collaborated with Louis Le Vau, architect to the king, to design the outer east face of the palace in 1673. It, too, employs classic elements, making especially graceful use of coupled columns and a pediment.
The Louvre Museum occupies the four sides of the palace around the Cour Carrée as well as the south gallery, which stretches along the river. Among the treasures of the museum are the Victory of Samothrace, the Venus de Milo, and the Mona Lisa. The enormous collections contain works from the 7th century BC to the mid-l9th century, with a huge cultural and geographic spread. The north gallery, along the rue de Rivoli, houses a separate museum, the Museum of Decorative Arts, as well as the Ministry of Finance.
Extensive remodeling has been undertaken throughout the Louvre to increase space for art works. Construction began in the early 1980s to create a new main entrance and underground reception hail in the vast Napoleon Courtyard, between the two galleries; the 70-foot-high glass pyramid designed by I.M. Pei to cover the entrance aroused both strong support and spirited criticism.
The Arts Bridge (Pont des Arts), which crosses the Seine from the Louvre to the Left Bank, is one of the most charming of all the Parisian bridges. It was the first (1803) to be made of iron, and it has always been reserved for pedestrians: it provides an intimate view of riverside Paris and of the Seine itself.
Ile de la Cite.
Downstream and just below the bridge is the tip of the Ile de la Cite, fashioned into a triangular gravel-pathed park bordered by flowering bushes, with rustic benches under the ancient trees. It is surrounded by a wide cobbled quay that is especially popular with sunbathers and lovers. Where the steps come onto the bridge from the park there is a bronze equestrian statue of King Henry W, who insisted on completion of the Pont-Neuf The statue is an 1818 reproduction of the 1614 original, which was the first statue to stand on a public way in Paris. Opposite is the narrow entrance to the Place Dauphine (1607), named for Henry's heir, the future Louis XIII. The place was formerly a triangle of uniform red-brick houses pointed in white stone, but the row of houses along its base was ripped out in 1871 to make room for construction of part of the Palace of Justice.
The ship-shaped lie de la Cite is 10 streets long and five wide. Eight bridges link itto the riverbanks and a ninth leads to the scow-shaped lie Saint-Louis, which lies to the southeast.
The palace of the early Roman governor (now the Palace of Justice) was rebuilt on the same site by Louis IX (St. Louis) in the 13th century and enlarged 100 years later by Philip IV the Fair, who added the grim, gray turreted Conciergerie, with its impressive Gothic chambers. The Great Hail, which, under the kings, was the meeting place of the Pariement (the high court of justice), was known throughout Europe for its Gothic beauty. Fires in 1618 and 1871 destroyed much of the original room, however, and most of the rest of the palace was devastated by flames in 1776. The Great Hall now serves as a waiting room for the courts, in one of which, the adjoining first Civil Chamber, the Revolutionary Tribunal sat from 1793, condemning 2,600 persons to the guillotine. After sentencing, the victims were taken back down the stone stairs to the dungeons of the Conciergerie to await the tumbrils. The Conciergerie still stands and is open to visitors.
In the palace courtyards is found one of the great monuments of France, the 13th-century Sainte-Chapelle ('Chapel"). Built at Louis IXs direction between 1243 and 1248, it is a masterpiece of Gothic Rayonnant style. With great daring, the architect (possibly Pierre de Montreuil) poised his vaulted ceilings on a trellis of slender columns, the walls between being made of stained glass. The exquisite chapel was designed to hold the Crown of Thorns, thought to be the very one worn by Jesus at his crucifixion. Louis IX had purchased the relic from the Venetians, who held it in pawn from Baldwin, the Latin king of Byzantium. Other holy relics, such as nails and pieces of wood from the True Cross, were added to the chapel's collection, the remnants of which are now in the treasury of Notre-Dame.
Under King Louis-Philippe (1830-48), the "sanitization" of the island was begun, and it was continued for his successor, Napoleon III, by Baron Georges Haussmann. The project involved a mass clearing of antiquated structures, widening of streets and squares, and the erection of massive new government offices, including parts of the Palace of Justice. The portion of the palace that borders the Quai des Orfêvres- formerly the goldsmiths' and silversmiths' quay-became the headquarters of the Paris municipal detective force, the Police Judiciaire ("Judicial Police"), which keeps a small museum on the fourth floor.
Across the boulevard du Palais is the Police Prefecture, another 19th-century structure. On the far side of the prefecture is the Place du Parvis-Notre-Dame, an open space enlarged six times by Haussmann, who also moved the Hôtel-Dieu, the first hospital in Paris, from the riverside to the inland side of the square. Its present buildings date from 1868.
Notre-Dame de Paris.
At the east end of the square is the cathedral of Notre Dame de Paris, which is situated on a spot that Parisians have always reserved to the practice of religious rites. The Gallo-Roman boatmen of the cite erected their altar to Jupiter there (it is now in the Cluny Museum), and, when Christianity was established, a church was built on the temple site. The first bishop of Paris, St. Denis, became its patron saint. The red in the colours of Paris represents the blood of this martyr who, in popular legend, after decapitation, picked up his head and walked.
When Maurice de Sully became bishop in 1159 he decided to replace the decrepit cathedral of Saint-Etienne and the 6th-century Notre-Dame with a church in the new Gothic style. The style was conceived in France, and a new structural development, the flying buttress, which added to the beauty of the exterior and permitted interior columns to soar to new heights, was introduced in the building of Noire-Dame. Construction began in 1163 and continued until 1345.
After being damaged during the French Revolution, the church was sold at auction to a building-materials merchant. Napoleon came to power in time to annul the sale, and he ordered that the edifice be redecorated for his coronation as emperor in 1804. Louis-Philippe later initiated restoration of the neglected church. The architect Eugene Viollet-le-Duc worked from 1845 to 1864 to restore the monument. Like all cathedrals in France, Notre-Dame is the property of the state, although its operation as a religious institution is left entirely to the Roman Catholic Church.
A few 16th- and 17th-century buildings survive north of the cathedral. They are what remain of the Cloister of the Cathedral Chapter, whose school was famous long before the new cathedral was built. Early in the 12th century, one of its theologians, Peter Abelard, left the cloister with his disciples, crossed to the Left Bank, and set up an independent school in the open air in the Convent of the Paraclete near the present Place Maubert. After a prolonged struggle with the monks of Saint-Denis the followers of Abelard in 1200 won the right, from both the king and the pope, to form and govern their own community. This was the beginning of the University of Paris.
Rue de Rivoli.
The Louvre and the Tuileries Gardens take up the south side of this street, and on the other side runs an arcade more than a mile long. Opposite the middle of the Louvre, the Place du Palais-Royal leads to the palace of Cardinal de Richelieu, which he willed to the royal family. Louis XIV lived there as a child, and during the minority of Louis XV the kingdom was ruled from there by the debauched but gifted regent Philippe II, duc d'Orléans from 1715 to 1723. Late in the 18th century Louis-Philippe d'Orléans, who was popularly renamed Philippe-Egalité during the Revolution for his radical opinions, undertook extensive building around the palace garden. It was a commercial operation, and the Prince hoped to pay his debts from the property rents. Around the garden he built a beautiful oblong of colonnaded galleries and at each end of the gallery farthest from his residence a theatre. The larger playhouse has been the home of the Comédie-Française, the state theatre company, since Napoleon's reign. The princely apartments now shelter high state bodies such as the Council of State.
Just behind the courtyard is the Bibliothêque Nationale (National Library), the national library of deposit, with an enormous collection of books and prints. Haussrnann greatly enlarged the Place du Palais-Royal in 1852, and he was careful to preserve the palace when he laid out the avenue de l'Opéra. At the top of the avenue, where the Grands Boulevards crossed an enormous new place, the new opera house was built from 1825 to 1898. The Paris Opera House, a splendid monument to the Second Empire, was designed in the neo-Baroque style by Charles Gamier. It is known especially for its decorative embellishments, chief among them the Grand Staircase. Just behind the Opera House are various large department stores.
The next place along the rue de Rivoli is the Place des Pyramides. The gilded equestrian statue of Joan of Arc stands not far from where she was wounded at the Saint Honoré Gate (Porte Saint-Honoré) in her unsuccessful attack on Paris (at that time held by the English), on Sept. 8, 1429.
Farther along toward the Place de la Concorde the rue de Castiglione leads to the Place Vendôme, an elegant octagonal place, little changed from the 1698 designs of Jules Hardouin-Mansart. In the centre, the Vendôme Column bears a statue of Napoleon. It was pulled down during the Commune and put back up under the Third Republic (187 1-1940). The place and the rue de la Paix have lost none of their discreet distinction, nor have their shops.
The "Triumphal Way."
From the Arc de Triomphe du Carrousel, in the courtyard between the open arms of the Louvre, extends one of the most remarkable perspectives to be seen in any modern city. It is sometimes called la Voie Triomphale ( Triumphal Way!!). From the middle of the Carrousel arch the line of sight runs the length of the Tuileries Gardens, lines up on the obelisk in the Place de Ia Concorde, and goes up the Champs-Elysees to the centre of the Arc de Triomphe and beyond to the skyscrapers of La Defense, in the western suburbs.
The Louvr&s modest triumphal arch stands in the open
space where costumed nobles performed in an equestrian
display-- carrousel--to celebrate the Dauphin's birth in
1662. The design of the arch, an imitation of that of the
Arch of Septimius Severus in Rome, was conceived in
1808 by Charles Percier and Pierre Fontaine. The flanks of the Carrousel arch are incised with a record of Napoleon's victories.
The Tuileries Gardens, which fronted the Tuileries Palace (looted and burned in 1871 during the Commune), have not altered much since André Le Nôtre redesigned them in 1664. Le Nôtre was born and died in the gardener's cottage in the Tuileries; he succeeded his father there as master gardener. His design carried the line of the central allée beyond the gardens and out into the countryside by tracing a path straight along the wooded hill west of the palace. On this hilltop, 170 years later, the Arc de Triomphe was erected.
The Place de la Concorde was designed as a moated octagon in 1755 by Jacques-Ange Gabriel. The river end was left open, and on the inland side two matching buildings were planned. Viewed clockwise starting from the Navy Ministry (Ministère de la Marine), the statues are Lille, Strasbourg, Lyon, Marseille, Bordeaux, Nantes, Brest, and Rouen. Louis-Philippe also had the Luxor Obelisk, a gift from Egypt, installed in the centre and flanked by two fountains
Between the twin buildings on the northeastern side of the place, the broad rue Royale mounts to the Church of Sainte-Marie-Madeleine, consecrated in 1842. The church is a stern oblong, fenced with columns 60 feet high. Its design, supposedly that of a Greek temple, is actually closer to the Roman notion of Greek.
The Place de la Madeleine is the western terminus of the Grands Boulevards, which imitate the arch of the river from there north and east to the Place de la Republique and the Bastille.
To the west off the rue Royale runs the rue du Faubourg Saint-Honoré, which, in addition to the British Embassy and the Elysee Palace (residence of the French president), has on its shop windows some of the most prestigious names in the Paris fashion trade.
Along the first 2,500 feet of the Champs-Elysées, between Concorde and the Rond-Point des Champs Elysées (a roundabout, or traffic circle), little has changed for a century: the avenue is bordered with chestnut trees, behind which on both sides are gardens, usually full of children at play. The pavilions in the gardens are used as tearooms, restaurants, and theatres. From the Rond-Point up to the Arc de Triomphe, however, the avenue has changed with the times. Under the Second Empire this was a street of luxurious town houses. They were supplanted by cafés, nightclubs, luxury shops, and cinemas, but the Street retained its feeling of luxury, and the tree-shaded sidewalks (wide as a normal Street) offered promenades that were the pride of Paris. Since the 1950s, however, banks, automobile showrooms, airline offices, and fast-food eateries have taken over much of the space.
At the top of the Champs-Elysëes is a circular place from which 12 imposing avenues radiate to form a star (étoile). It was called Place de l'Etoile from 1753 until 1970, when it was renamed Place Charles de Gaulle. In the centre of the place is the Arc de Triomphe, commissioned by Napoleon in 1806. It is twice as high and as wide as the Arch of Constantine, in Rome, which inspired it. Jean Chaigrin was the architect and François Rude sculpted the frieze and the spirited group, 'The Departure of the Volunteers of 1792" (called "La Marseillaise"). On Armistice Day in 1920, the Unknown Soldier was buried under the centre of the arch, and each evening the flame of remembrance is rekindled by a different patriotic group.
The Latin Quarter (Quartier Latin).
At the Concorde Bridge the boulevard Saint-Germain begins, curving eastward to join the river again at the Sully Bridge. A little less than halfway along the boulevard is the pre-Gothic church of Saint-Germain des-Prés. The old church, which belonged to a Benedictine abbey founded in the 8th century, was sacked four times by Vikings and was rebuilt between 990 and 1201. Parts of the present church date from that time.
Beyond the boulevard Saint-Michel is the university precinct, self-governing under the kings, where, in class and out, students and teachers spoke Latin until 1789. At the junction of the boulevards Saint-Germain and Saint Michel are the remains of one of the three baths of the Roman city. These are in the grounds of the Cluny Museum, a Gothic mansion built 1485-1500, which now houses a collection of medieval works of art, including the renowned six-panel unicorn tapestry "La Dame a Ia licorne."
The wide, straight boulevard Saint-Michel is the main street of the student quarter. It is lined with bookshops, cafés, cafeterias, and movie houses. The buildings of the university are found on smaller streets. The university was built up of colleges, each founded and supported by a donor, often a prelate or a religious order. In about 1257 Robert de Sorbon, chaplain to Louis LX, established a college, known as the Sorbonne, that eventually became the centre of theological study in France. The oldest part of the Sorbonne is the chapel (1635-42), the gift of Richelieu, who is buried there. Designed by Lemercier, it was one of a number of new domed Jesuit-style churches of the period.
The Sorbonne served for centuries as the administrative seat of the University of Paris. In 1968-71 the university was divided into a number of entirely separate universities, and the Sorbonne building proper continues to serve as premises for some of these.
At the top of the hill rising from the river the boulevard skirts the Luxembourg Gardens, the remains of the park of Marie de Médicis' Luxembourg Palace (1616- 21), which now houses the French Senate. The gardens are planted with chestnuts and are enhanced with a pond for toy sailboats, a marionette theatre, and statuary.
Across the boulevard at the end of the rue Soufflot stands the Pantheon (1755-92), designed by Jacques Germain Soufflot. It was commissioned by Louis XV, after his recovery from an illness, as a votive offering to St. Genevieve and was to replace the mouldering 5th- century abbey in her name. Though intended as the principal church in Paris, it was renamed the Pantheon by the Revolutionary authorities, who made it the last resting place for heroes of the Revolution. The walling up of a number of its windows and removal of much interior decoration replaced the intended effect of light interior space with a gloomy dignity. Among those buried under the inscription "Aux grands bommes, la Patrie reconnaissante" ("To great men, [ their grateful land") are the authors Victor Hugo, Voltaire, Rousseau, and Zola and Jean Moulin, chief of the Resistance in World War II.
The Buttes.
The river valley of Paris is almost entirely circled by high ground. Upon the heights of Passy, on the Right Bank between the western city limits and the Arc de Triomphe, perch the wealthy neighbourhoods of the 16th arrondissement. The Butte-Montmartre (18th arrondissement) and the Buttes-Chaumont( 19th arrondissement), which rise along the northern rim of the city, are still working-class. The 18th arrondissement has broad avenues, but it also has winding lanes, some of which become stairways on the steeper hills, From the early 19th century until the migration in the 1920s to Montparnasse, Montmartre was the major art colony of Paris. Some sections are highly commercialized for the tourist trade; others, however, are unself-consciously picturesque. Montmartre is known for its nightclubs and entertainment.
The most noted landmark of Montmartre was built only in 1919: the Sacred Heart Basilica (Basilique du Sacrd-Coeur), paid for by national subscription after the French defeat by the Prussians in 1870. The work began in 1876 but was delayed by the death of the architect, Paul Abadie, who took inspiration from the 12th-century five-domed Romanesque church of Saint-Front in Périgueux, itself inspired by either Venetian or Byzantine churches.
Basilique du Sacré-Coeur
Foreign Tours
The Bahamas
Officially COMMONWEALTH OF THE BAHAMAS, archipelago and state on the northwestern edge of the West Indies, consisting of about 700 islands and cays and more than 2,000 low, barren rock formations, located off the southeastern coast of Florida, U.S. The archipelago is spread across the Tropic of Cancer and about 90,000 square miles (233,000 square km) of ocean in the western Atlantic. Andros (104 miles long and 40 miles wide {167 km long and 64 km wide] is the largest of the islands. The capital is Nassau on New
Providence--the most important island. Area 5,382 square miles (13,939 square km). Pop. (1993 est.) 266,000.
The land.
New Providence has the majority of the archipelago's population. The rest of the islands, chief among which are Abaco, Andros, and Eleuthera, are called the Family, or Out, Islands. All the islands of the archipelago are composed of coraline limestone, lie mostly only a few feet above sea level, and are generally flat. The highest point, Mount Alvemia (formerly Como Hill), rises 206 feet (63 m) on Cat Island. Most of the islands are long and narrow, each rising from its eastern shore to a low ridge, beyond which lie lagoons and mangrove swamps; coral reefs mark the shorelines. There are no rivers in The Bahamas.
The mild subtropical climate of The Bahamas, with two seasons (winter and summer is greatly influenced by the Gulf Stream and Atlantic Ocean breezes. The average temperature varies from 70°F (21°C) during the winter to 81° F (27° C) during the summer; average annual rainfall is about 44 inches (1,120 mm), though there is some variation between the islands. The hurricane season lasts from mid-July to mid-November.
The islands abound in tropical flora, including bougainvillea, jasmine, orchid, and oleander. Caribbean pine forests occur on some islands, such as Andros, Great Abaco, and Grand Bahama. Native trees include the black olive, cork tree, and several species of palm; mahogany, casuarina, and cedar trees have been planted on some islands. Animal life is dominated by frogs, lizards, and snakes; mosquitoes, sandflies, and termites are widespread. There are numerous species of birds, including the flamingo, the national bird. The Inagua National Park on Great Inagua Island is the home of more than 50,000 West Indian flamingos, the largest such flock in the world. Salt, aragonite, and limestone are the only commercially important minerals. Salt is produced largely by solar evaporation from salt beds on Great Inagua.
The people.
The people of The Bahamas are a blend of European and African ancestry, the latter a legacy of the slave trade. English is the official language, and almost all of the population is Christian. Baptists account for about one-third of the population, and Anglicans and Roman Catholics each constitute approximately one-fifth of the total.
Only about 30 of the islands and cays are inhabited. During the 1970s there was significant rural-to-urban interisland migration, mostly directed to the already densely populated islands of New Providence (where two-thirds of the populace lives), Grand Bahama, and Great Abaco. Long Cay, on the other hand, had only a few dozen inhabitants. Average population density for the country is relatively low.
The population growth rate of The Bahamas was relatively high during the late 1970s (a trend that continued intermittently through the 1980s), mostly because of a substantial birth rate; consequently, almost two-fifths of the populace is younger than 15 years of age. The death rate is relatively low.
The Economy.
The Bahamas has a predominantly market economy that is heavily dependent on tourism and international financial services. The gross national product (GNP) is growing much more rapidly than the population. The GNP per capita is similar to those of other developed countries.
Agriculture accounts for about one-twentieth of the GNP and employs a comparable fraction of the workforce. Only about 1 percent of the land is arable, and soils are shallow. The government has had only limited success in increasing agricultural output, and nearly all of the country's foodstuffs are imported, largely from the United States. The sunny climate favours the cultivation of tomato, pineapple, banana, mango, guava, sapodilla, soursop, grapefruit, and sea grape. Some pigs, sheep, and cattle are raised. The small fishing industry's catch is dominated by crayfish, groupers, and conchs.
Mineral industries are limited to the production of salt and cement. Grand Bahama has several petroleum transshipment terminals. Manufacturing industries centre on the production of rum and other liquors, cement, pharmaceuticals (including hormones), canned tomatoes and pineapples, and frozen crayfish. The Industries Encouragement Act offers manufacturers relief from tariffs and various taxes. Electricity is generated entirely from imported fuels.
Tourism accounts for as much as two-thirds of the GNP and employs about two-fifths of the workforce. It centres on New Providence and Grand Bahama; most tourists come from the United States. Several hundred banks and trust companies have been attracted to The Bahamas because there are no income or corporation taxes and because the secrecy of financial transactions is guaranteed. Public expenditures are constrained by the government's dependence on indirect taxes, which are levied primarily on tourism and external trade. The United States is The Bahamas' principal trading partner and exempts certain Bahamian products from duties under the generalized system of preferences. Nassau and Freeport, the latter on Grand Bahama Island, are the country's two main ports and also have international airports.
Cultural life.
Outstanding among traditional group activities is the "Junkanoo" parade on Boxing Day and New Year's Day. The main thoroughfare is given over to hundreds of gaily bedecked celebrants who, with clanging cowbells and beating drums, march and dance to a rhythm of African origin. In Nassau, amateur choral, dramatic, and dancing groups provide entertainment with much local flavour.
History.
The Bahamas were originally inhabited by a group of Arawak Indians known as Lucayan. Originally from the South American continent, some of the Arawak had been driven north into the Caribbean by the Carib Indians. Unlike their Carib neighbours, the Lucayan were generally peaceful, more involved in fishing than agriculture, and noncannibalistic.
When Columbus reached the New World in 1492, he is thought to have landed on San Salvador (also called Watling Island) or possibly Sarnana Cay, both in the Bahamas. The Spaniards made no attempt to settle but operated slave raids on the peaceful Arawak that depopulated the islands, and by the time the English arrived the Bahamas were uninhabited.
In 1629 Charles I of England granted the islands to one of his ministers, but no attempt at settlement was made. In 1648 William Sayle led a group of English Puritans from Bermuda to, it is thought, Eleuthera Island. This settlement met with extreme adversity and did not prosper, but other Bermudian migrants continued to arrive. New Providence was settled in 1656. By 1670 the Bahamas were given to the Duke of Albemarle and five others as a proprietary colony. The proprietors were mostly uninterested in the islands, and few of the settlements prospered. Piracy became a way of life for many.
The colony reverted to the crown in 1717, and serious efforts were made to end the piracy. The first royal governor, Woodes Rogers, succeeded in controlling the pirates but mostly at his own expense. Little monetary and military support came from England. Consequently, the islands remained poor and susceptible to Spanish attack.
Held for a few days by the U.S. Navy in 1776, and for almost a year by Spain in 1782-83, the islands reverted to England in 1783 and received a boost in population from loyalists and their slaves who fled the United States after the American Revolution. For a time, cotton plantations brought some prosperity to the islands, but when the soil gave out and slavery was abolished in 1834, the Bahamas' endemic poverty returned.
Two other periods of prosperity followed: the years 1861-65, when the Bahamas became a centre for blockade runners during the American Civil War, and in 1920-33, when bootlegging became big business during the years of American Prohibition. But these were economic accidents; not until the tourist industry was developed after World War II did any form of pennanent prosperity come to the islands
International Trade
International trade includes all economic transactions that are made between countries. Among the items commonly traded are consumer goods, such as television sets and clothing; capital goods, such as machinery; and raw materials and food. Other transactions involve services, such as travel services and payments for foreign patents. International trade transactions are facilitated by international financial payments, in which the private banking system and the central banks of the trading nations play important roles.
International trade and the accompanying financial transactions are conducted generally toward the purpose of providing a nation with commodities it lacks in exchange for those that it produces in abundance; such transactions, functioning with other economic policies, generally improve the standard of living of a nation. This article provides a historical and contemporary overview of the structure of international trade, of the classic controversy over free versus controlled trade, and of the problems that arise in transactions between nations.
The theory of international trade
HISTORY
Accounts of barter of goods or of services among different peoples can be traced back almost as far as the record of human history. International trade, however, is specifically an exchange between members of different nations, and accounts and explanations of such trade begin (despite fragmentary earlier discussion) only with the rise of the modern nation-state at the close of the European Middle Ages. As political thinkers and philosophers began to examine the nature and function of the nation, trade with other nations became a particular topic of their inquiry. It is, accordingly, no surprise to find one of the earliest attempts to describe the function of international trade within that highly nationalistic body of thought now known as "mercantilism." Mercantilist analysis, which reached the peak of its influence upon European thought in the 16th and 17th centuries, focused directly upon the welfare of the nation. It insisted that the acquisition of wealth, particularly wealth in the form of gold, was of paramount importance for national policy. Mercantilists took the virtues of gold almost as an article of faith; consequently, they never undertook to explain adequately why the pursuit of gold deserved such a high priority in their economic plans.
The trade policy dictated by mercantilist philosophy was accordingly simple: encourage exports, discourage imports, and take the proceeds of the resulting export surplus in gold. Because of their nationalistic bent, mercantilist theorists either brushed aside or else did not realize that, from an international viewpoint, this policy would necessarily prove self-defeating. The nation that successfully gains an export surplus must ordinarily do so at the expense of one or more other nations that record a matching import surplus. Mercantilists' ideas often were intellectually shallow, and indeed their trade policy may have been little more than a rationalization of the interests of a rising merchant class that wanted wider markets--hence the emphasis on expanding exports--coupled with protection against competition in the form of imported goods. Yet mercantilist policies, as will be noted later, are by no means completely dead today.
COMPARATIVE-ADVANTAGE ANALYSIS
The British school of "classical economics" began in no small measure as a reaction against the inconsistencies of mercantilist thought. Adam Smith was the 18th-century founder of this school; his famous work, The Wealth of Nations (1776), is in part an antimercantilist tract. In The Wealth of Nations, Smith emphasized the importance of specialization as a source of increased output, and he treated international trade as a particular instance of specialization: in a world where productive resources are scarce and human wants cannot be completely satisfied, each nation should specialize in the production of goods it is particularly well equipped to produce; it should export part of this production, taking in exchange other goods that it cannot so readily turn out. Smith did not expand these ideas at much length; but David Ricardo, the second great classical economist, developed them into the "principle of comparative advantage," a principle still to be found, much as Ricardo spelled it out, in every textbook on international trade.
Simplified theory of comparative advantage.
For clarity of exposition, the theory of comparative advantage is usually first outlined as though only two countries and only two commodities were involved, although the principles are by no means limited to such cases. Again for clarity, the cost of production is usually measured only in terms of labour time and effort; the cost of a unit of cloth, for example, might be given as two hours of work. The two countries will here be A and B; and the two commodities produced, wine and cloth. The labour time required to produce a unit of either commodity in either country is as follows:
cost of production (labour time)
country A country B
wine (1 unit) 1 hour 2 hours
cloth (1 unit) 2 hours 6 hours As compared with country A, country B is productively inefficient. Its workers need more time to turn out a unit of wine or a unit of cloth. This relative inefficiency may result from differences in climate, in worker training or skill, or in the amount of available tools and equipment, or from numerous other possible reasons. Ricardo took it for granted that such differences do exist, and he was not concerned with their origins. Country A is said to have an absolute advantage in the production of both wine and cloth because it is more efficient in the production of both goods. Accordingly, A's absolute advantage seemingly invites the conclusion that country B could not possibly compete with country A, and indeed that if trade were to be opened up between them, country B would be competitively overwhelmed. Ricardo insisted that this conclusion is false. The critical factor is that country B's disadvantage is less pronounced in wine production, in which its workers require only twice as much time for a single unit as do the workers in A, than it is in cloth production, in which the required time is three times as great. This means, Ricardo pointed out, that country B will have a comparative advantage in wine production. Both countries will profit, in terms of the real income they enjoy, if country B specializes in wine production, exporting part of its output to country A, and if country A specializes in cloth production, exporting part of its output to country B. Paradoxical though it may seem, it is preferable for country A to leave wine production to country B, despite the fact that A's workers can produce wine of equal quality in half the time that B's workers can do so. To illustrate this conclusion, it can be considered that country A's total labour force consists of 300 workers. Disregarding the possibility of trade with B, A then has a choice of various outputs of cloth and of wine, depending on the number of workers engaged in each of the two occupations. This range of choices is illustrated by the line DEF in the accompanying diagram. If all 300 labourers work on cloth production, total hourly cloth output will be 150 units (point D in the diagram), since each such unit requires two hours' labour. At the other extreme, if all labour works on wine production, wine output will be 300 units per hour (point F). Any intermediate point on the line DEF is possible. Point E, for example, indicates 80 units of cloth produced each hour (160 workers so employed) and 140 units of wine (employing the other 140 workers). DEF is country A's "production possibility" line. If it does not trade with country B and so can consume only what it produces itself, DEF will also be country A's "consumption possibility" line; it will choose some point thereon, depending on the preferences of its citizens for wine and cloth. DEF represents the limit of production and consumption possibilities; points above and to the right of DEF are unattainable. In the right-hand diagram, the line GHJ has exactly the same production and consumption significance for country B--assuming its total force to be 600 workers (so as to make it roughly equal to A in total output capacity). The position of the line GHJ reflects the fact that labour in country B requires two hours to produce a unit of wine, and six hours for a unit of cloth. One may consider that A and B are initially isolated from one another. Country A has chosen point E (80 cloth, 140 wine) as its production-consumption point. Country B has chosen point H (55 cloth, 135 wine). The opportunity of free trade between the two countries is now opened up. If both countries want to attain the higher levels of production and consumption available to them through specializing on and trading of the product for which they have a comparative advantage, Country A will shift its entire labour force to cloth production, and Country B will shift its entire labour force to wine production. A possible barter rate (setting aside the detail of how this would be worked out) might be one cloth for two and one-half wine. Country A might then choose to export 60 units of its hourly cloth output of 150, keeping the other 90 for domestic consumption. In exchange for this 60 cloth (at the 1-for-2 1/2 exchange rate) it would receive 150 wine. A's real income position is thus improved in comparison with pretrade point E: cloth for domestic consumption has risen from 80 to 90, and wine consumption has risen from 140 to 150. Country B enjoys a similar gain. In comparison with pre-trade point H, its cloth consumption has risen from 55 to 60, and wine consumption has risen from 135 to 150. The incentive to export and to import can be explained in price terms. In country A (before international trade), the price of cloth ought to be twice that of wine, since a unit of cloth requires twice as much labour effort. If this price ratio is not satisfied, one of the two commodities will be overpriced and the other underpriced. Labour will then move out of the underpriced occupation and into the other, until the resulting shortage of the underpriced commodity drives up its price. In country B (again, before trade), a cloth unit should cost three times as much as a wine unit, since a unit of cloth requires three times as much labour effort. Hence, a typical before-trade price relationship, matching the underlying real cost ratio in each country, might be as follows: country A country B Price of wine per unit $ 5 1 Price of cloth per unit $10 3
The absolute levels of price do not matter. All that is necessary is that in each country the ratio of the two prices should match the labour-cost ratio. As soon as the opportunity of exchange between the two countries is opened up, the difference between the wine-cloth price ratio in country A (namely, 5:10, or 1:2) and that in country B (which is 1:3) provides the opportunity of a trading profit. Cloth will begin to move from A to B, and wine from B to A. A trader in A, starting with a capital of $10 for example, would buy a unit of cloth, sell it in B for £3, buy 3 units of B's wine with the proceeds, and sell this in A for $15. (This example assumes, for simplicity, that costs of transporting goods are negligible or zero. The introduction of transport costs complicates the analysis somewhat, but it does not change the conclusions, unless these costs are so high as to make trade impossible.) So long as the ratio of prices in country A differs from that in country B, the flow of goods between the two countries will steadily increase as traders become increasingly aware of the profit to be obtained by moving goods between the two countries. Prices, however, will be affected by these changing flows of goods. The wine price in country A, for example, can be expected to fall as larger and larger supplies of imported wine become available. Thus A's wine-cloth price ratio of 1:2 will fall. For comparable reasons, B's price ratio of 1:3 will rise. When the two ratios meet, at some intermediate level (in the example earlier, at 1:2 1/2), the flow of goods will stabilize.
Amplification of the theory.
At a later stage in the history of comparative-advantage theory, the English philosopher and political economist John Stuart Mill showed that the determination of the exact after-trade price ratio was a supply-and-demand problem. At each possible intermediate ratio (within the range of 1:2 and 1:3), country A would want to import a particular quantity of wine and export a particular quantity of cloth. At that same possible ratio, country B would wish to import and export particular amounts of cloth and of wine. For any intermediate ratio taken at random, however, A's export-import quantities probably will not match those of B. Ordinarily, there will be just one intermediate ratio at which the quantities correspond; that is the final trading ratio at which quantities exchanged will stabilize. (Once they have stabilized, there is no longer any profit in exchanging goods. Even with such profits eliminated, however, there is no reason why A producers should want to stop selling part of their cloth in B, since the return there is as good as that obtained from domestic sales. Any falloff in the amounts exported and imported would reintroduce profit opportunities.) In the elementary labour-cost example used above, there will be complete specialization: country A's entire labour force will move to cloth production and country B's to wine production. More elaborate comparative-advantage models recognize production costs other than labour (that is, the costs of land and of capital). In such models, part of country A's wine industry may survive and compete effectively against imports, as may also part of B's cloth industry. The models can be expanded in other ways: to take account of more than two countries, or more than two commodities, and of transport costs. The essential conclusions, however, come from the elementary model used above, so that this model, despite its simplicity, still provides a workable outline of the theory. (It should be noted that even the most elaborate comparative-advantage models continue to rely on certain simplifying assumptions without which the basic conclusions do not necessarily hold. These assumptions are discussed below.) As noted earlier, the effect of this analysis is to correct any false first impression that low-productivity countries are at a hopeless disadvantage in trading with high-productivity ones. The impression is false, that is, if one assumes, as comparative advantage theory does, that international trade is an exchange of goods between countries. It is pointless for country A to sell goods to country B, whatever its labour-cost advantages, if there is nothing that it can profitably take back in exchange for its sales. With one exception, there will always be at least one commodity that a low-productivity country such as B can successfully export. Country B must of course pay a price for its low productivity, as compared with A; but that price is a lower per capita domestic income and not a disadvantage in international trading. For trading purposes, absolute productivity levels are unimportant; country B will always find one or more commodities in which it enjoys a comparative advantage; that is, a commodity in the production of which its absolute disadvantage is least. The one exception is that case in which productivity ratios, and consequently pre-trade price ratios, happen to match one another in two countries. Such would have been the case had country B required four labour hours (instead of six) to produce a unit of cloth. In this particular circumstance, there would be no incentive for either country to engage in trade, and no gain from trading. In a two-commodity example such as that employed, it might not be unusual to find matching productivity and price ratios. But as soon as one moves on to cases of three and more commodities, the statistical probability of encountering precisely equal ratios becomes very small indeed. The major purpose of the theory of comparative advantage is to illustrate the gains from international trade. Each country can gain by specializing in those occupations in which it is relatively efficient; it should export part of that production and take in exchange those goods in whose production it is, for whatever reason, at a comparative disadvantage. The theory of comparative advantage thus provides a strong argument for free trade--and indeed for a laissez-faire attitude with respect to trade. The supporting argument is simple: specialization and free exchange among nations yield higher real income for the participants. The fact that a country will enjoy higher real income as a consequence of the opening up of trade does not mean, of course, that every family or individual within the country must share in that benefit. Producer groups affected by import competition obviously will suffer, to at least some degree. Comparative-advantage theorists concede that free trade would affect the relative income position of such groups, and perhaps even their absolute income level. But they insist that the special interest of these groups clashes with the total national interest, and the most that they are usually willing to concede is the possible need for temporary protection against import competition, in order that the persons affected may have sufficient time to move to another occupation. Nations do, of course, maintain tariffs and other barriers to imports.
SOURCES OF COMPARATIVE ADVANTAGE
As already noted, British classical economists simply accepted the fact that productivity differences exist between countries; they made no concerted attempt to explain which commodities a country would export or import. During the 20th century, international economists have offered a number of theories in an effort to explain why countries have differences in productivity, the factor that determines comparative advantage and the pattern of international trade.
Natural resources.
First, countries can have an advantage because they are richly endowed with a particular natural resource. For example, countries with plentiful oil resources can generally produce oil inexpensively. Thus, Saudi Arabia produces oil very cheaply, giving it a comparative advantage in oil, and it exports oil in order to finance its purchases of imports. Similarly, countries with large forests generally are the major exporters of wood, paper, and paper products. The supply available for export also depends on domestic demand. Canada, for example, has large quantities of lumber available for export to the United States, not only because of its large areas of forest but also because its small population consumes little of the supply, leaving much of the lumber available for export. Climate is another natural resource that provides an export advantage. Thus, for example, bananas are exported by Central American countries, not Iceland or Finland.
Factor endowments: the Heckscher-Ohlin theory.
The proposition that countries with plentiful natural resources generally have a comparative advantage in products using those resources is obvious and straightforward. A related, but much more subtle, explanation was put forward by two Swedish economists, Eli Heckscher and Bertil Ohlin. Ohlin's work was built upon that of Heckscher. In recognition of his ideas as described in his path-breaking book, Interregional and International Trade (1933), Ohlin shared the Nobel Prize for Economics in 1977. The Heckscher-Ohlin theory focuses on the two most important factors of production, labour and capital. Some countries are relatively well-endowed with capital; the typical worker has plenty of machinery and equipment at his disposal. In such countries, wage rates generally are high. Products requiring much labour--such as textiles, sporting goods, and simple consumer electronics--tend as a result to be more expensive than in countries with plentiful labour and low wage rates. On the other hand, goods requiring much capital and only a little labour (automobiles and chemicals, for example) tend to be relatively inexpensive in countries with plentiful and cheap capital. Thus, countries with abundant capital should generally be able to produce capital-intensive goods relatively inexpensively, exporting them in order to pay for imports of labour-intensive goods. In the Heckscher-Ohlin theory it is not the absolute amount of capital that is important; rather, it is the amount of capital per worker. A small country like Luxembourg has much less capital in total than India, but Luxembourg has more capital per worker. Accordingly, the Heckscher-Ohlin theory predicts that Luxembourg will export capital-intensive products to India and import labour-intensive products in return. Despite its plausibility the Heckscher-Ohlin theory is frequently at variance with the actual patterns of international trade. As an explanation of what countries actually export and import, it is much less accurate than the more obvious and straightforward natural resource theory. One early study of the Heckscher-Ohlin theory was carried out by Wassily Leontief, a Russian-born U.S. economist. Leontief observed that the United States was relatively well-endowed with capital. According to the theory, therefore, the United States should export capital-intensive goods and import labour-intensive ones. He found that the opposite was in fact the case: U.S. exports are generally more labour intensive than the type of products that the United States imports. Because his findings were the opposite of those predicted by the theory, they are known as the Leontief Paradox.
Economies of large-scale production.
Even if countries have quite similar climates and factor endowments, they may still find it advantageous to trade. Indeed, economically similar countries often carry on a large and thriving trade. The prosperous industrialized countries have become one another's best customers. A main reason for this situation lies in what is called the economies of large-scale production. For many products, there are advantages in producing on a large scale; costs become lower as more is produced. Thus, for example, automobiles can be made more cheaply in a factory producing 100,000 units than in a small factory producing only 1,000 units. This means that countries have an incentive to specialize in order to reduce costs. To sell a large volume of output, they may have to look to export markets. The smaller the country, and the more limited its domestic market, the more incentive it has to look to international trade as a way of gaining the advantages of large-scale production. Thus, Luxembourg or Belgium has much more to gain relatively than does the United States. Indeed, the advantages of large-scale production have been one of the major sources of gain from the establishment of the European Economic Community (EEC), which was formed for the purpose of providing free trade between most western European countries. Even a large country such as the United States, however, can gain in some cases by exporting in order to lengthen production lines. For example, the Boeing Company has been able to produce airplanes more cheaply because it is able to sell large numbers of aircraft to other countries. The importing countries also gain because they can buy aircraft abroad more cheaply than they could produce them at home.
Technology.
Technological development can also provide a distinctive trade advantage. The relatively advanced countries--particularly the United States, Japan, and those of western Europe--are the principal exporters of high-technology products such as computers and precision machinery. One important aspect of technology is that it can change rapidly. Such rapid changes present several challenges. For the countries that are not in the front rank, it raises the question of whether they should import high-technology products or attempt to enter the circle of the most advanced nations. For the countries that have held the technological lead in the past, there is always the possibility that they will be successfully overtaken by newcomers. This occurred in the second half of the 20th century when Japan advanced technologically in its automobile production to the point where it could challenge the automobile leadership of North America and Europe. Japan quickly became the world's foremost producer of automobiles.
The product cycle.
The spread of technology across national boundaries means that comparative advantage can change. The most technologically advanced countries generally have the advantage in making new products, but as time passes other countries may gain the advantage. For example, many television sets were produced in the United States during the 1950s. As time passed, however, and technological change in the television industry became less rapid, there was less advantage in producing sets in the United States. Producers of television sets had an incentive to look to other locations, with lower wage rates. In time, the manufacturers established overseas operations in Taiwan, Hong Kong, and elsewhere. Concurrently, the United States turned to new activities, such as the manufacture of large mainframe computers and the development of computer software.
State interference in international trade
METHODS OF INTERFERENCE
Regardless of what comparative-advantage theory may say about the virtues of unrestricted trade, all nations interfere with international transactions to at least some degree. Tariffs may be imposed on imports--in some instances making them so costly as to bar completely the entry of the good involved. Quotas may limit the permissible volume of imports. State subsidies may be offered to encourage exports. Money-capital exports may be restricted or prohibited. Investment by foreigners in domestic plant and equipment may be similarly restrained. These interferences may be simply the result of special-interest pleading, because particular groups suffer as a consequence of import competition. Or a government may impose restrictions because it feels impelled to take account of factors that comparative advantage sets aside. It is of interest to note that insofar as goods and services are concerned, the general pattern of interference follows the old mercantilist dictum of discouraging imports and encouraging exports. A company that finds itself barred from an attractive foreign market by tariffs or quotas may be able to leapfrog the barrier simply by establishing a manufacturing plant within that foreign country. This policy of foreign plant investment has expanded enormously since the end of World War II. U.S. companies have taken the lead, investing particularly in western Europe, Canada, and South America. Industry in other developed countries has followed a similar pattern--some foreign companies establishing plants within the United States as well as in other areas of the world. The governments of countries subject to this new investment find themselves in an ambivalent position. The establishment of new foreign-owned plants may mean more than simply the creation of new employment opportunities and new productive capacity; it may also mean the introduction of new technologies and superior business-control methods. But the government that welcomes such benefits must also expect complaints of "foreign control," an argument that will inevitably be pressed by domestic owners of older plants who fear a new competition that cannot be blocked by tariffs. This has been a pressing problem for many governments, particularly insofar as investment by U.S. firms is involved. Countries such as the United Kingdom and Canada have been liberal in their admissions policy; others, notably Japan, impose tight restrictions on foreign-owned plants.
Tariffs.
A tariff, or duty, is a tax levied on a commodity when it crosses the boundary of a customs area. The boundary may be that of a nation or a group of nations that have agreed to impose a common tax on goods entering their territory. Tariffs are often classified as either protective or revenue. Protective tariffs are designed to shield domestic production from foreign competition by raising the price of the imported commodity. Revenue tariffs are designed to obtain revenue rather than to restrict imports. The two sets of objectives are, of course, not mutually exclusive. Protective tariffs, unless they are so high as to keep out imports, yield revenue. Revenue tariffs give some protection to any domestic producer of the duty-bearing goods. A transit duty, or transit tax, is a tax levied on commodities passing through a customs area en route to another country. Similarly, an export duty, or export tax, is a tax imposed on commodities leaving a customs area. Finally, some countries provide export subsidies; import subsidies are rarely used.
How tariffs work.
Tariffs on imports may be applied in several ways. If they are imposed according to the physical quantity of an import (so much per ton, per yard, per item, etc.), they are called specific tariffs. If they are levied according to the value of the import, they are known as ad valorem tariffs. Tariffs may differentiate among the countries from which the imports are obtained. They may, for instance, be lower between countries that have previously entered into special arrangements, such as the trade preferences accorded to each other by members of the Commonwealth. Tariffs may affect the economy of the country imposing them in a number of ways. By raising the prices of imported goods, tariffs may encourage domestic production. As expenditures on domestic products rise, domestic employment tends to do likewise. This is why tariffs are favoured by industries that find themselves pressed by foreign competitors. The tariff may also encourage tendencies toward a monopolistic market structure to the extent that it lessens foreign competition, with a resulting decrease in the incentive to modernize or innovate. By increasing the price of an imported commodity a tariff may also reduce its consumption. The decrease in demand could be large enough in relation to the world market to force the price of the import down.
Measuring the effects of tariffs.
It is difficult to gauge the effect of tariff barriers among countries. First of all, how import demand responds to changes in tariffs depends on a variety of factors--the reaction of producers and consumers to price changes, the share of imports in domestic production and consumption, the substitutability of imports for domestic products, and so on. And the responsiveness to tariff levels will differ from country to country as well as from commodity to commodity. Thus, the amount of a tariff does not necessarily determine its restrictive effect. For another thing, such comparisons also must be restricted to commodities for which tariffs are the major protective device. This is generally true for nonagricultural commodities in developed countries, but other devices are often employed to protect agricultural production. In the third place, a tariff levied upon imports of raw materials will protect domestic raw material producers but will increase the costs of manufacturers using those raw materials. It is necessary, therefore, to distinguish between nominal and effective rates of protection. The nominal rate of protection is the percentage tariff imposed on a product as it enters the country. For example, if a tariff of 20 percent of value is collected on clothing as it enters the country, then the nominal rate of protection is that same 20 percent. The effective rate of protection is a more complex concept: consider that the same product--clothing--costs $100 on international markets. The material that is imported to make the clothing (material inputs) sells for $60. In a free trade situation, a firm can charge no more than $100 for a similar piece of clothing (ignoring transportation costs). Importing the fabric for $60, the clothing manufacturer can add a maximum of $40 for labour, profit markup, rents, and the like. This $40 difference between the $60 cost of material inputs and the price of the product is called the value added. The same situation may be considered with tariffs--say, 20 percent on clothing and 10 percent on fabric. The 20 percent tariff on clothing would raise the domestic price by $20 to $120, while a 10 percent tariff on fabrics would increase material costs to the domestic producer by $6 to $66. Protection would thus enable the firm to operate with a value-added margin of $54--the difference between the domestic price of $120 and the material cost of $66. The difference between the value added of $40 without tariff protection and that of $54 with it provides a margin of $14. This means that the effective rate of protection of the domestic processing activity--the ratio of $14 to $40--would be 35 percent. The effective rate of protection derived--35 percent--is greater than the nominal rate of only 20 percent. This will be the case whenever the tariff rate on the final product is greater than the tariff on inputs. Because countries generally do levy higher tariffs on final products than on inputs, effective rates of protection are generally higher than nominal rates--often much higher. The effective rate of protection also depends on the share of value added in the product price. Effective rates can be very high if value added to the imported commodity is a small percentage or very low if value added is a large percentage of the total price. Thus, effective protection in one country may be much higher than that in another even though its nominal tariffs are lower, if it tends to import commodities of a high level of fabrication with correspondingly low ratios of value added to product price.
Nontariff barriers.
Other government regulations and practices may also act as barriers to trade. Quotas or quantitative restrictions may prohibit the importation of certain commodities or limit the amounts imported. Such quotas are usually administered by requiring importers to have licenses to bring in particular commodities. Quotas raise prices just as tariffs do, but, being set in physical terms, their impact on imports is direct, with an absolute ceiling set on supply. Increased prices will not bring more goods in. There is also a difference between tariffs and quotas in their effect on revenues. With tariffs, the government receives the revenue: under quotas, the import license holders obtain a windfall in the form of the difference between the high domestic price and the low international price of the import. Another barrier, which has become increasingly common during the past several decades, is the "voluntary" export restraint (VER). For example, in the 1980s the Japanese (under pressure from the United States) "voluntarily" limited their exports of automobiles to the U.S. market. Like quotas, VERs limit the quantity of trade and therefore tend to raise the prices of imported goods. In this case the VER made Japanese automobiles less available in the United States and raised the prices that U.S. consumers had to pay for such automobiles. VERs are usually not voluntary in any meaningful sense. In this example, the Japanese agreement to a VER on automobiles was an attempt to avoid a U.S. import quota. For the Japanese, a VER was preferable to a U.S. import quota because Japanese exporters could charge higher prices. The Japanese exporters, rather than U.S. importers, reaped much of the windfall from the VER. A VER is also easier to get rid of. In addition, a VER has a less damaging effect on the political relations between countries. Still other barriers include state trading organizations and government procurement practices that may be used preferentially. In the United States, "buy American" legislation requires government procurement agencies to favour domestic goods. Customs classification and valuation procedures, health regulations, and marking requirements may also have a restrictive effect on trade. Finally, excise taxes may act as a barrier to trade if they are levied at higher rates on imports than on domestic goods.
Protectionism in the less-developed countries.
The industrialization that has taken place in the late decades of the 20th century in some developing countries has been characterized by the expansion of import-competing industries behind high tariff walls. In many of those countries tariffs and various quantitative restrictions on manufactured goods are great. The effective rates of protection may be even greater, because the goods tend to be highly fabricated and the proportion of value added in production after importation is low. While some places such as Taiwan and North Korea have oriented their manufacturing industries mainly toward export trade, those are exceptional cases in the developing world. More commonly the new industries seek to compete with foreign-made goods for the domestic market. High protection in these countries has often contributed to a slowdown in the production and export of primary commodities and has discouraged expansion of exports of manufactured goods. Furthermore, while domestic production of nondurable consumer goods has permitted rapid economic growth at an early stage, developing countries have encountered considerable difficulties in producing more sophisticated commodities. They suffer all of the disadvantages of small domestic markets, in addition to a lack of incentives for technological improvement.
ARGUMENTS FOR AND AGAINST INTERFERENCE
Revenue.
Developing nations in particular often lack the institutional machinery needed for effective imposition of income or corporation taxes. The governments of such nations may then finance their activity by resort to tariffs on imported goods, since such levies are relatively easy to administer. The amount of tax revenue obtainable through tariffs, however, is always limited. If the government tries to increase its tariff income by imposing higher duty rates, this may choke off the flow of imports and so reduce tariff revenue instead of increasing it.
Economic development.
Protection of domestic industry.
Probably the most common argument for tariff imposition is that particular domestic industries need tariff protection for survival. Comparative-advantage theorists will of course argue that the industry in need of such protection ought not to survive and that the resources so employed ought to be transferred to occupations having greater comparative efficiency. The welfare gain of citizens taken as a whole would more than offset the welfare loss of those groups affected by import competition; that is, total real national income would increase. An opposing argument would be, however, that this welfare gain would be widely diffused, so that the individual beneficiaries might not be conscious of any great improvement. The welfare loss, in contrast, would be narrowly and acutely felt. Although resources can be transferred to other occupations, just as comparative-advantage theory says, the transfer process is sometimes slow and painful for those being transferred. For such reasons, comparative-advantage theorists rarely advocate the immediate removal of all existing tariffs. They argue instead against further tariff increases--since increases, if effective, attract still more resources into the wrong occupation--and they press for gradual reduction of import barriers.
The infant-industry argument.
Advocates of protection often argue that new and growing industries, particularly in less-developed countries, need to be shielded from foreign competition. They contend that costs decline with growth and that some industries must reach a minimum size before they are able to compete with well-established industries abroad. Tariffs can protect the domestic market until the industry becomes internationally competitive and, it is often argued, the costs of protection can be recouped after the industry has reached maturity. In short, the infant-industry argument is based principally on the idea that there are economies of large-scale production in many industries and that developing countries have difficulty in establishing such industries. Advocates of such protection, however, can have their arguments turned against them. While an individual country can, in some circumstances, gain from protecting its infant industries, this protection is particularly costly for the international community as a whole. Where there are major advantages in large-scale production, there are also large advantages in relatively free international trade. By closing off markets, protection reduces the ability of firms to gain economies of large-scale by exporting. If a group of countries imposes infant-industry protection, it will split up the market; each country may end up with small-scale, localized, inefficient production, thus reducing the prosperity of all of the countries. One way in which developing nations have tried to deal with this problem has been through the establishment of customs unions or other regional groupings Infant-industry tariffs have been disappointing in other ways; the infant-industry argument is often abused in practice. In many developing countries, industries have failed to attain international competitiveness even after 15 or 20 years of operation and might not survive if protective tariffs were removed. The infant industry is probably better aided by production subsidies than by tariffs. Production subsidies do not raise prices and therefore do not curtail domestic demand; and the cost of the protection is not concealed in higher prices to consumers. Production subsidies, however, have the disadvantage of drawing upon government revenue rather than adding to it, which may be a serious consideration in countries at lower levels of development.
Unemployment.
Tariffs or quotas are also sometimes proposed as a way to maintain domestic employment--particularly in times of recession. There is, however, near-unanimity among modern-day economists that proposals to remedy unemployment by means of tariff increases are misguided. Insofar as a higher tariff is effective for this purpose, it simply "exports unemployment"; the rise in domestic employment is matched by a drop in production in some foreign country. That other country, moreover, is likely to impose a retaliatory tariff increase. Finally, the tariff remedy for unemployment is a poor one because it is usually ineffective and because more suitable remedies are now available. It has come to be generally recognized that unemployment is far more efficiently dealt with by the implementation of proper fiscal and monetary policies.
National defense.
A common appeal made by an industry seeking tariff or quota protection is that its survival is essential in the national interest: its product would be needed in wartime, when the supply of imports might well be cut off. The verdict of economists on this argument is fairly clear: the national-defense argument is frequently a red herring, an attempt to "wrap oneself in the flag," and insofar as an industry is essential, the tariff is a dubious means of ensuring its survival. Essential industries ought instead to be given a direct subsidy to enable them to meet foreign competition, with explicit recognition of the fact that the subsidy is a price paid by the nation in order to maintain the industry for defense purposes.
Autarky, or self-sufficiency.
Many demands for protection, whatever their surface argument may be, are really appeals to the autarkic feelings that prompted mercantilist reasoning. (Autarky is defined as the state of being self-sufficient at the level of the nation.) A proposal for the restriction of free international trade can be described as autarkic if it appeals to those half-submerged feelings that the citizens of the nation share a common welfare and common interests, whereas foreigners have no regard for such welfare and interests and might even be actively opposed to them. And it is quite true that a country that has become heavily involved in international trade has given hostages to fortune: a part of its industry has become dependent upon export markets for income and for employment. Any cutoff of these foreign markets (brought about by recession abroad, by the imposition of new tariffs by some foreign country, or by numerous other possible changes) would be acutely serious; and yet it would be a situation largely beyond the power of the domestic government involved to alter. Similarly, another part of domestic industry may rely on an inflow of imported raw materials, such as oil for fuel and power. Any restriction of these imports could have the most serious consequences. The vague threat implicit in such possibilities often results in a yearning for autarky, for national self-sufficiency, for a life free of dependence on the hazards of the outside world. There is general agreement that no modern nation, regardless of how rich and varied its resources, could really practice self-sufficiency, and attempts in that direction could produce sharp drops in real income. Nevertheless, protectionist arguments--particularly those made "in the interests of national defense"--often draw heavily on the strength of such autarkic sentiments.
The terms-of-trade argument.
When a country imposes a tariff, foreign exporters have greater difficulty in selling their products. As their exports decline, they may cut prices in order to keep their sales from falling drastically. Thus, for example, when a tariff of $10.00 is imposed, foreign exporters may cut their price by, say, $6.00. The foreign exporter is being "taxed" when the tariff is imposed; the other $4.00 is reflected in a higher price to the consumer. The use of tariffs to tax foreign exporters in this way is known as the terms-of-trade argument for protection. The terms of trade represent the relative price of what a nation is exporting, compared with the price paid to foreigners for imported goods. When the price of what is being exported rises, or when the price paid to foreigners for imported goods falls (as it may when a nation imposes a tariff), terms of trade improve.
Balance-of-payments difficulties.
Governments may interfere with the processes of foreign trade for a reason quite different from those thus far discussed: shortage of foreign exchange. Under the international monetary system established after World War II and in effect until the 1970s, most governments tried to maintain fixed exchange rates between their own currencies and those of other countries. Even if not absolutely fixed, the exchange rate was ordinarily allowed to fluctuate only within a narrow range of values. If balance-of-payments difficulties arise and persist, a nation's foreign exchange reserve runs low. In a crisis, the government may be forced to devalue the nation's currency. But before being driven to this, it may try to redress the balance by restricting imports or encouraging exports, in much the old mercantilist fashion. The problem of reserve shortages became acute for many countries during the 1960s. Although the total volume of international transactions had risen steadily, there was not a corresponding increase in the supply of international reserves. By 1973 payment imbalances led to an end of the system of fixed, or pegged, exchange rates and to a "floating" of most currencies.
International trade arrangements
Many efforts have been made in modern times to promote trade among nations. The ways in which this may be attempted range from agreements among governments to reduce or eliminate trade barriers to more ambitious attempts to harmonize economic policies, as in the European Economic Community (EEC) established by the nations of western Europe.
HISTORY OF MODERN TRADE POLICIES
Mercantilism.
Much of the modern history of international relations concerns efforts to promote freer trade among nations. The 17th century saw the growth of restrictive policies that later came to be known as mercantilism. The mercantilists held that economic policy should be nationalistic and aim to secure the wealth and power of the state. The concept was based on the conviction that national interests are inevitably in conflict--that one nation can increase its trade only at the expense of other nations. Thus, governments were led to impose price and wage controls, foster national industries, promote exports of finished goods and imports of raw materials, and prohibit the exports of raw materials and the import of finished goods. The state endeavoured to provide its citizens with a monopoly of the resources and trade outlets of its colonies. A typical illustration of the mercantilist spirit is the famous English Navigation Act of 1651, which reserved for the home country the right to trade with the colonies and prohibited the import of goods of non-European origin unless transported in ships flying the English flag. This law lingered on until 1849. A similar policy was followed in France.
Liberalism.
A strong reaction against mercantilist attitudes began to take shape toward the middle of the 18th century. In France, the economists known as Physiocrats demanded liberty of production and trade. In England, as discussed above, Adam Smith demonstrated in his The Wealth of Nations (1776) the advantages of removing trade restrictions. Economists and businessmen voiced their opposition to excessively high and often prohibitive customs duties and urged the negotiation of trade agreements with foreign powers. This change in attitudes led to the signing of a number of agreements embodying the new liberal ideas, among them the Anglo-French Treaty of 1786, which ended what had been an economic war between the two countries. After Adam Smith, the basic tenets of mercantilism were no longer considered defensible. This did not, however, mean that nations abandoned all mercantilist policies. Restrictive economic policies were now justified by the claim that, up to a certain point, the government should keep foreign merchandise off the domestic market in order to shelter national production from outside competition. To this end, customs levies were introduced in increasing number, replacing outright bans on imports, which became less and less frequent. In the middle of the 19th century, customs walls effectively sheltered many national economies from outside competition. The French tariff of 1860, for example, charged extremely high rates on British products: 60 percent on pig iron; 40 to 50 percent on machinery; and 600 to 800 percent on woolen blankets. Transport costs between the two countries provided further protection. A triumph for liberal ideas was the Anglo-French trade agreement of 1860, which provided that French protective duties were to be reduced to a maximum of 25 percent within five years, with free entry of all French products except wines into Britain. This agreement was followed by other European trade pacts.
Resurgence of protectionism.
A reaction in favour of protection spread throughout the Western world in the latter part of the 19th century. Germany adopted a systematically protectionist policy and was soon followed by most other nations. Shortly after 1860, during the Civil War, the United States raised its duties sharply; the McKinley Tariff Act of 1890 was ultraprotectionist. England was the only country to remain faithful to the principles of free trade. But the protectionism of the last quarter of the 19th century was mild by comparison with the mercantilist policies that had been common in the 17th century and were to be revived between the two world wars. Extensive economic liberty prevailed by 1913. Quantitative restrictions were unheard of, and customs duties were low and stable. Currencies were freely convertible into gold, which in effect was a common international money. Balance-of-payments problems were few. People who wished to settle and work in a country could go where they wished with few restrictions; they could open businesses, enter trade, or export capital freely. Equal opportunity to compete was the general rule, the sole exception being the existence of limited customs preferences between certain countries, most usually between a home country and its colonies. Trade was freer throughout the Western world in 1913 than it was in Europe in 1970.
The "new" mercantilism.
World War I wrought havoc with these orderly trading conditions. By the end of hostilities, world trade was in a straitjacket that made recovery very difficult. The first five years of the postwar period were marked by the dismantling of wartime controls proper. The 1920 crisis and the commercial advantages accruing to countries whose currencies had depreciated, as had Germany's, rapidly led to fresh measures in restraint of trade. The protectionist tide engulfed the world economy, not because policymakers consciously adhered to any specific theory but because of nationalist ideologies and the pressure of economic conditions. In an attempt to end the continual raising of customs barriers, the League of Nations organized the first World Economic Conference in May 1927. Twenty-nine states, including the main industrial countries, subscribed to an international convention that was the most minutely detailed and balanced multilateral trade agreement ever approved until that time. It was a precursor of the arrangements made under the General Agreement on Tariffs and Trade of 1947. The 1927 agreement remained practically without effect. During the Great Depression of the 1930s, unemployment in major countries reached unprecedented levels and engendered an epidemic of protectionist measures. Countries attempted to shore up their balance of payments by raising their customs duties and introducing a range of import quotas or even import prohibitions, accompanied by exchange controls. From 1933 onward, the recommendations of all the postwar economic conferences based on the fundamental postulates of economic liberalism were ignored. The planning of foreign trade came to be considered a normal function of the state. Mercantilist policies dominated the world scene until after World War II.
TRADE AGREEMENTS
The term trade agreement or commercial agreement can be used to describe any contractual arrangement between states concerning their trade relationships. Trade agreements may be bilateral or multilateral--that is, between two states or between more than two states.
Bilateral trade agreements.
A bilateral trade agreement usually includes a broad range of provisions regulating the conditions of trade between the contracting parties. These include stipulations governing customs duties and other levies on imports and exports, commercial and fiscal regulations, transit arrangements for merchandise, customs valuation bases, administrative formalities, quotas, and various legal provisions. Most bilateral trade agreements, either explicitly or implicitly, provide for (1) reciprocity, (2) most-favoured-nation treatment, and (3) "national treatment" of nontariff restrictions on trade.
Reciprocity.
In a trade agreement, the parties make reciprocal concessions to put their trade relationships on a basis deemed equitable by each. The principle of reciprocity is extremely old, and in one form or another it is to be found, implicitly at least, in all trade agreements. The concessions may, however, be in different areas. In the Anglo-French Agreement of 1860, for example, France pledged itself to reduce its duties to 20 percent by 1864. In return, Britain granted duty-free imports of all French products except wines and spirits. The principle of reciprocity implies only that the gains arising out of foreign trade are distributed fairly.
The most-favoured-nation clause.
The most-favoured-nation clause binds a country to apply to its partner country any lower rate of import duties that it may later grant to imports from some other country. The clause may cover a list of specified products only, or specific concessions yielded to certain foreign countries. Alternatively, it may cover all advantages, privileges, immunities, or other favourable treatment granted to any third country whatever. The clause is intended to provide each signatory with the assurance that the advantages obtained will not be attenuated or wiped out by a subsequent agreement concluded between one of the partners and a third country. It guarantees the parties against discriminatory treatment in favour of a competitor. The effect of the most-favoured-nation clause on customs duties is to amalgamate the successive trade agreements concluded by a state. If the rates in different agreements are fixed at varying levels, the clause reduces them to the lowest rate specified in any agreement. Thus, goods imported from a country benefiting from most-favoured-nation treatment are charged the rate of duty applicable to imports from another country which, in a subsequent trade agreement, has negotiated a lower rate of duty. The coverage of the most-favoured-nation clause can be considerably reduced by a minute definition of a particular item so that a concession, while general in form, applies in practice to only one country. The best-known illustration of this technique is to be found in the German Tariff of 1902, which admitted at a special rate
large dappled mountain cattle, reared at a spot at least 300 metres above sea level, and which have at least one month's grazing each year at a spot at least 800 metres above sea level.
The advantages granted under the most-favoured-nation clause may be conditional or unconditional. If unconditional, the clause operates automatically whenever appropriate circumstances arise. The country drawing benefit from it is not called on to make any fresh concession. By contrast, the partner invoking a conditional most-favoured-nation clause must make concessions equivalent to those extended by the third country. A typical wording was that of the 1911 treaty between the United States and Japan, which stated that
in all that concerns commerce and navigation, any privilege, favour or immunity . . . to the citizens or subjects of any other State shall be extended to the citizens or subjects of the other Contracting Party gratuitously, if the concession in favour of that other State shall have been gratuitous, and on the same or equivalent conditions, if the concession shall have been conditional.
The conditional form of the clause may at first sight seem more equitable. But it has the major drawback of being liable to raise dispute each time it is invoked, for it is by no means easy for a country to evaluate the compensation it is being offered as in fact being equivalent to the concession made by the third country. The effect of the unconditional form of the most-favoured-nation clause is, finally, to wipe out any relevance that the principle of reciprocity may have had to the purely bilateral preoccupations of the negotiating parties, since the results of the bargaining process, instead of being limited to the participants, influence their relationships with other states. In practice, therefore, a country negotiating a trade agreement must measure the advantages it is willing to concede in terms of the benefits these concessions will provide collaterally to that third country which is the most competitive. In other words, the concessions that may be granted are determined by the minimum protection that the negotiating state deems indispensable to protect its home producers. This sets a major limitation on the scope of bilateral negotiations. Protagonists of free trade consider that the unconditional most-favoured-nation clause is the only practical way by which to obtain the progressive reduction of customs duties. Apologists for protectionism are resolutely against it, preferring the conditional form of the clause or some equivalent mechanism. The conditional most-favoured-nation clause was generally in use in Europe until 1860, when the so-called Cobden-Chevalier Treaty between Great Britain and France established the unconditional form as the pattern for most European treaties. The United States used the conditional most-favoured-nation clause from its first trade agreement, signed with France in 1778, until the passage of the Tariff Act of 1922, which terminated the practice. (The Trade Reform Bill of 1974, however, in effect restored to the U.S. president the authority to designate preferential tariff treatment, subject to approval by Congress.) The Genoa conference in May 1922 and the World Economic Conference in May 1927 both recommended that trade agreements should include the most-favoured-nation clause whenever possible. But the Great Depression of the 1930s led instead to a rise of restrictions in world trade. Imperial or regional systems of preference came into being: the Ottawa Agreement of 1932 for the British Commonwealth, similar arrangements for the French empire, and a series of tariff and preference agreements negotiated in eastern and central Europe from 1931 on.
The "national treatment" clause.
The "national treatment" clause in trade agreements is designed to ensure that internal fiscal or administrative regulations are not used to introduce discrimination of a nontariff nature. It forbids discriminatory use of the following: taxes or other internal levies; laws, regulations, and decrees affecting the sale, offer for sale, purchase, transport, distribution, or use of products on the domestic market; valuation of products for purposes of assessment of duty; legislation on prices of imported goods; warehousing and transit regulations; and the organization and operation of state trading corporations.
Multilateral agreements since World War II.
When World War II ended, the lessons learned from the growth of protectionism since 1871, and most of all from the resurgence of trade restrictions in the interwar years, spurred the development of multilateral trade agreements and other forms of international economic cooperation. These developments culminated in the General Agreement on Tariffs and Trade (GATT).
The General Agreement on Tariffs and Trade.
The General Agreement on Tariffs and Trade was signed at Geneva on Oct. 30, 1947, by 23 countries, which among them accounted for four-fifths of world trade. On the same day 10 of them, including the United States, the United Kingdom, France, Belgium, and The Netherlands, signed a protocol bringing the agreement into force on Jan. 1, 1948. GATT takes the form of a multilateral trade agreement setting forth the principles under which the signatories, on a basis of "reciprocity and mutual advantage," shall negotiate "a substantial reduction in customs tariffs and other impediments to trade, and the elimination of discriminatory practices in international trade." With the adherence of additional countries, GATT has become a charter governing almost all world trade except for that of the Communist countries. The main principles underlying GATT are as follows: (1) There shall be no trade discrimination. The unconditional most-favoured-nation clause is regarded as fundamental. (2) As a rule, there is to be no protection other than that provided by the customs tariff (the "national treatment" principle). (3) Customs unions and free trade groupings are considered legitimate means of trade liberalization, provided that, taken as a whole, such arrangements do not discriminate against third countries. (4) Members of GATT are entitled to levy the following charges on imports: (a) an import tax equal in amount to internal taxes on the product concerned, subject only to the general principle embodied in (2) above, (b) "antidumping" duties in the case of imported products that are being sold at less than the price in the home market, or at less than cost, (c) countervailing duties to offset the effects of export subsidies, and (d) fees and other proper charges for services rendered. These, however, are only the basic principles. The agreement also contains a variety of clauses providing exceptions from the rules in special situations. These include balance-of-payments disequilibrium; serious and unexpected damage to domestic production; the requirements of economic development or, subject to very broad reservations, of agricultural policy; the need to protect domestic raw material production; and the interests of national security. In addition the GATT rules permit countries entering a customs union to depart from the most-favoured-nation principle. For example, within the European Economic Community, France can permit duty-free entry of goods from its fellow members--such as Germany and Italy--without extending such duty-free treatment to the products of outside nations. Periodically, major multilateral trade conferences, called rounds, are held by GATT countries to work out trade problems. Most of these have been held at Geneva, site of GATT headquarters. The formula for multilateral tariff bargaining applied in negotiations held under GATT auspices is a major innovation in intergovernmental cooperation. In appraising the concessions that they could afford to make, governments have been able to take account of the indirect advantages that they could expect to accrue to them from the full set of bilateral negotiations. Over the years since GATT's inception, it has been successful far beyond its creators' expectations; its contribution to the growth of world trade has been major. Two GATT sessions of particular historic importance were the Kennedy Round and the Tokyo Round. As the economic integration of western Europe progressed, opinion in the United States became concerned at the prospect of remaining outside. Pres. John F. Kennedy pursued the goal of an Atlantic partnership and secured special negotiating powers under the Trade Expansion Act of 1962. The act authorized tariff reductions of up to 50 percent, subject to reciprocal concessions from the European partners. This marked a fundamental shift away from the traditional protectionist posture of the United States and led to the so-called Kennedy Round negotiations in the GATT, held in Geneva from May 1964 to June 1967. The Kennedy Round negotiations concerned four types of problems: (1) progressive reduction, to amount finally to 50 percent, in the duties on all but a few products, in place of the item-by-item bargaining that had prevailed in earlier GATT conferences; (2) inclusion of agricultural as well as industrial products in the scope of the negotiations; (3) discussion of nontariff obstacles as well as of customs duties; and (4) nonreciprocity for economically less-developed countries. Fifty-four countries participated in the negotiations, which covered 400,000 tariff headings. The final result was an average reduction of 35 percent in the duties levied on industrial products, to be implemented over a five-year period. This was less than the 50 percent originally envisaged. Further, the reductions were not geographically uniform: U.S., European, and Japanese duties were to fall by an average of 35 percent, British duties by 38 percent, and Canadian by 24 percent. Little change was made in steel and textile tariffs, since the participants felt that reductions in those industries would create intolerable political and social tensions in most of the industrial countries. Problems arose with regard to chemicals because of a so-called American Selling Price that was used for appraising the dutiable value of some products, based on prices ruling in the U.S. market; in return for a reduction of 50 percent in the rates of duty charged by the United States, Great Britain and the European countries agreed to lower their duties by 22 percent, with a further 24 percent reduction to become effective upon abrogation of the American Selling Price. Rather less spectacular results were achieved for agricultural commodities. These included the setting of a minimum price for wheat and a weighted reduction of between 15 and 18 percent in the duties charged on other agricultural and food products. In the area of nontariff barriers to trade the most significant result was the adoption of a uniform antidumping code. The Kennedy Round continued the process of tariff reduction begun two decades earlier by the industrial countries. While developing countries drew little immediate advantage from the Kennedy Round negotiations, they were able to obtain the addition of a new part titled "Trade and Development" to the GATT charter, calling for stabilization, as far as possible, of raw material prices; reduction or abolition of customs duties or other restrictions that differentiate unreasonably between products in their primary state and the same products in finished form; and renunciation by the advanced countries of the principle of reciprocity in their relations with less-developed countries. The next ministerial meeting of GATT opened in Tokyo on Sept. 12, 1973, and was attended by representatives of ministerial or comparable level from 102 countries. On September 14 the meeting closed with the adoption of what came to be called the Tokyo Declaration. The declaration differed markedly from previous GATT documents in the inordinately large portion of its language devoted to strengthening the negotiating position of the less-developed countries. One of the general aims of the negotiations was said to be the securing of additional trade benefits for less-developed countries. Specifically, the trade negotiations would aim at improving the conditions of access for products of interest to such countries and ensuring stable, equitable, and remunerative prices for primary products. Tropical products would be given special and priority treatment. The principle of nonreciprocity in negotiations between developed and less-developed countries, an established principle in GATT, was reaffirmed: the importance of maintaining and improving the Generalized System of Preferences granted by developed countries to less-developed countries, as well as the need for special measures and the importance of providing special, differential, and more favourable treatment for less-developed countries, were recognized. Special attention was to be given to the trade interests of the least-developed countries. The Tokyo Declaration was followed by several years of multinational trade negotiations that came to be called the Tokyo Round, concluding in 1979 with the adoption of a series of tariff reductions to be implemented generally over an eight-year period beginning in 1980. Further progress was also made in dealing with nontariff issues. Most notably, a Code on Subsidies and Countervailing Duties was negotiated. This code had two main features: it listed a number of unacceptable subsidy practices, and it introduced a requirement that formal procedures be followed before the imposition of countervailing duties on imports subsidized by foreign nations. Specifically, before the imposition of a countervailing duty, an investigation had to establish that competing domestic firms were being injured. The code was not signed by all of the members, however, and the signing nations agreed only to follow the prescribed rules before applying countervailing duties to the exports of other signatories. Thus, while the code represented progress in dealing with a new topic, it also represented a departure from the most-favoured-nation principle: signatories were not required to extend the benefits of the code to GATT members who did not sign the code. A new set of negotiations was initiated at a conference in Uruguay in 1986. Because traditional tariffs were becoming much less important, most of the attention was focused on other impediments to international transactions. The United States was particularly eager that the new negotiations include international transactions in services and an attack on the problems of international agricultural trade, which had been severely distorted by domestic price support programs and subsidized exports of surplus production.
The Organisation for Economic Co-operation and Development.
On April 16, 1948, 16 European countries responded to a U.S. offer of economic aid under the European Recovery Program by setting up the Organisation for European Economic Co-operation (OEEC). Although the immediate aim was to coordinate the distribution of U.S. credits, the OEEC convention was also designed to foster free trade between the members and allow their participation in customs unions or similar institutions. The members by 1955 consisted of Britain, France, West Germany, Italy, Spain, the Benelux countries, Austria, Denmark, Sweden, Norway, Switzerland, Portugal, Greece, Ireland, Turkey, and Iceland. The Organisation for European Economic Co-operation did much to facilitate the recovery of intra-European trade and particularly to abolish most of the quantitative restrictions on imports within the area. On Sept. 30, 1961, the OEEC was converted into a new institution, the Organisation for Economic Co-operation and Development (OECD), and its membership was expanded to include the United States and Canada. Japan became a member in 1964, Finland joined in 1969, Australia in 1971, and New Zealand in 1973. The three fundamental aims of the OECD are to promote the economic growth of member countries in conditions of financial stability, to contribute to the economic growth of less-developed countries, and to foster the growth of world trade on a multilateral, nondiscriminatory basis. Having little power to enforce its decisions, the OECD has served mostly as a consultative body, influencing trade through its studies and communications.
ECONOMIC INTEGRATION
Forms of integration.
The economic integration of several countries or states may take a variety of forms. The term covers preferential tariffs, free-trade associations, customs unions, common markets, economic unions, and full economic integration. The parties to a system of preferential tariffs levy lower rates of duty on imports from one another than they do on imports from third countries. For example, Great Britain and its Commonwealth countries operated a system of reciprocal tariff preferences after 1919. In free-trade associations no duty is levied on imports from other member states, but different rates of duty may be charged by each member on its imports from the rest of the world. The European Free Trade Association is an example. A further stage is the customs union, in which free trade among the members is sheltered behind a unified schedule of customs duties charged on imports from the rest of the world. The 19th-century German Zollverein (see below) was a customs union. A common market is an extension of the customs union concept, the additional feature being that it provides for the free movement of labour and capital among the members; an example was the Benelux common market until it was converted into an economic union in 1959. The term economic union denotes a common market in which the members agree to harmonize their economic policies generally, as is the case with the European Economic Community (often referred to as the Common Market). Finally, total economic integration implies the pursuit of a common economic policy by the political units involved; examples are the states of the United States or the cantons of the Swiss confederation. Economic integration may be brought about by the political will of a state powerful enough to impose it, as under the Roman Empire or the European colonial systems of the 19th century, or it may result from freely negotiated agreement between sovereign states, as has been more common in the 20th century. The attempts at economic integration made after World War II can be appraised only by reviewing them against the background of the long process through which, over the centuries, the nations of the world have progressively achieved economic integration. Thus, for instance, the world's greatest power in the 17th century, France, was divided into a number of provinces separated from one another by various customs barriers involving a multitude of duties, tolls, and prohibitions. Trade regulations and fiscal charges differed from one region to the next; there was not even a single system of weights and measures. Not until after the Revolution did the economic integration of France really get under way.
Integration between the states of federations.
The United States.
The economic integration of the United States was not achieved all at once, but as the result of a long process during which the powers of the federal authorities were constantly reinforced. The Constitution empowered the federal government to regulate the conditions of trade with other countries and to set up a single system of duties. It also abolished the right of individual states to maintain separate customs legislation and to issue their own currencies. It authorized the federal government alone to issue currency and established the principle of free movement of persons, merchandise, and capital between the federated states. But the conflict of interest between North and South was settled only by the American Civil War. Almost 200 years were to elapse before the economies of the states could be considered as integrated for practical purposes, and even today many economic and fiscal disparities still exist among them. The difficulties faced by the 13 original states should not be underestimated. During the years prior to the adoption of the Constitution there were bitter trade disputes among the states, which imposed tariffs against each other and refused to accept each other's currencies. Everything seemed to justify the words of a contemporary liberal philosopher, Josiah Tucker, Dean of Gloucester (England):
As to the future grandeur of America, and its being a rising empire under one head, whether republican or monarchical, it is one of the idlest and most visionary notions that ever was conceived even by writers of romance. The mutual antipathies and clashing interests of the Americans, their differences of governments, habitudes, and manners, indicate that they will have no centre of union and no common interest. They never can be united into one compact empire under any species of government whatever; a disunited people till the end of time, suspicious and distrustful of each other, they will be divided and sub-divided into little commonwealths or principalities, according to natural boundaries, by great bays of the sea, and by vast rivers, lakes, and ridges of mountains.
Switzerland.
The Swiss example is no less instructive. Although the Helvetic Confederation emerged as a political entity in the 14th century, its economic integration was achieved, only after many vicissitudes, with the constitution of 1848. The terms of this document established a common currency, set forth the principle of a common protective system for the cantons, and provided for free movement of goods and Swiss citizens throughout the national territory. Swiss economic integration is all the more remarkable in that it comprises peoples who speak four different languages.
The economic integration of colonial empires.
When the great colonial powers of Europe founded their empires from the 16th century onward, they attempted to monopolize trade with the colonies and to turn it to their own profit. This policy involved four main restrictions: (1) The colonies were to trade exclusively with the mother country. (2) They were not to undertake manufacturing; transformation of raw materials into finished goods remained a monopoly right of the mother country. (3) Imports and exports of the colonies were to be carried only in ships flying the mother country's flag. (4) The mother country exempted colonial products from duty, or imposed lower rates. This system, although progressively attenuated, applied in various forms from the 16th to the 19th century. Based on force, it was to the benefit of the home countries and detrimental to the economic growth of their colonies.
The Zollverein.
The best known of the early customs unions is the German Zollverein (literally, "customs union"). Even though Napoleon had reduced the number of German states from 300 to 40 at the beginning of the 19th century, those that remained were isolated from each other by their own customs systems. In addition, numerous internal customs barriers hampered trade within each state. At the same time there was no single external tariff, and the German industries that had sprung up during the Napoleonic Wars were being crushed by English competition. These difficulties were at the root of the creation of the Zollverein. The starting point was Prussia's abolition of all internal duties and its adoption of an external tariff in 1818. In the next few years a number of other German states followed the Prussian example. Bavaria and Württemberg set up a customs union in 1828, and by 1830 four separate customs unions were in existence. Prussia then sought to break up the local customs unions and attach them to a general customs union, the Zollverein. The coverage of the Zollverein increased until, by 1871, it included all the German states. In its first phase, from 1834 to 1867, the Zollverein was administered by a central authority, the Customs Congress, in which each state had a single vote. A common tariff, the Prussian Tariff of 1818, shielded the member states from foreign competition, but free trade was the rule internally. During a second phase, from 1867 to 1871 (following Prussia's victory over Austria at Sadowa), executive power was wielded by a federal council (Bundesrat) composed of governmental delegates, in which decisions were taken by an absolute majority. Prussia was entitled to 17 of the 58 votes and held the chair of the council. Legislative power lay with a "customs parliament" (Zollparlament) composed of deputies directly elected by popular vote, and, like the council, taking decisions by a majority vote. This arrangement transformed what had been a confederation into a federal state. After the victory over France and the proclamation of the German empire in 1871, the customs parliament and the federal council were replaced by the parliament and the executive council of the empire. The federal state had become a nation. The progressive destruction of a tangled maze of regulations, prohibitions, and controls set the stage for the subsequent rapid development of the German economy. Although economic integration occurred before political unification, it would not have been possible had not many difficulties been swept away by irresistible pressure from Prussia with its military victories.
The Benelux Economic Union.
In 1921 Luxembourg, a former member of the Zollverein, signed the Convention of Brussels with Belgium, creating the Belgium-Luxembourg Economic Union. Since 1921 Belgium and Luxembourg have, then, had the same customs tariff and a single balance of payments. The union was expanded after World War II to include The Netherlands. At the beginning of 1948 most import duties within the Benelux area were abolished, and a common external tariff was put into operation. Exceptions were made, nevertheless, for a few agricultural products, and it was also felt necessary to introduce a system of quotas. It was rapidly perceived that a simple customs union was inadequate, and a treaty on Oct. 15, 1949, set as its target the progressive and complete liberalization of trade between the partners, systematic coordination of their international commercial and monetary policies, and the adoption of a joint bargaining position in negotiations with other countries. Though the experiment was optimistically viewed everywhere as the precursor of a wider European economic integration, it faced difficulties arising from the very different postwar situations of Belgium and The Netherlands. The two economies were competitive rather than complementary. Other problems arose in connection with the free access of Dutch agricultural products to the Belgian market. Moreover, the Belgian economic system was more liberal than the Dutch, where rigorous price control had long been a standard practice. The development of Benelux received strong impetus from the formation of the European Economic Community in the 1950s. The Treaty of Rome in 1957 creating the EEC, or Common Market, spurred the members of Benelux to confirm and strengthen their own integration in the Benelux Treaty of Economic Union signed at The Hague on Feb. 3, 1958. The Hague treaty, however, contained little that was new, and in outline it was no more than the codification of results already achieved. The Benelux Economic Union makes all of its decisions unanimously. The union has executive organs (the Committee of Ministers, the Council of the Economic Union, a number of commissions, and a Secretariat General); consultative organs (the Inter-Parliamentary Council and the Economic and Social Advisory Council); and legal organs (the Court of Justice).
The European Coal and Steel Community.
An important step in European integration was taken in May 1950 when the French foreign minister, Robert Schuman, proposed that a common market for coal and steel be set up by countries willing to delegate powers over these sectors of their economies to an independent authority. The motive behind the plan was the belief that a new economic and political framework was needed if European unity was to be achieved and if the threat of a future Franco-German conflict was to be avoided. In April 1951 France, West Germany, Italy, and the three Benelux countries signed a treaty in Paris setting up the European Coal and Steel Community (ECSC). The signatories bound themselves to abolish all customs barriers and other restrictions on the movement of coal and steel between their countries; to renounce all discriminatory practices among producers, purchasers, or users (with respect to price and delivery conditions, transport charges, selection of suppliers, etc.); to end government subsidies or grants-in-aid; and to eliminate all practices interfering with the operation of markets.
The constitution of the community.
When first promulgated, the constitution of the Coal and Steel Community allowed that it be governed by a High Authority, assisted by a Consultative Committee, a Common Assembly, a Special Council of Ministers, and a Court of Justice. The High Authority was the permanent executive organ of the community. Its decisions, taken by a majority vote, were fully binding on all member countries, each of which was pledged to respect the "supranational character" of the High Authority. The authority was to refer important substantive matters to the Consultative Committee before taking a decision. The latter was composed of coal and steel industry representatives, including producers, workers, users, and traders. The assembly was empowered to exercise only parliamentary control but could overrule the High Authority by a two-thirds majority. Its delegates were composed of deputies of national parliaments. The function of the Council of Ministers was to "harmonise the actions of the High Authority and the governments responsible for the economic policy of respective countries." It was composed of representatives of member countries, each of which delegated a member of its government. Most decisions of the council were valid if voted by a majority of representatives. Unanimous agreement was required only on decisions concerning production questions and shortages. Taken as a whole, the treaty was similar to a federal constitution, embodied in a long and complex document. There is, however, a basic incompatibility between the community's provenance, limited to the coal and steel industries, and the sovereignty of the member countries, each of which is responsible for its own general economic policy. As a practical matter, during the first 17 years of the community's existence, authority on all substantive issues remained vested in the national governments. The High Authority was autonomous only in matters of secondary importance. Thus, the coal crisis of 1958--when West German, Belgian, and French stocks of unsold coal rose to unmanageable proportions--was resolved at the national level. All the High Authority could do was to confirm the measures taken, even when they were contrary to the provision of the treaty. Similarly, the reduction of the labour force in coal mining from 650,000 persons at the end of 1957 to 300,000 10 years later was effected by individual countries; there was no community-wide action. The treaty reserved for member countries responsibility for their own trade policies toward third countries. This hindered the establishment of an effective common market since a common market requires a unified system of protection from foreign competition. At the height of the coal crisis, for example, when stocks of coal rose in Belgium, West Germany, and France, Italy nonetheless continued to buy cheap supplies from the United States.
Later developments.
Despite such difficulties much has been accomplished by the community. The markets for steel and coal have been liberalized to a considerable degree; the community has been a useful forum in which questions of common interest could be examined; and it has fostered the growth of an international spirit, which did much to facilitate the negotiation of the Treaty of Rome, establishing the European Economic Community and the European Atomic Energy Community (Euratom). In 1957 the Coal and Steel Community's assembly and Court of Justice were replaced by parallel institutions established by the European Economic Community. In 1967 its executive organs were merged with those of the European Economic Community and Euratom in what is now called the European Communities. The other provisions of the treaty remained unchanged.
The European Economic Community.
The European Coal and Steel Community was only the initial step in the movement for European integration. On March 25, 1957, its six member governments signed the Treaty of Rome, under which they agreed to establish the European Economic Community, or Common Market, which came into being on Jan. 18, 1958. In 1973 it was enlarged with the entry of Great Britain, Ireland, and Denmark. Since that time, Greece (1981), Spain (1986), and Portugal (1986) have become members. The EEC is the most far-reaching attempt at economic integration among sovereign countries. Its founding treaty has been the model, in whole or part, for all subsequent attempts at economic integration. The Treaty of Rome aimed to "establish a common market" and "progressively bring the economic policies of members into alignment" so as to
promote the harmonious growth of economic activity in the Community as a whole, regular and balanced expansion, augmented stability, a more rapidly rising standard of living, and closer relations between the participating states.
The treaty pledged the signatories to
abolish customs duties and quantitative restrictions on the entry and outflow of merchandise, to abrogate all other measures having an equivalent effect, and to fix a common customs tariff for imports from non-member states.
They also agreed to "abolish, as between members, all barriers to the free movement of persons, services and capital." This was to be accomplished during a transition period of 12 years. The transition period ended on Jan. 1, 1970, and the community then entered into its definitive phase.
Formation of a customs union.
The treaty set a timetable for the abolition of customs duties between member states. On balance, this timetable was met and in some areas exceeded so that, by the middle of 1968, tariff barriers had been abolished for agricultural as well as industrial products. By that date also, most quota restrictions had been lifted. The customs posts had not disappeared, however; they were still needed for such tasks as assessing and collecting the compensatory taxes that equalized the differences in taxes between member countries. Tariffs on imports from outside the community were gradually brought closer, and on July 1, 1970, a common community tariff was put into effect.
Development of a common agricultural policy.
When the treaty took effect at the beginning of 1958, agriculture was subsidized in all six member countries. The various price-support mechanisms differed substantially, as did foreign-trade policies and tariff levels. The cumulative impact of governmental intervention of various kinds over the years had led to major differences among the members in agricultural price levels. With the average price of wheat in the six countries in 1959 indexed at 100, the relative price levels in individual countries were as follows: Germany, 108; France, 78; Italy, 108; Belgium, 101; Luxembourg, 119; and The Netherlands, 86. The achievement of common policies in agriculture appeared to be so difficult that the treaty limited itself to setting forth a number of general provisions on which agreement seemed feasible. Despite this, a common agricultural policy was achieved: all tariff and quota restrictions on trade in farm products among member countries were abolished; a common set of tariffs on agricultural imports from non-EEC countries was established; and a common system of price supports took the place of the former national systems. The price supports required difficult compromises among the member governments because of the differences in their domestic price levels for farm products. The EEC wheat price, for example, was set roughly halfway between the prices of the lowest-cost suppliers in the community, France and The Netherlands, and those of West Germany, which was the highest. France exerted considerable political pressure to persuade West Germany to accept a substantial lowering of the returns to its wheat producers. The community prices are supported by purchases from a common fund. The fund begins buying in any area where the price of a crop drops to a fixed intervention level. The cost of the price support program is financed by contributions from the members. Since its inception, the common agricultural policy has experienced several fundamental problems, especially recurrent surpluses and conflicts of interest between large- and small-scale producers. Surpluses have originated as a result of the price support system. While this system has helped marginal farmers stay in business, it has often encouraged more productive farmers to overproduce, creating surpluses that must be purchased with EEC funds. Recurrent surpluses of butter and sugar have become a particular problem. Conflicts of interest have arisen between countries that are net food importers (e.g., the United Kingdom), which make large contributions to the common policy but receive little return in export subsidies and price supports, and those countries that are net food-exporting countries (like France and Italy), which receive greater relative support.
Toward a harmonization of policies.
Another fundamental aim of the Treaty of Rome was to achieve a general harmonization of national economic policies. The treaty envisaged the working out of common rules covering such matters as competition, taxation, and other economic legislation. It also called for the development of common policies in such areas as foreign trade and transportation. Members were asked to concert their economic policies in the fields of fiscal and monetary policy, balance-of-payments policy, and social welfare.
Relations with other countries.
The treaty provides that overseas countries and territories having a special relationship with Belgium, France, The Netherlands, and Italy may be granted associate membership. The purpose of this was to eliminate preferential tariff arrangements by any member with outside countries by extending the same preferential terms to all of the members. The treaty also provides for a European Development Fund to assist the economic development of these countries.
New members.
Any European state may request membership in the EEC. Acceptance requires a unanimous decision by the present members after "the conditions for entry and the modifications to be made to the Treaty as a result" have been agreed upon by the member states and the would-be entrant.
Associates.
The EEC may also conclude an agreement of association with a nonmember country, a union of states, or an international organization. The associate is entitled to special terms in its trade with the EEC and can send representatives to its meetings. Associate status providing for a customs union after a 12-year transitional period was granted to Greece in 1962, prior to its accession as a full member, and to Turkey in 1964. Partial association agreements have been signed with other countries.
Constitution of the EEC.
As mentioned above, since 1967 the governing bodies for the EEC, the ECSC, and Euratom have been integrated. These bodies include the Council of Ministers, the Commission, the European Parliament, and the Court of Justice. The Council of Ministers and Commission are assisted by the Economic and Social Committee with advisory functions. Headquarters are in Brussels, Luxembourg, and Strasbourg.
The council has decision-making power in all matters falling within the sphere of competence of the communities. Each member sends one delegate. During the transition period before 1970, all important decisions had to be taken unanimously; they may now be taken by either absolute majority or "qualified" majority (i.e., with weighted voting rights) or unanimously. Either a qualified majority or unanimity are required on certain matters by the treaty. Decisions must be taken unanimously on a very large number of issues. The Commission members are "selected by reason of their general competence and offering the utmost guarantees of independence." They are appointed by agreement among the member countries, not more than two being of the same nationality. Members serve a four-year term and may be reappointed. They are expected to act in the general interest of the communities, without deference to any government or other organization. The Commission's basic function is to watch over the application of the Treaty of Rome and other treaties and to assist the council with recommendations or advice. Its powers for the most part are delegated to it by the council. The European Parliament is formed of delegates selected from the parliaments of the members. In principle the parliament meets once a year. It passes recommendations and resolutions and discusses the Commission's annual report. It may pass a resolution of no confidence in the Commission by a two-thirds majority, resulting in immediate dismissal of the Commission members. The Court of Justice is charged with the interpretation and application of the treaties. It is composed of 11 judges appointed by mutual agreement of the governments of the member states for six-year terms. Actions may be brought in the court by any member state or by any physical or legal person. The court's powers are considerable since community law takes precedence over the national laws of each member country. The Economic and Social Committee is a consultative body composed of representatives of various economic and social strata, including manufacturing, agriculture, transportation, trade, handicrafts, the liberal professions, wage earners, and the public. Its members are appointed for a four-year term by unanimous decision of the council and may be reappointed.
The European Free Trade Association.
When the European Economic Community was being organized, Great Britain sought to organize a free-trade area that would include 17 member countries of the Organization for European Economic Co-operation. This would have given Britain access to the benefits of the industrial common market on the Continent while avoiding possible infringements of British sovereignty. The effort failed, mainly because of French opposition. Britain then undertook the formation of a free-trade area in association with Austria, Denmark, Norway, Portugal, Sweden, and Switzerland. The convention setting up the European Free Trade Association (EFTA) was signed at Stockholm on Jan. 4, 1960. The preamble stated that one of the main purposes of the organization was to "facilitate the future establishment of a wider multilateral association for abolition of customs barriers." More specifically, it was intended as a mechanism for freeing trade with the six Common Market countries without subscribing to the commitments of political character embodied in the Treaty of Rome. In the meantime, EFTA gave its seven members a stronger bargaining position vis-à-vis the other six, as well as the means of creating a large market of their own.
Operation of the EFTA.
The European Free Trade Association is governed by a council composed of one member from each participating state. The council found it useful to set up a joint consultative committee composed of representatives of industry, business, and labour; a set of six permanent technical committees (on customs, trade, economic development, agriculture, economics, and budget); and working parties dealing with special topics. The EFTA treaty, like that of the EEC, provided for a transitional period, set forth rules governing competition, and called for the abolition of all indirect protection and trade discrimination. The EFTA had one special problem arising from its nature as a free-trade area. Since the duties charged on imports from outside countries might differ from one member to another, traders could take advantage of the differences by channeling imports through the country levying the lowest rates and delivering them to customers in another member country. Rules were established to prevent this by classifying merchandise according to whether it was produced or fabricated in one of the member countries. In the case of goods made from imported raw materials, the rules required that the import content not exceed 50 percent of the export price of the finished product.
The EFTA's record.
Although a 10-year transitional period was originally envisaged, internal customs barriers on industrial goods were eliminated on Jan. 1, 1967, three years ahead of schedule. Bilateral trade agreements have also been negotiated to increase trade in agricultural products. The EFTA passed through two grave crises in the 1960s. The first was in 1961 when Britain, acting unilaterally, informed its partners that it had applied for membership in the EEC. The upshot was a joint declaration in which the EFTA members committed themselves to "coordinate their action and remain united throughout the negotiations." The second crisis occurred in October 1964, when, to shore up the pound sterling, Britain suddenly introduced a surcharge of 15 percent on all its industrial imports--an act that was in violation of the treaty. Finland became an associate member of EFTA in July 1961, and Iceland was admitted to full membership in March 1970. In 1973 Britain and Denmark left the association when they were accepted as members in the European Economic Community--Britain, after two previous unsuccessful tries. Since that time agreements have been reached between EFTA and EEC promoting trade between the two groups.
Economic integration in Latin America.
Progress toward economic integration in Europe encouraged the Latin-American republics to make similar attempts. By the late 20th century several organizations had been established to work toward such integration; they include the Central American Common Market; the Latin American Free Trade Association; the Andean Group; and the Caribbean Community and Common Market.
The Central American Common Market.
On June 10, 1958, El Salvador, Guatemala, Honduras, Nicaragua, and Costa Rica signed a multilateral treaty aiming at free trade and economic integration. It provided for the establishment of a free-trade area within 10 years. The participating countries also agreed to the industrial integration of the region. These arrangements were completed by the signature on Dec. 13, 1960, of the Treaty of Managua. Its aims were similar to those of the EEC in Europe, namely, the establishment of a common market within five years and the organization of integrated industrial development. Most barriers on the region's internal trade have since been removed or reduced, and a single customs tariff has been introduced for most products imported from outside the area. Economic integration in Central America has been hampered by disagreements and military conflicts in the area. Following a dispute with El Salvador in 1970, Honduras in effect withdrew from common market membership by implementing tariffs on imports from other member countries. In 1980, however, Honduras signed a treaty with El Salvador, settling their dispute and restoring Honduran participation in the common market trade agreements. During the 1980s, tensions between the revolutionary government of Nicaragua and its neighbours, as well as other disorders, have disrupted trade among the nations of Central America.
The Latin American Integration Association.
On Feb. 18, 1960, Argentina, Brazil, Chile, Mexico, Paraguay, Peru, and Uruguay signed a treaty setting up the Latin American Free Trade Association (LAFTA), predecessor to the Latin American Integration Association. By 1970 the seven signatories had been joined by Ecuador, Colombia, Venezuela, and Bolivia. The treaty provided for a 12-year transition period during which all obstacles to trade were to be eliminated. It was based on the principle of reciprocity and most-favoured-nation treatment. Member states also committed themselves to progressive coordination of their industrialization policies. Special treatment was provided for agriculture and for the relatively least-developed member countries. Liberalization of trade between the member countries was carried out initially through negotiation of product-by-product concessions. In 1967, however, the negotiations failed; they were postponed to 1968, when agreement was reached on a system of across-the-board automatic tariff reductions similar to those of the European Economic Community. The eventual aim was that LAFTA be the first step in a process that would lead to a common Latin-American market; but during the 1970s it became apparent that the geographic diversity and varying levels of economic development exhibited by the member countries were handicapping the formation of a true common market within the association's existing framework. In the late 1970s negotiations were begun to establish a new framework for economic integration, and in 1980, 20 years after the creation of LAFTA, the Latin American Integration Association (LAIA; Asociación Latino-Americana de Integración) was formed. Unlike its predecessor, LAIA adopted an alternative to the concept of a free-trade area in that it opted for the establishment of bilateral preference agreements that would take into account the varying stages of economic development of the member countries. In order to best negotiate bilateral preference agreements the member nations were divided into three categories: most developed countries (Argentina, Brazil, and Mexico), intermediate developed countries (Chile, Colombia, Peru, Uruguay, and Venezuela), and least-developed countries (Bolivia, Ecuador, and Paraguay). Cuba was admitted to LAIA in 1986 with observer status.
The Andean Group.
In 1966 Bolivia, Chile, Colombia, Ecuador, Peru, and Venezuela, all members of the Latin American Free Trade Association, agreed to form a regional subgroup. The Andean Group finally began its official existence in June 1969 without Venezuela, which had withdrawn. By 1973 Venezuela had decided to join, but Chile withdrew in 1976. (The Andean Judicial Tribunal was established in 1980 to monitor, interpret, and resolve problems resulting from Andean Group decisions. The tribunal is composed of one judge from each country, serving a six-year term.) Among the group's aims are the acceleration of economic integration between member countries, the coordination of regional industrial development, the regulation of foreign investment in member countries, and the maintenance of a common external tariff.
The Caribbean Community and Common Market.
Established in 1973 by 12 Caribbean countries, the Caribbean Community and Common Market (Caricom) is the successor to the Caribbean Free Trade Association, which was founded in 1968 by five former British colonies (Antigua, Barbados, Guyana, Jamaica, and Trinidad and Tobago), all of whom joined the new organization. The organization attempts to encourage economic integration in the Caribbean region and achieved partial agreement to a common external tariff and protective policy for the community in 1978. Caribbean economic integration was curtailed between 1976 and 1978, in part because of import restrictions imposed by Jamaica and Guyana, and in part because of dissatisfaction among the less-developed countries, who claimed that they were not receiving their fair share of trading revenues. By 1980 Jamaica and Guyana had removed their import restrictions, and the Caricom Council had endorsed several measures to improve the status of the less-developed countries within Caricom. The less-developed countries, however, remained dissatisfied, and in 1981 the seven former members of the West Indies Associated States (Antigua and Barbuda, Dominica, Grenada, Montserrat, Saint Kitts-Nevis, Saint Lucia, and Saint Vincent) formed a subregional economic integration organization, the Organization of Eastern Caribbean States. They retained their Caricom membership.
The Council for Mutual Economic Assistance (1949-90).
A Soviet-sponsored effort to integrate the economies of eastern Europe began as early as Jan. 25, 1949, in response to the Marshall Plan. The founding states were Bulgaria, Hungary, Poland, Romania, Czechoslovakia, and the Soviet Union. Albania joined in 1949, the German Democratic Republic in 1950, and the Mongolian People's Republic in 1962. Albania ceased to participate after 1961. In its early years the activities of the Council for Mutual Economic Assistance (or Comecon) were limited mainly to the registration of bilateral trade and credit agreements among the member countries. After Stalin's death in 1953 it made efforts to promote industrial specialization and to reduce "parallelism" in the economies of its members. In 1956 and 1957, when most of its standing commissions began to operate, attempts were made to harmonize the long-term plans of the members. The establishment of the European Economic Community in 1958, together with pressures from the eastern European countries for a greater degree of independence, induced the Soviet leadership to rethink the organization. A new charter was signed by the members in Sofia on Dec. 14, 1959. The council's economic objectives were to coordinate each member country's efforts for development in technology and industrialization, growth of labour productivity, and specialization in industry. However, the democratic revolutions throughout eastern Europe in 1989-90 left the organization defunct. In 1991 the Council for Mutual Economic Assistance was renamed the Organization for International Economic Cooperation, under which each member country was free to develop its own foreign trade. After the collapse of the communist governments, member countries moved toward private enterprise and market-based price systems. Comecon's original objectives had been hindered by certain political and economic constraints. One of the most serious was the absence of flexible and realistic price systems in the member countries. This made it impossible to base trade on relative prices; instead it was conducted mainly on a barter basis through bilateral agreements between governments. In negotiating such agreements, the parties were led to use "world prices"--i.e., prices prevailing in the trade of countries outside the Council for Mutual Economic Assistance. Another hindrance to economic integration was the highly centralized economic planning in the member countries, which had only limited success in coordinating their plans. There were also serious nationalistic tensions within the council. The Romanian government, for example, announced its intention to pursue all-around industrialization, including the development of its heavy industries, in opposition to the policy of specialization in raw materials and agricultural products that was said to have been the Council for Mutual Economic Assistance's policy for Romania. Among the practical achievements of the Council for Mutual Economic Assistance, however, were the organization of railroad coordination (1956); construction of a high-voltage electricity grid (1962); creation of the International Bank for Economic Cooperation (1963); the pooling of 93,000 railway freight cars (1964); and construction of the "Friendship" oil pipeline from Russia's Volga region to the eastern European countries. Comecon initially was composed of the old Soviet Union's eastern European satellites, but in 1972 Cuba became a member and in 1978 Vietnam joined. The highest authority of the organization was the council-in-session. It was composed of delegations from all member countries, the composition of each delegation being fixed by the government concerned. The conference of representatives of member countries, composed of one representative of each country, could issue recommendations and decisions. It could also submit proposals for examination by the council-in-session. Various permanent commissions were composed of experts and officials of member countries. Some were general economic commissions; others dealt with specific industries. The headquarters of the various commissions were located in the capital cities of member countries. The central secretariat was in Moscow. The Council for Mutual Economic Assistance was often called the eastern European counterpart of western Europe's EEC. Although the general aims were indeed the same, the two organizations differed radically in their approach to the problems involved. The EEC aims to achieve integration on a decentralized basis by means of an economic market in which goods, services, capital, and persons have full freedom of movement--a market regulated by uniform economic legislation. The Council for Mutual Economic Assistance sought to achieve cooperation among national economies each of which was centrally planned and administered.
GATT rules regarding regional arrangements.
When countries join regional trading groups such as the European Economic Community, they provide preferences to one another. For example, German producers can export duty-free to France, whereas U.S. or Japanese exporters still have to pay duties on products shipped to France. Thus, German producers are preferred over U.S. or Japanese suppliers; a customs union represents a departure from most-favoured-nation treatment. Nevertheless, countries entering a customs union or free-trade association are not in violation of their commitments under the General Agreement on Tariffs and Trade; customs unions and free-trade associations are permitted under GATT. GATT article XXIV allows countries to grant special treatment to one another by establishing a customs union or free-trade association, provided that (1) duties and other trade restrictions are "eliminated on substantially all the trade" among the participants, (2) the elimination of internal barriers occurs "within a reasonable length of time" (commonly interpreted as permitting a phase-in period of not more than 10 years), and (3) duties and other barriers to imports from nonmember countries "shall not on the whole be higher or more restrictive" than those preceding the establishment of the customs union or free-trade association. The third condition was explicitly aimed at protecting the rights of outside countries. The first condition disapproves partial preferential arrangements covering only some products, while accepting broad arrangements covering (substantially) all products. It was supported on the ground that large, unrestricted markets--most notably, that within the United States--provide substantial benefits. Such benefits should also be available to others. For example, when the GATT articles were being drafted, consideration was being given to an integration of the nations of western Europe. Shortly after article XXIV was written, it received substantial support in the classic study of Jacob Viner, The Customs Union Issue (1950). Viner, a Canadian-born U.S. economist, saw efficiency as the main gain from international trade, since trade encourages production in a less costly location. He contended that a customs union works to increase efficiency in one way, but decreases it in another. To explain, Viner drew a distinction between two forces at work when a customs union is established. As two (or more) countries cut tariffs on each other's products, new trade is created. Some goods previously bought from domestic producers are now bought from lower-cost producers in the trading partner, whose goods now come in duty-free, improving efficiency. When, however, a country removes tariffs on its partner's goods but not on the goods of outside countries, the partner has preferred access. As a result, some purchases are switched--goods are bought from the partner nation, rather than from the outside world. Such trade diversion reduces efficiency; purchases are switched from the efficient outside country to the less efficient partner nation. A customs union (or free-trade area) may be predominantly trade-creating, which is desirable, or it may be predominantly trade-diverting, which is not. Viner's book thus introduced a skeptical note into the discussion of customs unions, which had previously been given broad approval. Viner's work also supported the distinctions made in article XXIV of the General Agreement on Tariffs and Trade. Clearly, if barriers on imports from nonmember countries are kept down, then trade diversion is less likely. Furthermore, the provision to disapprove partial preferential arrangements covering only some products, while accepting broad arrangements covering virtually all products found support within Viner's framework. Because of the political dynamics of trade negotiations, partial preferential arrangements generally cause more trade diversion than trade creation. This can be illustrated in a hypothetical situation in which countries (say, France and Germany) are permitted to get together to make whatever preferential agreements they wish. A natural way for France to open negotiations would be to say to Germany: "We'll cut tariffs on your automobiles and buy from you rather than Japan, if you will cut tariffs on our sugar and buy from us rather than from the Caribbean nations." In other words, negotiators tend to pick and choose those items previously imported from outside countries; they tend to cut tariffs where trade diversion is greatest. By requiring a comprehensive approach, article XXIV ensures that trade-creating tariff cuts will be made, too.
Patterns of trade
DEGREES OF NATIONAL PARTICIPATION
Nations vary considerably in the extent of their foreign trade. As a very rough generalization, it may be said that the larger a country is in physical size and population, the less its involvement in foreign trade, mainly because of the greater diversity of raw materials available within its borders and the greater size of its internal market. Thus, the participation of the United States is relatively low, as measured by percentage of gross national product, and that of the former Soviet Union was even lower. The U.S. gross national product, however, is so immense by world standards that the United States still ranks as one of the world's most important trading countries. Some of the smaller countries of western Europe (such as The Netherlands) have export and import totals that approximate half of their gross national products.
TRADE AMONG DEVELOPED COUNTRIES
The greatest volume of trade occurs among the developed, capital-rich countries, especially among industrial leaders such as Australia, Belgium, Canada, France, Germany, Italy, Japan, The Netherlands, Spain, Sweden, the United Kingdom, and the United States. Generally, as a country matures economically, its participation in foreign trade grows more rapidly than its gross national product. The European Economic Community (EEC) affords an impressive instance of the gains to be derived from freer trade. A major part of the increases in real income in EEC countries is almost certainly attributable to the removal of trade barriers. The EEC's formation cannot, however, be interpreted as reflecting an unqualified dedication to the free-trade principle, since EEC countries maintain tariffs against goods from outside the Community.
TRADE BETWEEN DEVELOPED AND DEVELOPING COUNTRIES
Difficult problems frequently arise out of trade between developed and developing countries. Many less-developed countries are tropical, frequently relying heavily for income upon the proceeds from export of one or two crops, such as coffee, cacao, or sugar. Markets for such goods are highly competitive (in the sense in which economists use the term competitive)--that is, prices are extremely sensitive to every change in demand or in supply. Prices of manufactured goods, the typical exports of developed countries, are commonly much more stable. Hence, as the price of its export commodity fluctuates, the tropical country experiences large fluctuations in its "terms of trade," the ratio of export prices to import prices, often with painful effects on the domestic economy. With respect to almost all important primary commodities, efforts have been made at price stabilization and output control. These efforts have met with varied success. Comparable problems arise when the developing country exports a mineral resource such as petroleum or copper. The initiative in developing such a resource has often been taken by a foreign company from a developed country that owns (in part if not in full) the extracting capital facilities. Particularly since the mineral resource is exhaustible, charges of exploitation are common. The matter is a continuing source of political strife and may on occasion lead to expropriation of the mineral properties. Several groups of developing countries have joined in creating organizations for the promotion of trade between themselves. Notable examples include the Central American Common Market (1961), the Organisation Commune Africaine et Mauricienne (1965), the Association of Southeast Asian Nations (1967), the Caribbean Community and Common Market (1973), and the Latin American Integration Association (1980).
International commodity trade
Goods that are traded internationally fall into two broad categories--primary goods and manufactured products. Manufactured products, such as machinery and clothing, comprise products whose value reflects largely the cost of manufacturing processes. Such manufacturing processes contribute relatively little to the value of primary goods, such as crude petroleum and cotton, which undergo little processing before they are traded. Commodities and commodity markets are terms used as synonyms for primary goods and the markets in such goods.
PRIMARY COMMODITY MARKETS
Trade in primary goods may take the form of a normal exchange of goods for money as in any everyday transaction (referred to technically as trade in "actuals"), or it may be conducted by means of futures contracts. A futures contract is an agreement to deliver or receive a certain quantity of a commodity at an agreed price at some stated time in the future. Trade in actuals has declined considerably and in many cases (such as the Liverpool markets in cotton and grain) has even come to a halt.
Operation of the market.
The great bulk of commodity trading is in contracts for future delivery. The purpose of trading in futures is either to insure against the risk of price changes (hedging) or to make a profit by speculating on the price trend. If a speculator believes that prices will rise, he buys a futures contract and sells it when he wishes (e.g., at a more distant delivery date). The speculator either gains (if prices have risen) or loses (if they have fallen), the difference being due to the change in price. "Hedging" means the offsetting of commitments in the market in actuals by futures contracts. A producer who buys a commodity at spot (current) prices but does not normally resell until three months later can insure himself against a decline in prices by selling futures: if prices fall he loses on his inventories but can purchase at a lower price; if prices rise he gains on his inventories but loses on his futures sales. Since price movements in the actuals market and the futures market are closely related, the loss (or gain) in actual transactions will normally be offset by a comparable gain (or loss) in the futures market. The operation of futures markets requires commodities of uniform quality grades in order that transactions may take place without the buyer having to inspect the commodities themselves. This explains why there is no futures market, for example, in tobacco, which varies too much in quality. A steady, unfluctuating supply also is needed; this is referred to technically as "low elasticity of supply," meaning that the amount of a commodity that producers supply to the market is not much affected by the price at which they are able to sell the commodity. If supply could be adjusted relatively quickly to changes in demand, speculation would become too difficult and risky because exceptionally high or low prices, from which speculators are able to profit, are eliminated as soon as supply is adjusted. Monopolistic control of demand and supply is also unfavourable to the operation of a futures market because price is subject to a large extent to the control of the monopolist and is thus unlikely to fluctuate sufficiently to provide the speculator with an opportunity for making profits. There is, for example, no market in diamonds, because there is only one marketing cooperative. In 1966 the London market in shellac ceased to function after the Indian government applied control of exporters' prices at the source. Before World War II London was the centre of international trade in primary goods, but New York City has become at least as important. It is in these two cities that the international prices of many primary products are determined. Although New York often has the bigger market, many producers prefer the London market because of the large fluctuations in local demand in the United States that influence New York market prices. In some cases international commodity agreements have reduced the significance of certain commodity markets. There are markets in both New York and London for numerous primary goods, including cotton, copper, cocoa, sugar, rubber, coffee, wool and wooltops, tin, silver, and wheat. Tea, wool, and furs are auctioned in London, but in the case of many other commodities, auctions have been superseded by private sales. In London the metal market is much more a "spot" or delivery market than other futures markets. Many countries have their own markets: Australia for wool, Sri Lanka and India for tea, and Malaysia for rubber and tin.
The terms of trade.
The relation between the price of primary goods and that of manufactures has long intrigued economists. The relationship is known as the "terms of trade" and may be defined as the ratio of the average price of a country's or a group of countries' exports to the average price of its imports. The long-range trend of the terms of trade between primary products and manufactures has been the subject of diametrically opposed conclusions: some theorists hold that the trend is favourable to the less-developed countries, others that it is unfavourable. Faulty statistical material and methods in various countries are responsible for this lack of agreement. Any comparison of the terms of trade over a long period of time is very difficult and may be misleading because the structure of trade changes, as does the quality of the groups of goods studied. Many economists believe that the terms of trade were adverse for less-developed countries from 1870 to 1938. They point to the fact that as developed countries become more technologically advanced there is a tendency for them to require relatively less in the way of primary products. A downward influence is thus exercised on primary product prices. Another factor is that in the industrial countries the benefits of progress find expression not in lower prices but in higher wages. This, together with inflationary pressures, means that prices of manufactured goods produced by the developed countries tend to rise steadily. There is thus a tendency, it is argued, for the less-developed countries to receive relatively less for what they have to sell and to have to pay more for what they need to buy. But the statistical problems posed by any attempt to verify this hypothesis are considerable. The countries selected, the relative weight assigned to the various goods, changes in transport costs, and the fact that the quality of manufactured goods has improved much more than that of primary goods make the statistics unreliable. There is also the problem that the terms of trade between primary commodities and manufactures do not necessarily coincide with the terms of trade between less-developed and industrial areas. Even if it were established that the terms of trade have moved against the less-developed, largely primary-producing countries, this would not necessarily mean that their balance-of-payments situation has been adversely affected. A decline in the terms of trade may in fact improve a country's balance-of-payments, because, although the prices of that country's exports have fallen, it may, as a consequence of this fall in price, be able to sell a far larger quantity. Total revenue from exports may thus increase. Similarly, although imports may become more expensive, the result may be that the country's demand for imports drops very steeply, so that less is spent on them than when they were cheaper. These problems make it extremely difficult to generalize about the effects of commodity price changes on the economic situation of one or a group of countries.
PRICE MOVEMENTS
Prices usually vary widely in commodity markets, not only in the short run but also in the long run. In the short run there are frequent changes in supply because of varying climatic conditions (for agricultural products) and because of political and other events on the international scene (such as the closure of the Suez Canal) and in individual countries (such as strikes). As a rule, price changes do not give rise in the short run to substantial changes in the supply of or demand for primary goods (low elasticity of supply and demand). Business cycles in the importing countries, however, have an influence on demand. Market conditions differ, of course, from product to product. In the case of sugar and wheat, demand is fairly stable, but supply is not; as regards tin, and, indeed, the majority of metals, the converse is true. In the case of industrial commodities, such as cotton, there are fluctuations in both supply and demand. In the long run the extent of changes in demand and supply is usually greater. A considerable and sustained price increase, for example, may result in a fall in demand and the appearance of substitute products. After a number of years, supply may increase in response to a higher level of demand reflected by higher prices. The length of time required to adjust supply to demand varies from commodity to commodity. Tree crops, for example, need a long growth period, and mineral reserves are tapped only if expectations about the price trend are favourable.
Effect on economic development.
Through their repercussion on export earnings, price fluctuations are often held responsible for the variations in the growth rate of countries producing primary goods, especially since exports of a single primary good account for a large part of the total exports of many countries. But apart from the fact that, as described above, quantities exported influence export earnings as much as prices, there are many other factors that determine export earnings. Such factors include the type and destination of exports and, above all, the economic policies of the countries concerned. It is thus difficult to generalize about the relation of foreign trade to economic growth. Many countries with very unstable exports have relatively stable national incomes; others whose exports are stable have highly unstable national incomes. The stimulus from exports will usually be stronger, for example, if the rate of demand for these exports is growing rapidly. Often, however, the transmission of growth to the nonexporting sector of the economy is impeded in less-developed countries by the economic, social, and political organization of the economy. It is important, for example, for some countries to try to decrease exports of goods that have a slowly growing demand and at the same time to try to increase exports of goods, such as minerals, for which world demand is growing more rapidly.
Efforts to stabilize prices.
The uncertainty both for private producers and for governments resulting from sharp and sudden commodity price changes has resulted in many efforts to achieve greater stability on the market in primary goods.
Action in individual countries.
In theory a country could insulate domestic producers against international price fluctuations through variable charges and subsidies, but politically it is difficult to tax away producers' profits during a period of rising prices and to hold the resulting revenue in order to redistribute it should prices and profits fall. In Nigeria, Ghana, Sierra Leone, and The Gambia, for instance, national marketing boards that attempted to even out price fluctuations of cocoa, cotton, and peanuts (groundnuts) were in operation before those countries became independent. In the former French territories in Africa, stabilization funds fixed producer prices and controlled margins and profits. The main dangers inherent in national stabilization schemes are inconsistent government policies and the excessive operating costs of the public bodies concerned. These factors explain the unsatisfactory results of many national price agencies.
International cooperation.
In the 1920s international cartels were created for rubber, sugar, tin, and tea, but they yielded no lasting results. Nor did cooperation between the governments of exporting and importing countries (such as in the International Wheat Agreement of 1933 and the International Sugar Agreement of 1937) serve to attain the desired goals during the Great Depression. Of special significance among more recent attempts to raise and stabilize a commodity price has been the one made by the Organization of Petroleum Exporting Countries (OPEC). (The special features of the oil market are considered below.) Other attempts to stabilize commodity prices since World War II have mainly assumed three forms--the multilateral contract agreement, the quota agreement, and the buffer-stock agreement. Transactions are effected at world market prices. When a minimum or a maximum price is reached or approached, efforts are made to ensure that prices remain within the two limits. Each of the three systems achieves this in a different way. In the multilateral contract system, consumers and producers undertake to buy or sell a specified quantity of the commodity at agreed minimum and maximum prices, or at a price within the agreed range. In the quota method, the quantity negotiated is determined by a previously fixed quota when a minimum or maximum price is exceeded. When there is a surplus, the producers restrict their exports or production; when there is a shortage, quotas are allotted to the consumer countries. With the buffer-stock method, stability is ensured by a combination of an export control arrangement and a buffer-stock arrangement. In certain circumstances exports are restricted by the controlling body. The buffer-stock agency buys when the market price is in the lower sector or at the floor price set out in the agreement; the buffer-stock agency sells when the market price is in the upper sector or at the ceiling price.
Results.
The utility of commodity agreements in general can hardly be judged on past experience. Experience with wheat, sugar, and tin agreements, which cover a comparatively long period, is not conducive to generalization. Some degree of stability, though at a high price level, was achieved in the case of wheat, but this was due to the dominant influence of U.S. and Canadian policies. In the case of tin, too, transactions for the U.S. strategic stockpile exerted an influence. Political factors (including the Cuban revolution) underlay the de facto suspension from 1962 to 1969 of the sugar agreement, which had covered, and still covers, only a limited share of the world market. The value of world transactions in tin, wheat, coffee, and sugar amounts to only a small part of the value of the world's entire commodity trade. Furthermore, the agreements in question do not cover all transactions. It is, in a way, understandable that only a few such agreements have been concluded; during a boom the producer countries are not inclined to conclude them, and during a depression there is little incentive for consumer countries to enter into them.
Conditions for success.
A prerequisite for the success of commodity agreements is that they should embrace the vast majority of producers and especially the largest of them. No transactions should be excluded, and substitute commodities should be covered by the agreements. The most intractable of the difficulties in concluding commodity agreements lies in the fixing of the price range. Neither unduly high nor unduly low price scales are tenable. Future market conditions are not easily foreseeable, so the possibility of errors cannot be ruled out; regular adjustment of the price ranges is necessary. When it comes to determining the price range, the importing and exporting countries, respectively, do not systematically advocate low and high prices. Certain importing countries are not opposed to a relatively high price because the difference between the international price and the tariff-protected price of domestic producers is thereby reduced; exporting countries in a favourable competitive position are often in favour of lower prices so that they will be able to increase their share of the market at the expense of less-competitive countries. In concluding an agreement, the parties have to bear in mind that complete price stabilization is impossible. It would in fact be undesirable, because in the long run supply and demand need to remain in equilibrium, and the necessary adjustments in the economies concerned must not be precluded. Price fluctuations do not necessarily imply failure, because the fluctuations might well have been larger had the agreement not been concluded. The method of stabilization needs to be chosen carefully, with due regard for the characteristics of the commodities concerned. The multilateral purchase contract and buffer-stock systems offer the advantage of not requiring any restrictions on production; new producers with improved technical equipment may participate. A buffer stock needs to be sufficiently large if it is to achieve its purpose. Wider financing facilities are necessary; this is something to which the importing countries could contribute. Even then the buffer stock is better used together with other methods of stabilization. Because of the perishable nature of certain commodities or their bulk and high storage costs, however, a buffer stock is not always feasible. Buffer stocks alone often are not sufficient for the control of prices, and it is sometimes necessary for producers to restrict exports in order to reduce supply, thus pushing prices up.
INTERESTS OF THE LESS-DEVELOPED COUNTRIES
So far as the producer countries are concerned, stabilization of incomes, rather than of prices, is the most important factor. Although commodity agreements may contribute to this, their relatively limited success has caused other proposals to be advanced. Compensatory financing refers to international financial assistance to a country whose export earnings have suffered as a result of a decline in primary commodity prices. Such a system was instituted in 1963 by the International Monetary Fund (IMF). In 1969 the IMF also began making loans available to countries having a balance-of-payments need in relation to the financing of buffer stocks under international commodity agreements.
EEC stabilization fund.
The European Economic Community has established a stabilization fund for its associated overseas countries; prices must fall by a specified percentage before the mechanism of the fund goes into effect, and the richer beneficiary countries must repay the aid received. Other proposals involve the introduction of simultaneous negotiations for a whole range of commodities. These discussions, however, and more particularly the administration of the resulting multicommodity agreement, would be highly complex. It may also be argued that the significance of export instability has been exaggerated and that most of the economies involved have suffered no serious damage. Thus, the resources devoted to countering price fluctuations and compensatory financing might be better employed in investments or technical assistance. As to the possibility of the less-developed countries themselves influencing prices, circumstances vary from commodity to commodity. In the case of primary goods, such as coffee, that are produced only in the less-developed countries and for which practically no substitutes exist, action to increase prices can easily be taken if demand is not too much affected by price increases. A simple way to raise prices would be for the governments of producing countries to levy a duty on exports. Attempts by some developing countries to raise prices, however, can induce other developing countries to increase their output. For example, African coffee production was stimulated when Latin-American countries took steps to raise the price of their coffee.
Limitations on pricing.
The fact that there are substitutes for a few primary goods (such as cotton, wool, and rubber) limits the extent to which primary-goods producers can raise their prices. Also, most commodities produced by less-developed countries face competition from the developed countries, which may produce the same commodities (such as petroleum, sugar, rice, and tobacco) or goods substitutable in varying degrees (such as soybean oil for peanut oil). Many agricultural commodities are protected in the developed countries by tariffs, which means that their requirements are often met entirely from domestic production. Some developed countries produce surpluses that are sold abroad at low, subsidized prices. Such commodities are therefore traded to a relatively small extent on world markets. The sales of the less-developed countries are thus influenced by the developed countries' national policies and by the price at which these countries sell their surpluses on the residual markets. The less-developed countries that produce minerals and metals seemingly have the most favourable export prospects because demand for such finite commodities is expanding among the developed countries, many of which are concerned over the depletion of their domestic resources.
OPEC AND OIL
Of the multinational organizations aimed at affecting the price of a commodity, one of the most significant is the Organization of Petroleum Exporting Countries (OPEC). It was founded in 1960 by Middle Eastern countries and Venezuela, although its membership has come to include developing nations in other parts of the world. Some major oil-exporting nations have remained outside the organization, notably Mexico and Russia. The principal objective of OPEC has been to raise the price received by the oil-exporting countries. During its early years, it was notably unsuccessful: plentiful supplies of oil kept the price low throughout the 1960s. In the early 1970s, however, major changes took place. The rapid economic expansion, which was simultaneously occurring in many countries, put upward pressure on the demand for oil. At the same time, the production of oil was leveling out and beginning to decline in the United States, with the result that U.S. demand for imported oil was rising rapidly. In 1973 OPEC seized the opportunities offered by the changing market conditions--and by the political and economic disruptions associated with the war between Israel and its Arab neighbours--to raise prices sharply, from about $3 to more than $12 per barrel. Between 1974 and 1979 the international price of oil remained quite stable, but then OPEC was once again successful in pushing the price up sharply--to more than $30 per barrel in 1980. These price increases caused a huge transfer in revenues from the oil-importing nations to the oil-exporting countries. They also contributed to a major increase in inflation in the importing countries. The large increase in revenues in the OPEC nations allowed many of them to embark on major development programs. On the other side, the loss of revenues, combined with the inflationary impact, precipitated major recessions in many of the oil-importing countries in 1974-75 and 1980-82. The higher oil price also has been suggested as a cause of a decline in productivity in many countries after 1973, although the causes of the decline are not well understood. OPEC has often been called an international cartel, but it lacked the standard enforcement mechanism of a cartel during the two periods (1973 and 1979-80) when prices rose spectacularly. That is, it did not have a mechanism for sharing the market among the oil-exporting nations. Saudi Arabia played a key role in enforcing the organization's price increases. In the 1970s Saudi Arabia had proven reserves in excess of 150 billion barrels, more than twice as much as any other nation, and five or six times the proven reserves of such major non-OPEC producers as the United States and Mexico. Because of its huge reserves and productive capacity, Saudi Arabia was able to act as the residual supplier, cutting back on production when demand slackened, thus reducing downward pressures on prices. Saudi Arabia's willingness to act as the residual supplier was partly the result of its limited population; even when producing at much less than capacity, it had a very large oil income per capita. During the early and middle 1980s, the oil market softened markedly. Oil consumption grew much more slowly, partly as a result of the major U.S. recession of 1982 and sluggish growth in western Europe, and partly as a result of increased conservation measures, a reaction to the upward spiral of fuel prices in the 1970s. At the same time, oil output increased in a number of non-OPEC areas such as the North Sea. The result was downward pressure on prices through the mid-1980s. In order to maintain sales and revenues, OPEC members had an incentive to undercut the posted price. As its oil production fell sharply and the bills from its ambitious development projects continued to increase, Saudi Arabia became less willing to act as the residual supplier. In order to relieve the downward pressure on prices, OPEC members attempted to transform the organization into a more formal cartel, with production quotas for each member. However, these efforts faced the classic problem of cartels: each member had an incentive to cheat on the organization by producing more than its quota and by offering secret price concessions to buyers.
International payments and exchange
Economic life does not stop at national boundaries but flows back and forth across them. The money of one country, however, cannot as a rule be used in another country; the flow of payments must be interrupted at national boundaries by exchange transactions in which one national money is converted into another. These transactions serve to cover payments so long as there is a balance between them: local money can be exchanged against foreign money only insofar as there is a counterbalancing offer of foreign money in exchange. In China and other countries with centralized economic planning, there are no legal private markets for foreign exchange; in those countries the state has a monopoly of the business of foreign trade, which is generally conducted through formal agreements on a country-by-country basis. While the currencies of the Communist countries have official par values, these bear no particular relationship to their purchasing power or to the prices at which goods are exchanged. The international economic relationships of those countries therefore fall outside the scope of this discussion.
BALANCE-OF-PAYMENTS ACCOUNTING
The balance-of-payments accounts provide a record of transactions between the residents of one country and the residents of foreign nations. The two types of accounts used are the current account and the capital account.
The current account.
When using balance-of-payments statistics, it is important to understand their basic concepts. The balance of payments includes, among other things, payments for goods and services; these are often referred to as the balance of trade, but the expression has been used in a variety of ways. In order to be more specific, some authorities have taken to using the expression "merchandise balance," which unmistakably refers to trade in goods and excludes services and other occasions of international payment. Figures for the merchandise balance often quote exports valued on an FOB (free on board) basis and imports valued on a CIF basis (including cost, insurance, and freight to the point of destination). This swells the import figures relative to the export figures by the amount of the insurance and freight included. The reason for this practice has been that in many countries the trade statistics have been based on customs house data, which naturally include insurance and freight costs for imports but not for exports. The authorities have more recently made a point of providing estimates of imports valued on an FOB basis. Another expression, "balance of goods and services," is often used. The British, however, continue to use the term invisibles for current services entering into international transactions. For many years the "visible" balance was taken to be equivalent to exports quoted FOB and imports CIF as explained above. The British authorities have more recently instituted another linguistic usage by which the visible balance is equivalent to the true merchandise balance. The old usage still lingers on in the less-expert literature. And so the total current account is the balance of goods (merchandise) and services. The United Kingdom includes unilateral transfers among invisibles and in the current account. The United States statistics, more correctly, show them under a separate heading. Services include such items as payments for shipping and civil aviation, travel, expenditures (including military) by the home government abroad and expenditures by foreign governments at home, interest and profits and dividends on investments, payments in respect of insurance, earnings of banking, merchanting, brokerage, telecommunications and postal services, films and television, royalties payable by branches, subsidiaries and associated companies, agency expenses in regard to advertising and other commercial services, expenditures by journalists and students, construction work abroad for which local payment is made and, conversely, earnings of temporary workers such as entertainers and domestic workers, and professional consultants' fees. This list contains the more important items but is not comprehensive. Among unilateral transfers the more important are outright aid by governments, subscriptions to international agencies, grants by charitable foundations, and remittances by immigrants to their former home countries.
The capital account.
There is also the capital account, which includes both long-term and short-term capital movements.
Long-term flows.
Long-term capital movement divides into direct investments (in plant and equipment) and portfolio investments (in securities). In the 19th century direct investment in plant and equipment was preponderant. The United Kingdom was by far the most important contributor to direct investment overseas. In the early part of the century it even contributed to the industrial development of the United States; later its attention shifted to South America, Russia, other European countries, and India. Investment in what came to be called the "Commonwealth" and "Empire," not prominent at that time, became very important in the 20th century. The other countries of western Europe also made important contributions to direct investment overseas. The most important items of direct investment were railways and other basic installations. In early stages direct investment may help developing countries to balance their payments, but in later stages there will have to be a flow of interest and profit in the opposite direction back to the investing country. The United Kingdom is frequently cited as the country whose overseas investments were most helpful for developing countries because its rapidly growing population and small cultivable land area permitted it to develop large net imports of food and to run corresponding deficits on its merchandise account. The complementary surplus this generated in the developing countries from which the imports came enabled them to pay the interest and profit on British capital without straining their balances of payments. Between World War I and World War II the United States began to take a more active interest in overseas investment, but this was not always well-advised. After the great world slump, which started in 1929, international investment almost ceased for lack of profit opportunities. After World War II the United States began to build up a leading position as overseas investor. The process accelerated in 1956 and afterward, both on direct investment and on portfolio investment accounts. This may have been partly due to the desire of U.S. firms to have plants inside the European Economic Community. Other countries also found more opportunities for capital export than there had been in the interwar period. The United Kingdom gave special attention to the Commonwealth. During the 1970s and 1980s Japan became a major overseas investor, financing its foreign investments with the funds accumulated with its large current account surpluses. The U.S. international position changed sharply in the 1980s. As a result of its large current account deficits, the United States accumulated large overseas debts. Its position changed from that of major net creditor (it had larger investments abroad than foreign nations had in the United States) to that of the largest debtor nation. Its liabilities to foreign nations came to exceed its foreign assets by hundreds of billions of dollars.
Short-term flows.
A very important distinction must be drawn between the short-term capital that flows in the normal course of industrial and commercial development and that which flows because of exchange-rate movements. The first class of short-term capital may be thought of as going in the train of direct long-term investment. A parent company may desire from time to time to supply its branch or affiliate with working capital. There may also be repayments from time to time. The second type of short-term capital flow occurs because of expectations of changes in exchange rates. For example, if people expect that the price of the dollar will fall in terms of the Japanese yen, they have an incentive to sell dollars and buy yen. An international capital market developed in the 1960s dealing in what are known as Eurocurrencies, of which much the most important was the Eurodollar. The prefix Euro is used because initially the market largely centred on the countries of Europe, but it has by no means been confined to them. Japan and the Middle Eastern oil states have been important dealers. While these short-term lendings normally move across national frontiers, they do not directly involve foreign exchange transactions. They may, however, indirectly cause such transactions to take place. The nature of the market is as follows: In the ordinary course of affairs, an Italian, for example, acquiring dollars--say from exports or from a legacy--would sell these dollars for his own currency. But he may decide to deposit the dollars at his bank instead, with an instruction not to sell them for cash but to repay him in dollars at a later date. Thus the bank has dollars in hand and a commitment to pay them out in, say, three months. It may then proceed to lend these dollars to another bank, anywhere in the world. Since the lending and borrowing is done in dollars, no foreign exchange transaction is directly involved. The sum total of all operations of this sort is the Eurodollar market. It is not centred on any particular place and has no formal rules of procedure or constitution. It consists of a network of deals conducted by telephone and telex around the world. U.S. residents themselves lend to and borrow from this market. One may ask why lenders and borrowers use this market in preference to more conventional methods of lending and borrowing. Ordinarily the answer is because they can get more favourable terms, since the market works on very narrow margins between lending and borrowing rates. This involves expertise; London has played the most important part in the creation of the market. The lender hopes to get a better rate of interest than he would on a time deposit in the United States (restrictions limiting interest payable on U.S. time deposits are said to have been a contributing cause of the growth of the market during the 1960s). At the same time, normally, the borrower will find that he has to pay a lower rate than he would on a loan from a commercial bank in the United States. This has not always been the case. In 1969 Eurodollar interest rates went to very high levels. One reason for this was the set of restrictions imposed by the United States on its commercial banks lending abroad. The second was that although the prime lending rates of the principal U.S. banks might be below Eurodollar rates, many individuals, including U.S. citizens, found that they could not get loans from their banks because of the "credit squeeze." Because this form of international lending does not involve the sale of one currency for another, it does not enter into balance-of-payments accounts. Nonetheless it may have a causal effect on the course of the exchanges. For instance, the Italian cited above might have chosen to sell his dollars had he not been tempted by the more attractive Eurodollar rate of interest. In this case, the market causes dollars not to be sold that otherwise would have been. Others who have liquid cash at their disposal for a time may even buy dollars in order to invest them in the market at short term. That would be helpful to the dollar. There are countercases. An individual who has to make a payment in dollars but lacks cash may borrow the dollars in the Eurodollar market, when otherwise he would have got credit in his own country and used that to buy dollars; in this case the market is damaging to the dollar because its existence prevents someone from buying dollars in the regular way.
Assessing the balance.
To summarize, the overall balance of payments comprises the current account (merchandise and services), unilateral transfers (gifts, grants, remittances, and so on), and the capital account (long-term and short-term capital movements). If payments due in exceed those due out, a country is said to be in overall surplus; and when payments due out exceed payments due in, it is in overall deficit. The surplus or deficit must be balanced by a monetary movement in the opposite direction, and consequently the overall balance including monetary movements must always be equal. In practice, great difficulties have been found in assessing whether a country is in deficit or in surplus. It is often important to establish this with a view to possible corrective measures. The United Kingdom stresses the combined balance of current and long-term capital account--i.e., excluding short-term capital. Such a balance, however, omits short-term movements that occur in the ordinary course of business, which may be called "normal" and which ought in principle to be included. On the other hand it is not desirable to include equilibrating or disequilibrating capital movements. These occur in consequence of a deficit (or surplus), actual or anticipated. But there may be great statistical difficulty in distinguishing between the normal short-term capital flows and those that are consequential on a surplus or deficit. It has been noted that the overall balance, including monetary movements, must be equal, but it usually happens that the figures do not in fact balance. U.S. statisticians call the residual figure that has to be inserted to square the account "errors and omissions." If the average value of this figure over a substantial period, such as 10 years--an even longer period may have to be taken if a country is in persistent surplus or deficit--has a positive or negative value of substantial amount, then it may be taken to constitute genuine items that have escaped the statistical net. These may legitimately be included in assessing whether a country is in genuine surplus or deficit and whether corrective measures are needed. The "errors and omissions" item is extremely volatile from year to year and often very large. Such movements up and down are probably caused by precautionary short-term capital movements. There have been periods when a minus item in the U.S. account was rather strikingly associated with a plus item in the U.K. account, and conversely. Accordingly, in the short term, the "errors and omissions" item should not be included in assessing whether a country is in surplus or deficit. It has been noted that the United Kingdom stresses the balance of current and long-term capital accounts (which include unilateral transfers). The U.S. position is less clear. It traditionally published two overall balance-of-payments measures: the "Liquidity Balance" and the "Official Settlements Balance." In distinguishing between monetary and nonmonetary items, the Liquidity Balance included any increase in the holding of short-term dollar securities abroad as part of the U.S. deficit during the period; but it did not include as counterweight any increase in short-term foreign claims held by U.S. resident banks or others (apart from official holdings). Thus, in this respect the treatment was asymmetrical. The rationale for this was precautionary. The argument was that short-term dollar assets held abroad outside the central banks might at any time be sold in the market or turned in to the central banks of the respective countries and thus constitute a drain, or the threat of a drain, on U.S. reserves. On the other hand the corresponding foreign short-term assets held by U.S. resident banks or others were not readily mobilizable by U.S. authorities for making payments. Thus by this reckoning, if during a period non-central-bank foreign holdings of short-term dollar securities and resident non-central-bank U.S. holdings of short-term foreign securities went up by an equal amount, the situation would be shown as having deteriorated, since the former class (liabilities) were a threat to U.S. reserves, while the latter class (assets) could not be mobilized by U.S. authorities to meet such a threat. Thus, though the motive for this asymmetrical treatment may have been understandable, it was statistically unsatisfactory and also unsatisfactory as a guide to corrective action. This balance is thus mainly of historical interest, and it has not been commonly used since 1971. The U.S. Official Settlements Balance reckoned an increase in non-central-bank foreign holdings of short-term dollar assets as an inflow of short-term capital into the United States; similarly an increase in U.S. resident holdings of short-term foreign assets was an outflow of short-term capital. This was a logical treatment. But the balance thus defined proved in the 1960s to be extremely volatile. This was due to large movements of funds between foreign central banks and non-central-bank foreign holders, associated with the rise of the Eurodollar market. Oscillations of this kind do not represent changes in the fundamental balance that are needed in order to determine whether corrective measures are required. It may well be that the British method of omitting short-term capital movements altogether in the assessment of surplus or deficit is, although imperfect, the most practical available. Since exchange rates began to float in the early 1970s, the major industrial countries have paid much less attention to overall balance-of-payments measures. The current account and the trade account are the two measures that are now most commonly used in developing countries.
ADJUSTING FOR FUNDAMENTAL DISEQUILIBRIUM
A "fundamental disequilibrium" exists when outward payments have a continuing tendency not to balance inward payments. A disequilibrium may occur for various reasons. Some may be grouped under the head of structural change (resulting from changes in tastes, habits, institutions, technology, etc.). A fundamental imbalance may occur if wages and other costs rise faster in relation to productivity in one country than they do in others. Imbalance may also result when aggregate demand runs above the supply potential of a country, forcing prices up or raising imports. A war may have a profoundly disturbing effect on a country's economy.
The classical view.
In the traditional "classical" view no intervention by the authorities was necessary to maintain external equilibrium, except for their readiness to convert currency into gold (or silver) upon demand. The system was supposed to work automatically. If a country had a deficit, gold would flow out, and the consequent reduction in the domestic money supply would cause prices to move downward. This would stimulate exports and tend to reduce imports. The process would continue until the deficit was eliminated. Classical doctrine did not embody a clear-cut theory about international capital movements. It was usually assumed that the trade balance (more strictly, balance on goods and services) would be tailored to accommodate any capital movement that occurred. Thus, if the country was exporting capital, gold flows would cause prices to move to such a level that exports minus imports would be equal to the capital flow; equilibrium in the overall balance was automatically secured. In due course the classical scheme of thought came under criticism. Some critics asked if an outflow or inflow of specie would necessarily have a sufficient effect on the price level to ensure an equal balance of payments. More important, a reduction in the money supply, it was pointed out, might have a side effect on the level of economic activity. Some critics went further and argued that this side effect would be stronger than the effect on prices to such a degree as to cause unemployment to rise to an undesirable level.
Contemporary views.
Monetary and fiscal measures.
The belief grew that positive action by governments might be required as well. The doctrine was first related to monetary policy in particular. The idea was that interest-rate adjustments should be combined with open-market operations by a central bank to ensure that the domestic money supply and borrowing facilities were conducive to external long-period equilibrium. After World War II the idea came to be widely held that government budget policy (usually called fiscal policy) should be brought in to assist monetary policy. For instance, if aggregate domestic demand was running so high as to cause rising prices, this should be reduced both by having a tight monetary policy and by increasing taxation more than expenditure or reducing expenditure without reducing taxation. The correct apportionment of this task between the monetary and fiscal arms is still a subject of discussion. Nor is there yet agreement about the scope of these policies or their ability to secure fundamental equilibrium in all cases. There is probably agreement that when overall demand is running in excess of the supply potential of the economy, it should be reduced by monetary and fiscal policies. There is difference of opinion, however, as to whether the reduction of aggregate demand will bring external payments into balance in all cases. For instance, a country may have a deficit owing to some underlying economic change (such as a shift in the pattern of world trade), even if domestic demand is not above the supply potential and prices are not rising. In this case, policies designed to reduce domestic demand (commonly called deflationary policies) would cause unemployment. Some hold that, if there is an external deficit, deflationary policies should be pursued to whatever extent may be needed to eliminate the deficit. Others hold that such a policy is socially unacceptable. Opinions differ also about how deflationary measures work to improve the external balance. Some hold that they work mainly by reducing domestic activity and thereby the amount of imported materials that a country needs and the amount of income that people can afford to spend on imported goods. If this were the whole effect of a deflationary policy, it would improve the external balance only in proportion to the amount by which it increases unemployment. Those who hold that this is the only manner in which deflation affects the external balance are especially opposed to relying on deflationary policies alone to eliminate a deficit in conditions in which aggregate domestic demand is not running above the supply potential. Some hold that a reduction of home demand also helps because it makes producers look around more eagerly for export markets (and increase their selling efforts in the home market). This appears to be doubtful, however. There is further disagreement on the extent to which deflationary policies influence the course of prices. If aggregate demand is running above the supply potential of the economy, it is highly probable that deflationary policies will slow the increase of prices and thus make a country more competitive with foreign suppliers. There is not the same agreement about the effects when demand is initially running below the supply potential of the economy. Some hold that a deflationary policy, if pushed hard enough, will infallibly slow up price increases and so help the country's external balance. Others hold that it will not, and some even argue that higher interest rates and higher taxes (weapons of deflation) can cause prices to rise. Thus, it is not absolutely clear that monetary and fiscal policies will in all cases suffice to cure an external deficit, at least without socially unacceptable results. There is also the opposite case of countries with a trade surplus. It is clear that these countries will be unwilling to encourage policies that cause domestic prices to rise. Price inflation is a social evil and politically unpopular. In the case of surplus countries, the same distinction must be made between the situation in which aggregate demand is fully up to or above the supply potential of the economy and that in which it is not. In the former case a further increase in demand would almost certainly have an inflationary effect; accordingly, surplus countries in this condition will be unwilling to use monetary and fiscal policies to eliminate their external surpluses. On the other hand, if aggregate demand is running below supply potential, then a surplus country might reasonably be asked to increase aggregate demand by monetary and fiscal policies on the view that the increase will not cause inflation but will tend to remove the external surplus by inducing more imports and possibly causing producers to be less active in their selling efforts abroad.
Incomes policy.
Prices may rise even when aggregate demand is not in excess of the supply potential. This may be due to wage increases and other factors. Some hold that this can be dealt with through efforts to discourage excessive wage increases by a direct approach, which may consist of a propaganda campaign on the evil effects of wage-price inflation, together with guidelines governing rates of wage increases. This direct attempt to deal with the problem is generally known as "incomes policy."
Changes in exchange rates.
Exchange-rate movements work by making the products of a deficit country more price competitive or those of a surplus country less price competitive. Any program that seeks to rectify an imbalance by changing the level of prices will be effective only if demand is "price elastic." In other words, if the offer of an article at a lower price does not cause an increase in demand for it more than in proportion to the fall in price, the proceeds from its export will fall rather than increase. Economists believe that price elasticities are sufficiently great for most goods so that price reductions will increase revenues in the long run. The outcome is not quite so certain in the short run. A fast means of changing relative price levels is devaluation, which is likely to have a quick effect on the prices of imported goods. This will raise the cost of living and may thereby accelerate demands for higher wages. If granted, these will probably cause rises in the prices of domestically produced goods. A "wage-price spiral" may follow. If this spiral moves too quickly it may frustrate the intended effect of the devaluation, namely that of enabling the country to offer its goods at lower prices in terms of foreign currency. This means that if the beneficial effects of a devaluation are not gathered in quickly, there may be no beneficial effect at all. The authorities of a country that has just devalued must therefore be especially active in preventing or moderating domestic price increases. They will need to use the other policy measures discussed above. Devaluation (or the downward movement of a flexible rate) is thus not a remedy that makes other forms of official policy unnecessary. Some have argued that, if exchange rates were allowed to float, nothing further would have to be done officially to bring the external balance into equilibrium, but this is a minority view. One further point must be made regarding exchange-rate movements. It has been found in practice that governments resist upward valuation more than they do devaluation. Under the IMF system prior to 1973, devaluations in fact were larger and more frequent than upward valuations. This had an unfortunate consequence. It meant that the aggregate amount of price inflation in deficit countries resorting to devaluation as a remedy was not offset by equivalent price decreases in the surplus countries. Therefore this system had a bias toward worldwide inflation.
Trade restrictions.
Since World War II the major industrial countries have attempted to reduce interferences with international trade. This policy, by extending the international division of labour, should increase world economic welfare. An exception has had to be allowed in favour of the less-developed countries. In the early stages of the development of a country, the effectiveness and feasibility of the three types of adjustment mechanism discussed above, particularly monetary and fiscal policies, may be much less than in the more advanced countries. The less-developed countries may therefore be driven to protection or the control of imports, for lack of any other weapon, if they are to stay solvent. It has already been noted that, even in the case of a more advanced country, the effectiveness and appropriateness of the above-mentioned adjustment mechanisms are not always certain. Thus, there is no certainty that some limitation on foreign trade and on the international division of labour may not be a lesser evil than the consequences that might follow from a vigorous use of the other adjustment mechanisms, such as unemployment.
Restrictions on capital exports.
Interference with capital movements is generally considered a lesser evil than interference with the free flow of trade. The theory of the optimum international movement of capital has not yet been thoroughly developed, but there may be a presumption in favour of absolutely free movement. The matter is not quite certain; for instance, it might be desirable from the point of view of the world optimum to channel the outflow of capital from a high-saving country into the less-developed countries, although the level of profit obtainable in other high-saving countries might be greater. Or it might be expedient to restrain wealthy individuals in less-developed countries, where domestic saving was in notably short supply, from sending their funds to high-saving countries. While there may be good reasons for interfering with the free international flow of capital in certain cases, it is not obvious that the outflow of capital from, or inflow of capital into, a country should be tailored to surpluses or deficits in current external accounts. It may be that in some cases the sound remedy for a deficit (or surplus) is to adopt adjustment measures such as those discussed above, bearing upon current items, rather than taking the easier way of adjusting capital movements to the de facto balance on current account.
FOREIGN EXCHANGE MARKETS
Buying and selling currencies.
A foreign exchange market is one in which those who want to buy a certain currency in exchange for another currency and those who want to move in the opposite direction are able to do business with each other. The motives of those desiring to make such exchanges are various. Some are concerned with the import or export of goods between one country and another, some with the purchase and sale of services. Some wish to move capital from one area to the other, and some wish to make gifts (the latter including government aid and gifts by charitable foundations). In any organized market there must be intermediaries who are prepared to "quote a price," in this case a rate of exchange between two currencies. These intermediaries must move the price quoted in such a way to permit them to make the supply of each currency equal to the demand for it and thus to balance their books. In an important foreign exchange market the price quoted is constantly on the move. An exchange rate is the price of one currency in terms of another. For example, in the market for the British pound sterling ( ) in exchange for U.S. dollars ($), the exchange rate might be 1 = $2. This price may also be quoted the other way around; that is, $1 = 0.50.
Determination of exchange rates.
In a foreign exchange market, there may be a standard, government-determined price, or par value. This par value may be quoted in terms of another currency; for example, the par value of the pound was 1 = $2.80 between 1949 and 1967. In 1973 many governments abandoned their par values and let their exchange rates be determined by the forces of demand and supply. An exchange rate determined in this way, without being tied to an official par, is called a flexible or floating exchange rate; in contrast, an exchange rate is said to be pegged if the government ties it to par value. Historically, countries often tied their currencies to gold, setting their official parities in terms of that metal. Under this historical gold standard, the gold equivalence of currencies determined exchange rates. For example, the British pound was worth 4.86 times as much gold as the U.S. dollar during the period prior to World War I. The exchange rate remained at or quite close to the mint parity of 1 = $4.86. Nobody would pay much more than $4.86 for a British pound, nor take much less. Historically, there were also periods of bimetallism, when the gold standard was combined with a silver standard, and currencies were fixed in terms of both gold and silver. The bimetallic standard was given up by most of its adherents (the United States, France, Italy, Switzerland, The Netherlands, and Belgium) in the 1870s.
THE GOLD STANDARD
The function of gold.
If the demand by those holding a particular currency, say sterling, for another currency, say the dollar, exceeds the demand of dollar holders for sterling, the dollar will tend to rise in the foreign exchange market. Under the gold standard system there was a limit to the amount by which it could rise or fall. If a sterling holder wanted to make a payment in dollars, the most convenient way for him to procure the dollars would be in the foreign exchange market. But under the gold standard he had another option; i.e., he had a legal right to obtain gold from the authorities in exchange for paper currency at the established par value of that currency and remit the gold to the other country, where he would have a legal right to obtain its currency in exchange for bars of gold at the official valuation. Thus, it would not be advantageous for a sterling holder to obtain dollars in the foreign exchange market if the quotation for a dollar there exceeded parity by more than the cost of remitting gold. The exchange rate at which it became cheaper to remit gold rather than use the foreign exchange market was known as the "gold-export point." There was also a "gold-import point" determined on similar lines . Most of those seeking dollars, however, did not undertake to remit gold even if the dollar quotation was at the gold-export point. The remission of gold was handled by arbitrageurs. These are people who buy and sell currencies simultaneously on different exchanges in order to profit by small differences in the quoted rates. Their action would reduce the supply of sterling, since they would be selling sterling for gold to the British authorities, and increase the supply of dollars, since they would acquire dollars in exchange for gold from the U.S. authorities. The arbitrageurs would carry out these operations to the extent needed to prevent the scarcity of the dollar from raising its sterling price above the gold-export point for the United Kingdom, and conversely. At the same time, the gold reserve of the British authorities would be diminished, and the gold reserve of the U.S. authorities increased. The international gold standard provided an automatic adjustment mechanism, that is, a mechanism that prevented any country from running large and persistent deficits or surpluses. It worked in the following manner. A country running a deficit would see its currency depreciate to the gold-export point. Arbitrage would then result in a gold flow from the deficit to the surplus country. In other words, the deficit would be settled in gold. The gold flow had an effect on the money system. When gold flowed into the banking system of the surplus country, its money stock rose as a consequence. On the other side, when a deficit country lost gold, its money stock fell. The falling money stock caused deflation in the deficit country; the rising money stock caused inflation in the surplus country. Thus, the goods of the deficit country became more competitive on world markets. Its exports rose, and its imports declined, correcting the balance-of-payments deficit.
Problems with the gold standard.
Although this adjustment process worked automatically, it was not problem-free. The adjustment process could be very painful, particularly for the deficit country. As its money stock automatically fell, aggregate demand fell. The result was not just deflation (a fall in prices) but also high unemployment. In other words, the deficit country could be pushed into a recession or depression by the gold standard. A related problem was one of instability. Under the gold standard, gold was the ultimate bank reserve. A withdrawal of gold from the banking system could not only have severe restrictive effects on the economy but could also lead to a run on banks by those who wanted their gold before the bank ran out. These twin problems materialized during the Great Depression of the 1930s; the gold standard contributed to the instability and unemployment of that decade. Because of the strains caused by the gold standard, it was gradually abandoned. In 1931, faced with a run on its gold, Britain abandoned the gold standard; the British authorities were no longer committed to redeem their currency with gold. In early 1933 the United States followed suit. Although the tie of the dollar to gold was partially restored at a later date, one very important feature of the old gold standard was omitted. The public was not permitted to exchange dollars for gold; only foreign central banks were allowed to do so. In this way the U.S. authorities avoided the risk of a run on their gold stocks by a panicky public.
THE INTERNATIONAL MONETARY FUND
The International Monetary Fund (IMF), founded at the Bretton Woods Conference in 1944, is the official organization for securing international monetary cooperation. It has done useful work in various fields, such as research and the publication of statistics and the tendering of monetary advice to less-developed countries. It has also conducted valuable consultations with the more developed countries. Of particular interest to this discussion is the Fund's system of Drawing Rights, which permits countries in temporary deficit to draw supplies of foreign currency according to predetermined quotas. These extra supplies of currency give a country more time in which to adjust its balance of payments and so avoid taking unsound or unneighbourly measures like import restrictions for lack of enough reserves to tide it over a difficulty. The mechanism is as follows: members of the Fund are required to make initial deposits according to their quotas, which are based on the country's national income, monetary reserves, trade balance, and other economic factors. Quotas are payable partially in Special Drawing Rights and partially in a country's own currency. A country's quota closely approximates its voting power, the amount of foreign exchange it may purchase (Drawing Rights), and its allotment of Special Drawing Rights. The Fund makes its stock of members' currencies available to member countries that wish to draw upon their quotas. When creditor countries are presented with their own currencies previously deposited by them with the Fund, they are obliged to take them in final discharge of debts owed by other member countries. Since they previously deposited these currencies themselves they are in effect getting nothing from the debtor countries in respect of the debts owed to them, and their willingness to accept payment in this way is their contribution to the overall liquidity of the world system. Later the creditor countries may themselves become debtors and partake of the benefits. The debtors have to repay the Fund usually in three to five years. A country with more serious financial problems may draw as much as 140 percent of its quota during a three-year period, and repayment must be made between four to 10 years afterward. The exercise of Drawing Rights is subject to discussion and sometimes to conditions, except for drawings on what are called the reserve tranches (sums equal to the member's original deposits in its own currency and Special Drawing Rights), which are given "the overwhelming benefit of the doubt." Countries are also free to draw without discussion up to the net amount to which they have previously been drawn upon by other countries. The quotas paid by members of the IMF are the primary source of income for the organization. Quotas for member countries are periodically reviewed and reevaluated according to the country's financial situation. General increases in quotas normally occur following the periodic reviews, although special reviews and increases sometimes occur for specific countries, such as Saudi Arabia in 1981. The IMF also borrows to supplement its quota resources. In 1981, for example, Saudi Arabia agreed to loan the Fund more than $8,000,000,000 over a two-year period, and an additional $1,300,000,000 was loaned by a group of countries. Between 1976 and 1980 about one-third of the Fund's gold holdings were sold at public auction to benefit the member developing countries. More than $4,600,000,000 was received from the gold sale; part of the revenue was made available to members according to their quotas, and part of the revenue was placed in a trust fund to dispense low-interest loans to developing countries. The International Monetary Fund as it finally emerged from the wartime discussions was a much more modest undertaking than had originally been conceived by the British. An early British proposal would have required creditor countries to receive payment in paper money up to the total amount of all the quotas of all the debtor countries. This seemed to many to be more than it was fair to ask creditors to do. The United States claimed that for a number of years after the war it was likely to be in credit against the whole of the rest of the world, and so it was. Under the British plan they would have had to give an unconscionably large amount of credit, with no certainty of repayment. At that time it did not seem at all likely that the United States would ever go into deficit, which, of course, it eventually did.
THE IMF SYSTEM OF PARITY (PEGGED) EXCHANGE RATES
When the IMF was established toward the end of World War II, it was based on a modified form of the gold standard. The system resembled the gold standard in that each country established a legal gold valuation for its currency. This valuation was registered with the International Monetary Fund. The gold valuations served to determine parities of exchange between the different currencies. As stated above, such fixed currencies are said to be pegged to one another. It was also possible, as under the old gold standard, for the actual exchange quotation to deviate somewhat on either side of the official parity. There was agreement with the International Monetary Fund about the range, on either side of parity, within which a currency was allowed to fluctuate. But there was a difference in the technical mode of operation. The service of the arbitrageurs in remitting physical gold from country to country as needed was dispensed with. Instead the authorities were placed under an obligation to ensure that the actual exchange rates quoted within their own territories did not go outside the limits agreed upon with the International Monetary Fund. This they did by intervening in the foreign exchange market. If, for instance, the dollar was in short supply in London, the British authorities were bound to supply dollars to the market to whatever extent was needed to keep the sterling price of the dollar from rising above the agreed-upon limit. The same was true with the other currencies of the members of the International Monetary Fund. Thus, the obligation of the monetary authorities to supply the currency of any Fund member at a rate of exchange that was not above the agreed-upon limit took the place of the obligation under the old gold standard to give actual gold in exchange for currency. It would be inconvenient for the monetary authorities of a country to be continually watching the exchange rates in its market of all the different currencies. Most authorities confined themselves to watching the rate of their own currency against the dollar and supplying from time to time whatever quantity of dollars might be required. At this point the arbitrageurs came into service again. They could be relied upon to operate in such a way that the exchange rates between the various currencies in the various foreign exchange markets could be kept mutually consistent. This use of the dollar by many monetary authorities caused it to be called a currency of "intervention." The official fixing of exchange rates as limits on either side of parity, outside of which exchange-rate quotations were not allowed to fluctuate, bears a family resemblance to the gold points of the old gold standard system. The question naturally arose why, in devising a somewhat different system, it was considered desirable to keep this range of fluctuation. In the old system it arose necessarily out of the cost of remitting gold. Since there was no corresponding cost in the new system, why did the authorities decide not to have a fixed parity of exchange from which no deviation would be allowed? The answer was that there was convenience in having a range within which fluctuation was allowed. Supply and demand between each pair of currencies would not be precisely equal every day. There would always be fluctuations, and if there were one rigidly fixed rate of exchange the authorities would have to supply from their reserves various currencies to meet them. In addition to being inconvenient, this would require each country to maintain much larger reserves than would otherwise be necessary. Under a system of pegged exchange rates, short-term capital movements are likely to be equilibrating if people are confident that parities will be maintained. That is, short-term capital flows are likely to reduce the size of overall balance-of-payments deficits or surpluses. On the other hand, if people expect a parity to be changed, short-term capital flows are likely to be disequilibrating, adding to underlying balance-of-payments deficits or surpluses.
Equilibrating short-term capital movements.
Commercial banks and other corporations involved in dealings across currency frontiers are usually able to see some (but not necessarily all) of their needs in advance. Their foreign exchange experts will watch the course of the exchanges closely and, if a currency is weak (i.e., below parity), advise their firms to take the opportunity of buying it, even if somewhat in advance of need. Conversely, if the currency is above parity but not expected to remain so indefinitely, they may recommend postponing purchases until a more favourable opportunity arises. These adjustments under the influence of common sense and self-interest have an equilibrating influence in foreign exchange markets. If a currency is temporarily weak, it is presumably because of seasonal, cyclical, or other temporary factors. If on such an occasion private enterprise takes the opportunity to buy the currency while it is cheap, that tends to bring demand up to equality with supply and relieves the authorities from the need to intervene in order to prevent their currency from falling below the lower point whenever there is a temporary deficit in the balance of payments. As previously noted, when confidence in the fixed parity exchange rate drops and market participants expect a change in parity, short-term capital movements may be disequilibrating. Another equilibrating influence arises from the movements of short-term interest rates. When the authorities have to supply foreign currencies in exchange for the domestic currency, this causes a decline in the money supply in domestic circulation--unless the authorities deliberately take offsetting action. This decline in the money supply, which is similar to that occurring under the gold standard, tends to raise short-term interest rates in the domestic money market. This will bring an inflow of money from abroad to take advantage of the higher rates or, what amounts to the same thing, will discourage foreigners from borrowing in that country's money market since borrowing will have become more expensive. Thus, the interest-rate differential will cause a net movement of short-term funds in the direction required to offset the temporary deficit or, in the opposite case, to reduce a temporary surplus that is embarrassing to others. It must be stressed again that this equilibrating interest-rate mechanism implies confidence that the parity will not be altered in the near future. The helpful movement of interest rates may be reinforced by action of the monetary authorities, who by appropriate open-market operations may cause short-term interest rates to rise above the level that they would have attained under market forces and thus increase the equilibrating movement of short-term funds. The Bank of England provided the most notable example of the smooth and successful operation of this policy under the old gold standard during many decades before World War I.
Forward exchange.
The transactions in which one currency is exchanged directly for another are known as spot transactions. There can also be forward transactions, consisting of contracts to exchange one currency for another at a future date, perhaps three months ahead, but at a rate determined now. For instance, a German firm may have a commitment to pay a U.S. firm in dollars in three-months' time. It may not want to take the risk that the dollar will rise relative to the mark during the three months, so that it would have to surrender more marks in order to honour its commitment. It could of course buy the dollars right away and thus obviate this risk, but it may not have any spare cash and borrowing may be inconvenient. The firm has the alternative of buying dollars at a rate agreed upon now for which it does not have to surrender marks until three months have passed. Some firms have a regular routine procedure for covering all future commitments to be paid for in a foreign currency as soon as these are entered into. Of course, even a firm that does this may combine its routine procedure with a little judgment, for instance, if there are good reasons for believing that the foreign currency will become cheaper during the relevant period. And firms with multinational commitments will vary the distribution of their assets among different currencies in accordance with changing conditions. The forward-exchange rate will, like the spot rate, be continually varying. It is not usually identical with the spot rate but in normal times has a regular relation to it. This relation is determined as follows: Dealers in forward exchange usually balance their commitments; for instance, a contract to deliver forward marks can be offset against one to deliver forward dollars, and nothing more has to be done about it. If a particular dealer cannot manage this he will be in communication with another who may be in the opposite position. It may not, however, always be possible to offset every transaction. If this is not done, the dealer must make a spot purchase of the currency--say marks--in excess demand in the forward market. If he did not do this he would risk an exchange loss on some of his forward transactions. For the purpose of evaluating the forward-exchange rate to be asked in a particular deal, it is always correct to suppose that the deal is one that cannot be offset. If the dealer has to purchase marks on the spot, he can earn the rate of interest prevailing in Frankfurt until the time comes when he has to deliver the marks. Whether this is advantageous or not depends on whether the rate of interest in Frankfurt is higher or lower than that in New York City. If it is higher in Frankfurt, the dealer will normally quote a rate per forward mark that is lower than the spot rate; but if the rate of interest in Frankfurt is lower, then the forward mark will normally stand above the spot mark to compensate the dealer for having to employ his liquid funds in a less remunerative market. When the relation of the forward rate to the spot rate is determined by a comparison of the short-term interest rates in the two centres in the manner just described, the forward rate is said to be at "interest parity." The question arises as to what particular interest rates are used to calculate the interest parity. There is a variety of practice. In previous times the rate of interest on U.S. Treasury bills and the rate of interest on British Treasury bills were used to determine the interest parity of the sterling price for forward dollars. More recently the interest rates on Eurodollars and Eurosterling have been used--that is, the interest on dollar and sterling accounts held by European banks. In normal times arbitrage may be expected to hold forward rates to their interest parities. There have been times, and even rather prolonged periods, in which the forward rate for a currency has fallen below (or risen above) its interest parity. This may happen when there is a large one-way movement of funds (such as when there is a lack of confidence in a particular currency). In some cases, such as a simultaneous multiple swapping of currencies, the arbitrager does not have to commit any funds, but in forward arbitrage funds have to be committed for a period of three months. It is true that an arbitrageur who had bought three-months' sterling could resell the sterling before the three months had elapsed, but if he did so he might have to accept a loss. If the one-way movement is very heavy there may be a shortage of funds available for forward arbitrage. Nonetheless the demand for forward sterling has to be kept equal to the supply of it, and if there is insufficient arbitrage for this purpose then a positive profit has to appear on the purchase of forward sterling; in other words, its price has to fall below the interest parity. If dealers in a forward currency cannot offset contracts for sale with contracts for purchase and find an excess of customers wishing to sell, the excess supply causes immediate pressure on the spot market, since arbitrageurs and others who supplement the forward demand for the weak currency must cover their positions by selling an equivalent amount spot. The only way in which the authorities can prevent an excess offer of their currency forward from causing an immediate drain on their reserves is by offering to buy it forward themselves, without simultaneously selling it spot. British authorities engaged in such operations during periods when sterling was weak, and similar operations have been conducted by other central banks in connection with swap agreements for mutual accommodation. The foregoing descriptions of the equilibrating movements of short-term funds have not applied when there has been a serious lack of confidence that a given parity will be maintained. Occasions of lack of confidence occurred much more frequently under the modified gold standard (International Monetary Fund) than they did under the old gold standard. The reason for this is simple. Under the old gold standard it was not expected that a country of good standing would alter the gold valuation of its currency (although in much earlier days "debasement" was common enough). A devaluation of the official gold content was regarded as not far removed from a declaration of bankruptcy, and it was assumed that a country would avoid it at all costs and in all times short of a major war or revolution. Under the International Monetary Fund this position was altered quite deliberately to allow a country whose payments were in "fundamental disequilibrium," to propose a change of parity. This remedy was proposed at the Bretton Woods Conference (1944), which set up the International Monetary Fund, because it was thought to be better than alternative remedies, such as domestic deflation.
Disequilibrating capital movements.
Whatever its merits from a long-term point of view, the idea that it is quite respectable for a country to alter the par value of its currency in certain circumstances had disturbing effects on the movements of short-term funds--effects that may not have been clearly foreseen at the time of Bretton Woods. Such movements of funds were sometimes very large indeed. These movements were not equilibrating, like those described in relation to a parity in which there is confidence; on the contrary, they were disequilibrating. If a currency became weak--if the demand for it fell below the supply--this could give rise to the idea that the authorities having the weak currency might in due course decide to devalue it, as they were perfectly entitled, under International Monetary Fund principles, to do.
Covering.
Foreign exchange advisers to corporations had to watch for such possibilities and propose a readjustment of assets entailing a movement out of the weak currency. It was not necessary that there be, on an objective assessment, a probability (more than a 50 percent chance) that the currency in question had to be devalued. To provoke a disequilibrating movement of funds it was enough that there should be a small chance (much less than 50 percent) that it would be devalued. In strict theory, funds should be moved out of a given currency whenever the probability that it will be devalued outweighs the cost of moving the funds. If a firm or its affiliate has foreseeable commitments to make payments in a currency other than that of the area in which it operates, it may think it wise to "cover" its position by buying the currency at once, in either the spot or the forward market. Covering may take other forms also. If a contract to pay abroad is in the currency of the home, or paying, country, then the prospective foreign receiver of these funds will have to consider whether he should not cover his own position by selling the currency of the paying country forward. Payments in the opposite direction have also to be considered. If these are in the currency of the home country, the foreigner due to make the payment will consider whether he should cover his position by buying the currency of the home country forward. If the payment is in the foreign currency, then the firm in the home country due to receive it will consider whether to cover itself by selling the foreign currency forward. Thus, there are four main classes of covering. In normal times it is probable that not all positions are covered in these four ways, although it is not impossible that they should be. If a suspicion arises that a particular currency, say that of the home country, may be devalued, then the position is radically changed. The following arguments apply in reverse to the case when it is believed that a particular currency may be valued upward. It is necessary to go through the four classes of cases. Members of the home country who normally cover their commitments to make payments in a foreign currency would clearly continue to do so. And those, if any, who do not habitually do so would be strongly advised to do so when there is a possibility that the home currency may be devalued. To take the second case--that of outward payments to be made in the home currency--the same applies: foreigners who normally sell it forward should continue to do so, and those who do not normally sell it forward would be strongly advised to do so lest the currency be devalued before the payment is made. Coming to the payments due to the home country, in the case of those to be made in the home currency, the foreigners who normally cover themselves by buying forward or spot should be advised to cease doing so immediately, since they may get the currency cheaper before the payment has to be made. Thus, in this case the fear of devaluation causes those concerned to stop covering their positions. The same applies to inward payments to be made in foreign currencies; residents of the home country would be advised to cease from such covering, since in the interval their currency may be devalued, and therefore it would be foolish to sell the foreign currency due to come, in advance of payment. Thus, the prospect of devaluation may cause both additional covering and uncovering. Both types of change are adverse to the currency under suspicion. It is notable that the total value of the appropriate covering plus that of the uncovering when a currency becomes suspect is independent of the proportion of positions that are normally covered. If all positions are normally covered then the adverse effect will consist of an uncovering of about half of all positions. If all positions are not normally covered, then the adverse effect will be equal to the sum of the amount of extra covering and the amount of uncovering. The movement of funds under these heads can be very large in relation to a country's normal balance of incoming and outgoing payments. It makes no difference whether the changed action by the firms relates to the spot or to the forward markets. This is because, when there is a big one-way movement in the forward market, the whole of it is thrown, through the actions of the dealers, arbitrageurs, and the like, onto the spot market.
Hedging.
Whereas the word "covering" relates to payments foreseen or possible, the term hedging is used for operations related not to prospective payments but to existing assets. Thus, a non-British firm may need to have a sterling balance for an indefinite period ahead. It may think it desirable in this case to protect its position against the possibility of sterling being devalued in the near future by selling sterling forward at the existing quoted rate. If sterling is devalued before the forward contract matures, the operator will get a foreign currency--say the franc--at the old rate and can rebuy sterling at a cheaper rate. The profit that he makes recoups him for the loss in the franc value of his sterling due to the devaluation. If there is no devaluation he can renew his hedge at the date due, if sterling is still suspect, or he can terminate it without loss except for the actual cost, or service charge, of the hedging transaction. An even more important use of hedging is to protect the international value of real assets such as securities, real estate, and industrial buildings and plants. If a non-British person conducts business and has assets in Britain, he may think it wise to protect the international value of these assets by selling a certain amount of sterling forward. A devaluation, if it occurs, will reduce the foreign exchange value of the sterling assets; but the profit that the owner makes from selling sterling forward and buying it back at a cheaper rate will be an offset to this loss.
Speculation.
The movements so far considered are of a precautionary nature. It is sometimes suggested, when there is a big movement of funds out of a currency, that those prompting it are actuated by some motive hostile to the suspect currency. This is usually quite wrong. Such large movements of funds are often referred to incorrectly as "speculative." This gives a false impression of what is happening. Speculation can, and often does, occur when a currency becomes suspect; but the word speculative should be confined to movements of funds made not to protect positions but purely in the hope of gain. A person may believe that the Deutsche Mark is likely to be valued upward and decide to buy Deutsche Marks, not because he has any commitments denominated in Deutsche Marks but because he wants to resell them afterward at a profit. He will probably buy the Deutsche Marks forward. Such speculation plays only a minor role in the early movements of funds in anticipation of a change of parity. It may, however, mount up very strongly in the last stages when an upward or downward revaluation has become almost certain. A big outward movement of funds may precipitate a change of parity, desirable or undesirable in itself, simply because there are not enough reserves to finance the withdrawals. Even if the country in trouble is assisted by international credits, in certain cases these may not be large enough to avert the need for devaluation. A great movement of funds from a particular country may occur because it is thought likely that it will have to devalue. There may also be a great movement into a country thought likely to value upward. The latter kind of movement will cause difficulties for other countries, since the funds must come from somewhere. This adverse effect may be concentrated on one other currency, as in the classic crisis centred on a possible upward valuation of the Deutsche Mark in November 1968, where the drain was mainly from the French franc; or it may be more widely diffused, as in the crisis of the mark in September 1969.
Stresses in the IMF system.
The International Monetary Fund system of pegged-but-adjustable exchange rates came under increasing pressures during the 1960s. The system suffered from three major, interrelated problems: inadequate adjustment, confidence, and liquidity. Changes actually made in exchange rates were inadequate to deal with the major disturbances occurring in international payments. Because the adjustment mechanisms in the system were inadequate, a number of countries ran large and persistent imbalances in their international payments. This led to a lack of confidence that existing par values could be maintained and to periodic speculative rushes into strong currencies and away from weak ones. Deficit countries were not in a position to meet large speculative attacks because of their limited quantities of liquid reserves. Traditionally, there had been two major methods of international reserve creation: the mining of gold and the acquisition of reserves in the form of key currencies (mainly dollars). Gold mining did not keep up with the rapid increase in international trade; gold reserves became less and less adequate as a means for covering balance-of-payments deficits. The alternative method for acquiring reserves--the accumulation of U.S. dollars by central banks--had one major disadvantage. For countries such as the United Kingdom, West Germany, or Brazil to accumulate dollars, the United States had to run a balance-of-payments deficit. But when the United States ran large deficits, doubts arose regarding the ability of the United States to maintain the convertibility of the dollar into gold. In other words, there was a fundamental inconsistency in the design of the IMF system, which created something of a paradox: if the United States did run large deficits, the dollar would sooner or later be subject to a crisis of confidence; if it did not run large deficits, the rest of the world would be starved for dollar reserves.
Special Drawing Rights.
To deal with the inability of the existing system to create an adequate quantity of reserves without requiring the United States to run large deficits, a new kind of reserve called Special Drawing Rights (SDRs) was devised by the International Monetary Fund. Members of the Fund were to be allocated SDRs, year by year, in prearranged quantities to be used for the discharge of international indebtedness. At the IMF meeting in 1969, agreement was reached for an issue extending over three years. These Special Drawing Rights differed from ordinary Drawing Rights in three important respects: (1) The use of Special Drawing Rights was not to be subject to negotiations or conditions. (2) There was to be only a very much modified form of repayment obligation. A member who used more than 70 percent of all the Special Drawing Rights allotted in a given period had to repay to the extent needed to reduce its average use of the rights during that period to 70 percent of the total. Thus, 70 percent of all Special Drawing Rights issued could be thought of as reserves in the fullest sense, since a member who limited its use to this amount would have no repayment obligation. (3) In the case of Drawing Rights, the Fund uses currencies as subscribed by members to provide the medium of payment. By contrast, the Special Drawing Rights were to be accepted in final discharge of debt without being translated into any particular currency. Though currencies would still have to be subscribed by members receiving Special Drawing Rights, these would be in the background and would not be used, except in the case of a member in net credit on Special Drawing Rights account who wished to withdraw from the scheme. Initially, the total amount of Special Drawing Rights allocated was equivalent to more than U.S. $9,000,000,000, but additional allocations to IMF members during the 1970s more than doubled the total. The value of the Special Drawing Rights is based on the currencies of the largest exporting IMF members. The use of SDRs was altered and expanded in 1978, allowing agencies other than the IMF to use SDRs in monetary exchange. Subsequently SDRs have been used by the Andes Reserve Fund, the Arab Monetary Fund, the Bank for International Settlements, and others.
Other efforts at financial cooperation.
The Group of Ten.
As early as 1961 there were signs of a crisis in the IMF system. The United States had been running a heavy deficit since 1958, and the United Kingdom plunged into one in 1960. It looked as if these two countries might need to draw upon continental European currencies in excess of the amounts available. Per Jacobssen, then managing director of the IMF, persuaded a group of countries to provide standby credits amounting to $6,000,000,000 in all, so that supplementary supplies of their currencies would be available. The plan was not confined to the countries that happened to be in credit at that time but was extended to other important countries, the currencies of which might run short at some future time. This plan was known as the "General Arrangements to Borrow." The adhering countries were 10 in number: the United States, the United Kingdom, Canada, France, West Germany, Italy, The Netherlands, Belgium, Sweden, and Japan. They became known as the "Group of Ten."
The arrangement was subject to the agreement that countries actually supplying additional currency would have the right to take cognizance of how the Fund used it. This put them in a power position as against the International Monetary Fund itself. Since then the Group of Ten has worked together in deliberating on international monetary problems. The dominant position gained by the Group of Ten has been due not only to their provision of standby credit but also to the manner in which they do their business. The ultimate authority of the Group resides in the finance ministers of the countries concerned, who meet from time to time. Their deputies meet more frequently for detailed work on particular problems. These deputies consist of high-ranking persons in their respective treasuries and central banks; they are resident in their own countries and have day-to-day knowledge of their problems and of what is politically feasible. In this respect they are in a much more advantageous position than the executive directors of the International Monetary Fund, who live in Washington, D.C., and have less contact with their home governments; they also tend to be persons of higher standing and authority.
The Basel Group.
In 1930 a Bank for International Settlements was established at Basel, Switz.; its main duty was to supervise and organize the transfer of German reparations to the recipient countries. This "transfer problem" had caused much trouble during the 1920s. There may also have been a hope in the minds of some that this institution might one day develop into something like a world central bank. Not long after it was set up the Germans gained a moratorium on their reparations payments. By then, however, the Bank for International Settlements had become a convenient place for the heads of the European central banks to meet together and discuss current problems. This practice was resumed after the war, and the United States, although not a member, was invited to join in the deliberations. When Marshall Plan aid was furnished by the United States to help European countries in their postwar reconstruction, a European Payments Union was established to facilitate multilateral trade and settlements in advance of the time when it might be possible to reestablish full multilateralism on a world scale. The war had left a jumble of trade restrictions that could not be quickly abolished. The European Payments Union also contained a plan for the provision of credit to European debtors. The United Kingdom was a member, and with it was associated the whole sterling area. Responsibility for working the machinery of the European Payments Union was assigned to the Bank for International Settlements. The European Payments Union was ultimately wound up after the countries of Europe were able to eliminate the last restrictions and make their currencies fully convertible in 1958. In January and February 1961 there was a serious sterling crisis, due partly to the British deficit of 1960 and partly to a large movement of funds in anticipation of an upward valuation of the West German mark, which happened, and thereafter in anticipation of a second upward valuation, which did not happen at that time. To help the British, the Basel Group of central banks provided substantial credits. These were liquidated when the United Kingdom transferred its indebtedness to the International Monetary Fund the following July. The Basel Group has provided further credits from time to time. The problems involved have continued to be discussed at the monthly meetings. The arrangement made for the support of the sterling area in 1968 is noteworthy. After the devaluation of sterling in 1967 it was feared that the monetary authorities of the countries composing the sterling area might wish to reduce their holdings of sterling. Because there was a continuing problem of world liquidity and sterling played an important part as a reserve currency, the international consensus was that any substantial reduction in the holding of sterling as a reserve currency would be damaging to the international monetary system. Under the arrangement made in 1968 the United Kingdom on its side agreed to give a dollar guarantee to the value of the greater part of the sterling-area reserves; there were slightly different arrangements with each monetary authority. On its side the Bank for International Settlement agreed to organize credits to finance payments deficits for some countries of the sterling area, should these occur at times when the United Kingdom might find it difficult to handle them.
The OECD.
The Organisation for European Economic Co-operation (OEEC) was set up in 1948 to make arrangements for the distribution of Marshall Aid among the countries of Europe. When its tasks in this connection were accomplished, it remained in existence, was broadened to include the United States, Canada, and Japan, and it was renamed the Organisation for Economic Co-operation and Development (OECD). It has a permanent staff and headquarters in Paris. It undertakes research on a substantial scale and affords a forum for the discussion of international economic problems. The Working Party No. 3 of the organization's Economic Committee, which is concerned with problems of money and exchange, has made significant contributions; it issued a very important report on balance-of-payments adjustment problems in 1966. At times the personnel of the Working Party has been much the same as that of the deputies of the Group of Ten. The Organisation for Economic Co-operation and Development has also set up an organization called the Development Assistance Committee, concerned with problems of assistance to the developing countries.
Swap agreements.
The informal system of swap agreements provides a mutual arrangement between central banks for standby credits designed to see countries through difficulties on the occasions of large movements of funds. These are intended only to offset private international flows of capital on precautionary or speculative account, not to finance even temporary deficits in countries' balance of payments. Arranged ad hoc and informally, they depend on the mutual goodwill and trust of the central banks involved. The system of credits, although informal, must be reckoned as important, because they are of large amount.
The end of pegged exchange rates.
The crisis of the dollar.
The monetary system established by the IMF in 1944 underwent profound changes in the 1970s. This system had assumed that the dollar was the strongest currency in the world because the United States was the strongest economic power. Other countries were expected to have difficulty from time to time in stabilizing their exchange rates and would need assistance in the form of credits from the IMF, but the dollar was expected to remain stable enough to function as a substitute for gold in international transactions. In the second half of the 1960s these assumptions came into question. The war in Vietnam led to inflation. The flood of dollars into other countries caused difficulty for the European central banks, which were forced to increase their dollar holdings in order to maintain their currencies at the established exchange rates. As the flood continued in 1971, the West German and Dutch governments decided to let their currencies float--that is, to let their exchange rates fluctuate beyond their assigned parities. Austria and Switzerland revalued their currencies upward in relation to the dollar. These measures helped for a time, but in August the outflow of dollars resumed. On August 15 Pres. Richard M. Nixon suspended the U.S. commitment made in 1934 to convert dollars into gold, effectively ending the postwar monetary system established by the IMF. Most of the major trading countries decided to abandon fixed exchange rates temporarily and let their currencies find their own values in relation to the dollar.
The Smithsonian Agreement and after.
On Dec. 17 and 18, 1971, representatives of the Group of Ten met at the Smithsonian Institution in Washington, D.C., and agreed on a realignment of currencies and a new set of pegged exchange rates. The dollar was devalued in terms of gold, while other currencies were appreciated in terms of the dollar. On the whole, the dollar was devalued by nearly 10 percent in relation to the other Group of Ten currencies (those of the United Kingdom, Canada, France, West Germany, Italy, The Netherlands, Belgium, Sweden, and Japan). Several months after the Smithsonian Agreement, the six members of the European Economic Community (EEC) agreed to maintain their exchange rates within a range of 2.25 percent of parity with each other. The Smithsonian Agreement proved to be only a temporary solution to the international currency crisis. A second devaluation of the dollar (by 10 percent) was announced in February 1973, and not long afterward Japan and the EEC countries decided to let their currencies float. At the time, these were thought of as temporary measures to cope with speculation and capital shifts; it was, however, the end of the system of established par values.
FLOATING EXCHANGE RATES
The floating exchange-rate system emerged when the old IMF system of pegged exchange rates collapsed. The case for the pegged exchange rate is based partly on the deficiencies of alternative systems. The IMF system of adjustable pegs proved unworkable in a world in which there were huge volumes of internationally mobile financial capital that could be shifted out of countries in balance-of-payments difficulties and into the stronger nations. The earlier gold standard system had likewise contained substantial defects. Under some circumstances, it required countries to go through a painful deflation. The gold standard, it is widely held, made the Great Depression of the 1930s even deeper than it might otherwise have been. Three major, interrelated hopes were expressed when flexible exchange rates replaced the collapsing IMF system of pegged exchange rates in the early 1970s. First, flexible exchange rates would allow currencies to hold at or near their fundamental equilibrium values; national authorities would not feel obliged to defend exchange rates that were severely out of line. Second, deficit countries would be able to reestablish their international competitiveness without going through the painful deflationary process required by the old gold standard and without facing the political embarrassment of abandoning an established par value. Finally, the national monetary authorities would have a substantial degree of independence to pursue the most appropriate domestic monetary and fiscal policies, without being severely constrained by balance-of-payments pressures. In practice, exchange-rate flexibility turned out to be more complicated than its proponents had anticipated.
Exchange-rate fluctuations.
The pegged exchange-rate system collapsed in two speculative flurries against the U.S. dollar in 1971 and 1973. In each case, the dollar depreciated about 10 percent in terms of an average of other currencies. (In calculating an average exchange rate for the dollar, the currencies of each other nation is weighted according to the volume of trade of that nation with the United States.) After these initial adjustments, exchange rates of the major trading nations were generally quite stable for the next four years (late 1973-77), although there were some fluctuations. The dollar strengthened following the first oil shock, which occurred in 1973-74; because the United States still produced most of the oil it consumed, it was expected to be less severely shaken by high oil prices than would its major trading partners, especially West Germany and Japan. In the 1973-77 period, the major exchange-rate change was a fall in the British pound sterling by about 30 percent when measured in terms of dollars. In late 1977 the dollar entered a period of instability. As the U.S. economy expanded and inflation increased, U.S. goods became less competitive on world markets. In response, the dollar began to slide downward. This raised the price of imported goods in the United States, adding to inflationary pressures. The United States seemed in danger of entering a wage-price-exchange rate spiral. Anticipating worse to come, speculators began to unload dollars, moving the exchange value of the dollar even lower. During the 1977-79 period, the average exchange value of the dollar declined by about 15 percent. Faced with a rapidly deteriorating situation, the United States tightened its domestic policies sharply. In particular, monetary policy was tightened in order to combat the rapid inflation. This experience provided one early, important lesson about flexible exchange rates. Even though flexible exchange rates provide some independence for domestic monetary policies, domestic policies cannot be made without concern for international complications. This is true even for a large, prosperous economy, such as that of the United States. During the late 1970s, the U.S. dollar was threatened with a collapse. By the mid-1980s the opposite had occurred: the dollar had soared--rising about 80 percent. A number of forces contributed to this rise. One was U.S. fiscal policy: tax rates were cut sharply, and budgetary deficits ballooned. Large-scale government borrowing added to the demands on financial markets, leading to high interest rates. This encouraged foreign asset holders to buy U.S. bonds. To do so, they bought dollars, creating upward pressure on the exchange value of the dollar. In turn, the high dollar made it difficult for U.S. producers to compete on world markets. U.S. imports rose briskly; exports were relatively sluggish, and the U.S. trade deficit soared. Because of strong competition from imports, U.S. producers of automobiles, textiles, and a number of other products lobbied for protection. Under the threat of unilateral U.S. actions, the government of Japan was persuaded to impose "voluntary" limits on exports of cars to the United States. There were concerns--both in the United States and in its trading partners--that the United States might adopt a much more protectionist policy because the high exchange value of the dollar was making it so difficult for U.S. producers to compete. Faced with this unwelcome prospect, senior officials of the "Group of Five" (France, West Germany, Japan, the United Kingdom, and the United States) met at the Plaza Hotel in New York City in 1985. In the "Plaza Agreement," they declared their intention to bring the dollar down to a more competitive level, if necessary by official sales of dollars on exchange markets. This episode raised fundamental questions about flexible exchange rates, leading some financial experts to suggest an intermediate system between freely flexible exchange rates and the old IMF system of adjustable pegs. With sizable exchange-market interventions by governments and central banks, exchange rates were not freely flexible. They were being managed by the authorities. (Such a managed floating rate is sometimes called a "dirty" float.) Some experts supported more active exchange-rate management in order to prevent currencies from becoming severely misaligned. Governments were advised to declare "target zones" for exchange rates and to buy or sell currencies whenever needed to keep exchange rates within these zones--moving the target zones as fundamental economic conditions changed. The concept was to avoid large exchange-rate swings.
THE INTERNATIONAL DEBT CRISIS
Developing nations have traditionally borrowed from the developed nations to support their economies. In the 1970s such borrowing became quite heavy among certain developing countries, and their external debt expanded at a very rapid, unsustainable rate. The result was an international financial crisis. Countries such as Mexico and Brazil declared that they could not keep up with the schedule of interest and principal payments, causing severe reactions in the financial world. Cooperating with creditor nations and the IMF, these countries were able to reschedule their debts--that is, delay payments to remove financial pressure. But the underlying problem remained--developing countries were saddled with staggering debts that totaled more than $800,000,000,000 by the mid-1980s. For the less-developed countries as a whole (excluding the major oil exporters), debt service payments were claiming more than 20 percent of their total export earnings. The large debts created huge problems for the developing countries and for the banks that faced the risk of substantial losses on their loan portfolios. Such debts increased the difficulty of finding funds to finance development. In addition, the need to acquire foreign currencies to service the debt contributed to a rapid depreciation of the currencies and to rapid inflation in Mexico, Brazil, and a number of other developing nations. The wide fluctuations in the price of oil were one of the factors contributing to the debt problem. When the price of oil rose rapidly in the 1970s, most countries felt unable to reduce their oil consumption quickly. In order to pay for expensive oil imports, many went deeply into debt. They borrowed to finance current consumption--something that could not go on indefinitely. As a major oil importer, Brazil was one of the nations adversely affected by rising oil prices. Paradoxically, however, the oil-importing countries were not the only ones to borrow more when the price of oil rose rapidly. Some of the oil exporters--such as Mexico--also contracted large new debts. They thought that the price of oil would move continually upward, at least for the foreseeable future. They therefore felt safe in borrowing large amounts, expecting that rapidly increasing oil revenues would provide the funds to service their debts. The price of oil drifted downward, however, making payments much more difficult. The debt reschedulings, and the accompanying policies of demand restraint, were built on the premise that a few years of tough adjustment would be sufficient to get out of such crises and to provide the basis for renewed, vigorous growth. To the contrary, however, some authorities believed that huge foreign debts would act as a continuing drag on growth and could have catastrophic results.
Political Parties and Interest Groups
A political party is a group organized to achieve and exercise power within a political system. An interest group (or special-interest group) is an aggregate of individuals who, bound by one or more concerns or wants, makes claims upon other groups or upon society in general in order to maintain or promote its position or objectives. An interest group that attempts to influence government becomes a "pressure group." It is distinguished from a political party in that, whereas a party puts up candidates for election to public office and carries out activities to secure their election, a pressure group seeks to influence both the government and the parties. The Roman Catholic interest in Italy, for instance, is served by the Christian Democratic Party and also by the Catholic Action Society. The first is a party, and the second is a pressure group. Again the ethnic Swedes in Finland is served by the Swedish People's Party; this is clearly a special-interest group, yet it puts up candidates and is represented in the legislature because it thinks its members think their constituents' interest is best served by exerting pressure as part of a governmental coalition. Thus, what begins as a pressure group may eventually become a political party. The British Labour Party, for example, had its origins in 1900, when trade unionists formed a Labour Representation Committee in order to elect working-class MPs to Parliament; later it broadened its membership and program to become the Labour Party. In France, Pierre Poujade's pressure group, the Union of Small Shopkeepers, was involved in the 1956 elections and won more than 40 seats, thus becoming a political party, before reverting to pressure-group status in 1958. The reverse process can also occur, as when a political party engenders pressure groups; thus, Communist parties set up interest groups for women, youth, workers, and the like.
Political parties
Political parties originated in their modern form in Europe and the United States in the 19th century, along with the electoral and parliamentary systems, whose development reflects the evolution of parties. The term party has since come to be applied to all organized groups seeking political power, whether by democratic elections or by revolution. In earlier, prerevolutionary, aristocratic and monarchical regimes, the political process unfolded within restricted circles in which cliques and factions, grouped around particular noblemen or influential personalities, were opposed to one another. The establishment of parliamentary regimes and the appearance of parties at first scarcely changed this situation. To cliques formed around princes, dukes, counts, or marquesses there were added cliques formed around bankers, merchants, industrialists, and businessmen. Regimes supported by nobles were succeeded by regimes supported by other elites. These narrowly based parties were later transformed to a greater or lesser extent, for in the 19th century in Europe and America there emerged parties depending on mass support. The 20th century saw the spread of political parties throughout the entire world. In Africa large parties have sometimes been formed in which a modern organization has a more traditional ethnic or tribal basis; in such cases the party leadership is frequently made up of tribal chiefs. In certain areas of Asia, membership in modern political parties is often determined largely by religious factors or by affiliation with ritual brotherhoods. Many political parties in the developing countries are partly political, partly military. Certain Socialist and Communist parties in Europe earlier experienced the same tendencies. These last-mentioned European parties have demonstrated an equal aptitude for functioning within multiparty democracies and as the sole political party in a dictatorship. Developing originally within the framework of liberal democracy in the 19th century, political parties have been used in the 20th century by dictatorships for entirely undemocratic purposes.
TYPES OF POLITICAL PARTY
A fundamental distinction can be made between cadre parties and mass-based parties. The two forms coexist in many countries, particularly in western Europe, where Communist and Socialist parties have emerged alongside the older conservative and liberal parties. Many parties do not fall exactly into either category but combine some characteristics of both.
Cadre parties.
Cadre parties--i.e., parties dominated by politically elite groups of activists--developed in Europe and America during the 19th century. Except in some of the states of the United States, France from 1848, and the German Empire from 1871, the suffrage was largely restricted to taxpayers and property owners, and, even when the right to vote was given to larger numbers of people, political influence was essentially limited to a very small segment of the population. The mass of people were limited to the role of spectators rather than that of active participants.
The cadre parties of the 19th century reflected a fundamental conflict between two classes: the aristocracy on the one hand and the bourgeoisie on the other. The former, composed of landowners, depended upon rural estates on which a generally unlettered peasantry was held back by a traditionalist clergy.
The bourgeoisie, made up of industrialists, merchants, tradesmen, bankers, financiers, and professional people, depended upon the lower classes of clerks and industrial workers in the cities. Both aristocracy and bourgeoisie evolved its own ideology. Bourgeois liberal ideology developed first, originating at the time of the English revolution of the 17th century in the writings of John Locke, an English philosopher. It was then developed by French philosophers of the 18th century. In its clamouring for formal legal equality and acceptance of the inequities of circumstance, liberal ideology reflected the interests of the bourgeoisie, who wished to destroy the privileges of the aristocracy and eliminate the lingering economic restraints of feudalism and mercantilism. But, insofar as it set forth an egalitarian ideal and a demand for liberty, bourgeois classical liberalism expressed aspirations common to all men.
Conservative ideology, on the other hand, never succeeded in defining themes that would prove as attractive, for it appeared to be more closely allied to the interests of the aristocracy. For a considerable period, however, conservative sentiment did maintain a considerable impact among the people, since it was presented as the expression of the will of God. In Catholic countries, in which religion was based upon a hierarchically structured and authoritarian clergy, the conservative parties were often the clerical parties, as in France, Italy, and Belgium.
Conservative and liberal cadre parties dominated European politics in the 19th century. Developing during a period of great social and economic upheaval, they exercised power largely through electoral and parliamentary activity. Once in power, their leaders used the power of the army or of the police; the party itself was not generally organized for violent activity. Its local units were charged with assuring moral and financial backing to candidates at election time, as well as with maintaining continual contact between elected officials and the electorate. The national organization endeavoured to unify the party members who had been elected to the assemblies. In general, the local committees maintained a basic autonomy and each legislator a large measure of independence. The party discipline in voting established by the British parties--which were older because of the fact that the British Parliament was long established--was imitated on the Continent hardly at all.
The first United States political parties of the 19th century were not particularly different from European cadre parties, except that their confrontations were less violent and based less on ideology. The first United States form of the struggle between the aristocracy and the bourgeoisie, between conservative and liberal, was carried out in the form of the Revolutionary War, in which Great Britain embodied the power of the king and the nobility, and the insurgents that of bourgeoisie and liberalism. Such an interpretation is, of course, simplified. There were some aristocrats in the South and, in particular, an aristocratic spirit based on the institutions of slaveholding and paternalistic ownership of land. In this sense, the Civil War could be considered as a second phase of violent conflict between the conservatives and the liberals. Nevertheless, the United States was from the beginning an essentially bourgeois civilization, based on a deep sense of equality and of individual freedom. Federalists and Anti-Federalists, Republicans and Democrats--all belonged to the liberal family since all shared the same basic ideology and the same system of fundamental values and differed only in the means by which they would realize their beliefs.
In terms of party structure, United States parties in the beginning differed little from their European counterparts. Like them, the United States parties were composed of local notables. The ties of a local committee to a national organization were even weaker than in Europe. At the state level there was some effective coordination of local party organizations, but at the national level such coordination did not exist. A more original structure was developed after the Civil War--in the South to exploit the vote of the blacks and along the East Coast to control the votes of immigrants. The extreme decentralization in the United States enabled a party to establish a local quasi-dictatorship in a city or county by capturing all of the key posts in an election. Not only the position of mayor but also the police, finances, and the courts came under the control of the party machine, and the machine was thus a development of the original cadre parties. The local party committee came typically to be composed of adventurers or gangsters who wanted to control the distribution of wealth and to ensure the continuation of their control. These men were themselves controlled by the power of the boss, the political leader who controlled the machine at the city, county, or state levels. At the direction of the committee, each constituency was carefully divided, and every precinct was watched closely by an agent of the party, the captain, who was responsible for securing votes for the party. Various rewards were offered to voters in return for the promise of their votes. The machine could offer such inducements as union jobs, trader's licences, immunity from the police, and the like. Operating in this manner, a party could frequently guarantee a majority in an election to the candidates of its choosing, and, once it was in control of local government, of the police, the courts, and public finances, etc., the machine and its clients were assured of impunity in illicit activities such as prostitution and gambling rings and of the granting of public contracts to favoured businessmen. The degeneration of the party mechanism was not without benefits. The European immigrant who arrived in the United States lost and isolated in a huge and different world might find work and lodging in return for his commitment to the party. In a system of almost pure capitalism and at a time when social services were practically nonexistent, machines and bosses took upon themselves responsibilities that were indispensable to community life. But the moral and material cost of such a system was very high, and the machine was often purely exploitative, performing no services to the community. By the end of the 19th century the excesses of the machines and the bosses and the closed character of the parties led to the development of primary elections, in which party nominees for office were selected. The primary movement deprived party leaders of the right to dictate candidates for election. A majority of the states adopted the primary system in one form or another between 1900 and 1920. The aim of the system was to make the parties more democratic by opening them up to the general public in the hope of counterbalancing the influence of the party committees. In practice, the aim was not realized, for the committees retained the upper hand in the selection of candidates for the primaries. In its original form the British Labour Party constituted a new type of cadre party, forming an intermediate link with the mass-based parties. It was formed with the support of trade unions and left-wing intellectuals. At the base, each local organization sent representatives to a district labour committee, which was in turn represented at the national congress. The early (pre-1918) Labour Party was thus structured of many local and regional organizations. It was not possible to join the party directly; membership came only through an affiliated body, such as a trade union. It thus represented a new type of party, depending not upon highly political individuals brought together as a result of their desire to acquire and wield power but upon the organized representatives of a broader interest--the working class. Certain Christian Democrat parties--the Belgian Social Christian Party between the two world wars and the Austrian Popular Party, for example--had an analogous structure: a federation of unions, agricultural organizations, middle class movements, employers' associations, etc. After 1918, the Labour Party developed a policy of direct membership on the model of the continental Socialist parties, individual members being permitted to join local-constituency branches. The majority of its membership, however, continued to be affiliated rather than direct.
Mass-based parties.
Cadre parties normally organize a relatively small number of party adherents. Mass-based parties, on the other hand, unite hundreds of thousands of followers, sometimes millions. But the number of members is not the only criterion of a mass-based party. The essential factor is that such a party attempts to base itself on an appeal to the masses. It attempts to organize not only those who are influential or well known or those who represent special interest groups but rather any citizen who is willing to join the party. If such a party succeeds in gathering only a few adherents, then it is mass based only in potential. It remains, nevertheless, different from the cadre-type parties. At the end of the 19th century the Socialist parties of continental Europe organized themselves on a mass basis in order to educate and to organize the growing population of labourers and wage earners, which industrialization was making increasingly large and which was becoming more important politically because of extensions of the suffrage, and to gather the money necessary for propaganda by mobilizing in a regular fashion the resources of those who, although poor, were numerous. Membership campaigns were conducted, and each member paid party dues. If its members became sufficiently numerous, the party emerged as a powerful organization, managing large funds and diffusing its ideas among an important segment of the population. Such was the case with the German Social Democratic Party, which by 1913 had more than 1,000,000 members. Such organizations were necessarily rigidly structured. The party required an exact registration of membership, treasurers to collect dues, secretaries to call and lead local meetings, and a hierarchical framework for the coordination of the thousands of local sections. A tradition of collective action and group discipline, more developed among workers as a result of their participation in strikes and other union activity, favoured the development and centralization of party organization. A complex party organization tends to give a great deal of influence to those who have responsibility at various levels in the hierarchy, resulting in certain oligarchical tendencies. The Socialist parties made an effort to control this tendency by developing democratic procedures in the choice of leaders. At every level those in responsible positions were elected by members of the party. Every local party group would elect delegates to regional and national congresses, at which party candidates and party leaders would be chosen and party policy decided. The type of mass-based party described above was imitated by many non-Socialist parties. Some cadre-type parties in Europe, both conservative and liberal, attempted to transform themselves along similar lines. The Christian Democrat parties often developed organizations copied even more directly from the mass-based model. But non-Socialist parties were generally less successful in establishing rigid and disciplined organizations. The first Communist parties were splinter groups of existing Socialist parties and at first adopted the organization of these parties. After 1924, as a result of a decision of the Comintern (the Third International, or federation of working class parties), all Communist parties were transformed along the lines of the Soviet model, becoming mass parties based on the membership of the largest possible number of citizens, although membership was and is limited to those who embraced and espoused the ideology of Marxism-Leninism. The Communist parties developed a new structural organization: whereas the local committees of cadre and Socialist parties focussed their organizing efforts and drew their support from a particular geographical area, Communist groups formed their cells in the place of work. The work-place cell was the first original element in Communist party organization. It grouped together all party members who depended upon the same firm, workshop, or store or the same professional institution (school or university, for example). Party members thus tended to be tightly organized, their solidarity, resulting from a common occupation, being stronger than that based upon residence. The work-place-cell system proved to be effective, and other parties tried to imitate it, generally without success. Such an organization leads each cell to concern itself with problems of a corporate and professional nature rather than with those of a more political nature. These basic groups, however, smaller and, therefore, more numerous than the Socialist sections, tend to go their separate way. It is necessary to have a very strong party structure and for party leaders to have extensive authority if the groups are to resist such centrifugal pressure. This has resulted in a second distinctive characteristic of the Communist parties: a high degree of centralization. Although all mass-based parties tend to be centralized, Communist parties are more so than others. There is, in principle, free discussion, which is supposedly developed at every level before a decision is made, but afterward all must adhere to the decision that has been made by the central body. The splintering that has from time to time divided or paralyzed the Socialist parties is forbidden in Communist parties, which have generally succeeded in maintaining their unity. A further distinctive characteristic of Communist parties is the importance given to ideology. All parties have a doctrine or at least a platform. The European Socialist parties, which were doctrinaire before 1914 and between the two wars, later became more pragmatic, not to say opportunistic. But, in Communist parties, ideology occupies a much more fundamental place, a primary concern of the party being to indoctrinate its members with Marxism. The 1920s and '30s saw the emergence of Fascist parties that attempted, as do the Communist and Socialist parties, to organize the maximum number of members but that did not claim to represent the great masses of people. Their teaching was authoritarian and elitist. They thought that societies should be directed by the most talented and capable people--by an elite. The party leadership, grouped under the absolute authority of a supreme head, constituted such an elite. Party structure had as its goal the assurance of the obedience of the elite. This structure resembled that of armies, which are also organized in such a way as to ensure, by means of rigorous discipline, the obedience of a large number of men to an elite leadership. The party structure, therefore, made use of a military-type organization, consisting of a pyramid made up of units that at the base were very tiny but that, when joined with other units, formed groups that got larger and larger. Uniforms, ranks, orders, salutes, marches, and unquestioning obedience were all aspects of Fascist parties. This similarity rests upon another factor; namely, that Fascist doctrine taught that power must be seized by organized minorities making use of force. The party thus made use of a militia intended to assure victory in the struggle for control over the unorganized masses. Large parties built upon the Fascist model developed between the two wars in Italy and Germany, where they actually came into power. Fascist parties appeared also in most other countries of western Europe during this period but were unable to achieve power. The less-developed nations of eastern Europe and Latin America were equally infected by the movement. The victory of the Allies in 1945, as well as the revelation of the horrors of Nazism, stopped the growth of the Fascists and provoked their decline, but Fascist-type party organization and doctrine remain a potent means of exercising power.
PARTIES AND POLITICAL POWER
Whether they are conservative or revolutionary, whether they are a union of notables or an organization of the masses, whether they function in a pluralistic democracy or in a monolithic dictatorship, parties have one function in common: they all participate to some extent in the exercise of political power, whether by forming a government or by exercising the function of opposition, a function that is often of crucial importance in the determination of national policy.
The struggle for power.
It is possible in theory to distinguish revolutionary parties, which attempt to gain power by violence (conspiracies, guerrilla warfare, etc.), from those parties working within the legal framework of elections. But the distinction is not always easy to make, because the same parties may sometimes make use of both procedures, either simultaneously or successively, depending upon the circumstances. In the 1920s, for example, Communist parties sought power through elections at the same time that they were developing an underground activity of a revolutionary nature. In the 19th century, liberal parties were in the same situation, sometimes employing the techniques of conspiracy, as in Italy, Austria, Germany, Poland, and Russia, and sometimes confining their struggles to the ballot box, as in Great Britain and France. Revolutionary methods vary greatly. Clandestine plots by which minority groups seize the centres of power presuppose monarchies or dictatorships in which the masses of people have little say in government. But terrorist and disruptive activity can serve to mobilize citizens and to demonstrate the powerlessness of any government. At the beginning of the 20th century leftist trade unionists extolled the revolutionary general strike, a total stoppage of all economic activity that would paralyze society completely and put the government at the revolutionaries' mercy. Rural guerrilla activity has often been used in countries with a predominantly agrarian society; urban guerrilla warfare was effective in the European revolutions of the 19th century, but the development of techniques of police and military control has made such activity more difficult. Revolutionary parties are less numerous than parties that work within the law: the contest at election time is the means normally used in the struggle for power. Such activity corresponds, morever, to the original nature of political parties and involves three factors: the organization of propaganda, the selection of candidates, and the financing of campaigns. The first function is the most visible. The party first of all gives the candidate a label that serves to introduce him to the voters and to identify his position. Because of
this party label the voters are better able to distinguish the candidates. The promises and declarations of individuals are seldom taken with too much seriousness, and it means more to indicate that one candidate is a Communist, another a Socialist, a third a Fascist, and a fourth a liberal. Finally, the party also furnishes the candidate with workers to raise funds, put up his posters, distribute his literature, organize his meetings, and canvass from door to door. The function of selecting candidates is exercised in three ways. In cadre parties, candidates are selected by committees of the party activists who make up the party -- the caucus system, as it is known in the United States. In general, local committees play essential roles in this regard. In some countries, however, the selection is centralized by a national caucus, as, for example, by the Conservative Party in Britain and the Union of Democrats in France. In mass-based parties, selection is made by members of the regional and national congresses according to apparently democratic procedures; in actual practice, the governing committees play an essential role, the local constituency members generally ratifying their choice. Thirdly, in the United States the mechanism of primary elections has established a system for selecting candidates by means of the votes of all party members or all voters within a particular electoral district. The various processes of selecting candidates do not, however, differ significantly in their results, for it is almost always the party leaders who play the essential role. This introduces an oligarchical tendency into party politics, a tendency that has not been overcome by the congresses of the mass-based parties or the United States primaries, which provide only a partial limitation on the power of the governing committees. An important aspect of the struggle for power between political parties is the financing of campaigns. Cadre parties always have in their committees some key figure having connections with businessmen who is responsible for collecting gifts from them. In mass-based parties, rather than looking for large sums of money from a few people, leaders gather smaller sums from a large number of people who usually give on a monthly or annual basis. This method has been viewed as one of the distinguishing characteristics of mass-based parties. Sometimes the law intervenes in the financing of elections and of parties. Laws often limit campaign expenses and attempt to restrict the resources of the parties, but they are generally inoperative because it is quite easy to circumvent them. In some countries the state contributes public funds to the parties. At first, such financial participation was limited to expenses for campaigns and was based on the uniform treatment of candidates (as in France), but in Sweden and Finland the state contributes to the general finances of parties.
Participation in power.
Only the functions of parties in democratic regimes will be considered at this time. The role of the single party in a dictatorship will be analyzed separately. Once a political party has achieved electoral victory, the question arises of how much influence the party is to have on the government. The influence of the party on members in elective office is frequently quite weak. It defines the general lines of their activity, but these lines can be quite hazy, and few decisions are taken in the periodic meetings between officeholders and their party. Each member of the legislature retains personal freedom of action in his participation in debates, in his participation in government, and, especially, in his voting. The party may, of course, attempt to enforce the party line, but parliamentary or congressional members cannot be compelled to vote the way the party wants them to. Such is the situation in the United States, within most of the liberal and conservative European parties, and within cadre parties in general. The question of how disciplined a party is, of the extent to which it will always present a united front, enables a distinction to be made between what may be termed rigid and flexible parties; that is, between those that attempt always to be united and disciplined, following what is most often an ideologically based party line, and those that, representing a broader range of interests and points of view, form legislatures that are assemblies of individuals rather than of parties. Whether the parties operating within a particular system will be rigid or flexible depends largely on the constitutional provisions that determine the circumstances in which a government may continue in office. This is clearly illustrated by comparing the situation in the United States with that in Great Britain. In the United States the president and his government continue in office for the constitutionally defined period of four years, regardless of whether a majority in the legislature supports him or not. Since a united party is thus not crucial to the immediate survival of the government, both major parties are able to contain broad coalitions of interests, and votes on issues of major importance frequently split each party. In the United Kingdom the situation is quite different. There, government can continue in office only so long as it commands a majority in the legislature. A single adverse vote can result in the dissolution of Parliament and a general election. Party discipline and unity are thus of crucial importance, and this fact has far-reaching consequences for the composition, organization, and policies of each party. The consequences of party disunity within such a constitutional framework are well illustrated by the weakness and instability of the governments of the Third and Fourth French republics. The distinction between flexible and rigid parties applies equally to parties in power and to those forming the opposition. Votes of censure or of lack of confidence, votes on proposed legislation or on the budget, questions put to ministers or challenges made to them--in short, all the functions of an opposition party--are worked out differently in flexible and rigid party systems. In flexible party systems the absence of strong discipline is often of great consequence to the opposition party because only rigid parties can constitute an opposition force sufficiently strong to counterbalance the strength of the party in power. At the same time, party discipline permits the opposition to present the public with an alternative to the majority party; the logical consequence of such a situation is Britain's "shadow cabinet," which accustoms the electorate to the idea that a new group is ready to take over the reins of government. Parties provide, moreover, a channel of communication between opposition legislators and the public. The governing party performs a similar service for the government, although it is less necessary, since the government has at its disposal numerous means of communicating with the public. Opposition parties thus provide a means of expressing negative reaction to decisions of government and proposing alternatives. This role justifies the official recognition given to opposition parties, as is the case in Great Britain and Scandinavia.
Power and representation.
It is difficult to envisage how representative democracy could function in a large industrialized society without political parties. In order for citizens to be able to make an intelligent choice of representative or president, it is necessary for them to know the real political orientation of each candidate. Party membership provides the clearest indication of this. The programs and promises of each individual candidate are not too significant or informative, because most candidates, in their attempt to gain the most votes, try to avoid difficult subjects; they all tend to speak the same language; that is, to camouflage their real opinions. The fact that one is a Socialist, another a conservative, a third a liberal, and a fourth a Communist provides a far better clue as to how the candidate will perform when in office. In the legislature the discipline of the party limits the possibility that elected representatives will change their minds and their politics, and thus the party label acts as a sort of guarantee that there will be at least some correspondence between promise and performance. Parties make possible the representation of varying shades of opinion by synthesizing different positions into a stance that each representative adopts to a greater or lesser extent. But parties, like all organizations, tend to manipulate their members, to bring them under the control of an inner circle of leaders that often perpetuates itself by cooptation. In cadre parties, members are manipulated by powerful committees containing cliques of influential party leaders. In mass-based parties, leaders are chosen by the members, but incumbents are very often re-elected because they control the party apparatus, using it to ensure their continuation in power. Democratic political systems, while performing the function of representation, thus rest more or less on the competition of rival oligarchies. But these oligarchies consist of political elites that are open to all with political ambition. No modern democracy could function without parties, the oligarchical tendencies of which are best regarded as a necessary evil.
PARTY SYSTEMS
Party systems may be broken down into three broad categories: two-party, multiparty, and single-party. Such a classification is based not merely on the number of parties operating within a particular country but on a variety of distinctive features that the three systems exhibit. Two-party and multiparty systems represent means of organizing political conflict within pluralistic societies and are thus part of the apparatus of democracy. Single parties usually operate in situations in which genuine political conflict is not tolerated. This broad statement is, however, subject to qualification, for, although single parties do not usually permit the expression of points of view that are fundamentally opposed to the party line or ideology, there may well be intense conflict within these limits over policy within the party itself. And even within a two-party or a multiparty system, debate may become so stymied and a particular coalition of interests so entrenched that the democratic process is seriously compromised. The distinction between two-party and multiparty systems is not as easily made as it might appear. In any two-party system there are invariably some tiny parties in addition to the two major parties, and there is always the possibility that such small parties might prevent one of the two main parties from gaining a majority of seats in the legislature. This is the case with regard to the Liberal Party in Great Britain, for example. Other countries do not fall clearly into either category; thus, Austria and the Federal Republic of Germany only approximate the two-party system. It is not simply a question of the number of parties that determines the nature of the two-party system; many other elements are of importance, the extent of party discipline in particular.
Multiparty systems.
In Anglo-Saxon countries there is a tendency to consider the two-party system as normal and the multiparty system as the exceptional case. But, in fact, the two-party system that operates in Great Britain, the United States, and New Zealand is much rarer than the multiparty system, which is found in almost all of western Europe. In western Europe, three major categories of parties have developed since the beginning of the 19th century: conservative, liberal, and Socialist. Each reflects the interests of a particular social class and expounds a particular political ideology. After World War I other categories of parties developed that were partly the result of divisions or transformations of older parties. Communist parties began as splinter groups of Socialist parties, and Christian Democrat parties attempted to weld together moderate Socialists and conservatives and some liberals. Other distinctive types of party emerged in some countries. In Scandinavia, liberal rural parties developed in the 19th century, reflecting a long tradition of separate representation of the rural population. In many countries ethnic minorities formed the basis of nationalist parties, which then either joined existing parties or divided them. The appearance of Socialism in the 19th century upset the earlier lines of battle between conservatives and liberals and tended to throw the latter two groups into a common defense of capitalism. Logically, this situation should have led to the fusion of conservatives and liberals into one bourgeois party that would have presented a united stand against Socialism. This is, in fact, what happened in Great Britain after World War I. One of the most important factors determining the number of parties operating within a particular country is the electoral system. Proportional representation tends to favour the development of multiparty systems because it ensures representation in the legislature for even small parties. The majority, single-ballot system tends to produce a two-party system, because it excludes parties that may gain substantial numbers of votes but not the majority of votes necessary to elect a representative within a constituency. The majority system with a second ballot favours a multiparty system tempered by alliances between parties. Such a system is very rare, found only in the German Empire (1871-1914) and in the French Third (1870-1940) and Fifth (since 1958) republics. Voters choose between the parties that did best in a first ballot. This leaves small parties at a disadvantage but, nevertheless, gives them opportunity to strengthen their role during the second balloting as long as they are willing to enter into alliances with the leading parties. Another factor producing multiparty systems is the intensity of political conflicts. If, within a given political movement, extremists are numerous, then it is difficult for the moderates in that party to join with them in a united front. Two rival parties are likely to be formed. Thus, the power of the Jacobins among 19th-century French liberals contributed to the inability of the moderates to form one great liberal party, as was successfully achieved in Great Britain. Likewise, the power of the extremists among the conservatives was an obstacle to the development of a strong conservative party. The distinction between the multiparty system and the two-party system corresponds largely to a distinction between two types of Western political regime. In a two-party situation the administration has, in effect, an assurance of a majority in the legislature, deriving from the predominance of one party; it has, therefore, a guarantee of continuance and effectiveness. Such a system is often referred to as majority parliamentarianism. In a multiparty situation, on the other hand, it is quite rare for one party to have a majority in the legislature; governments must, therefore, be founded on coalitions, which are always more heterogeneous and more fragile than a single party. The result is less stability and less political power. Such systems may be referred to as nonmajority parliamentarianism. In practice, majority and nonmajority parliamentary systems do not coincide exactly with two-party systems and multiparty systems. For, if each of the two parties is flexible and does not control the voting patterns of its members (as is the case in the United States), the numerical majority of one of the parties matters little. It can happen, moreover, that one party in a multiparty system will hold an absolute majority of seats in the legislature so that no coalition is required. Such a situation is unusual but did occur in West Germany, Italy, and Belgium at various times after 1945. Ordinarily, however, a coalition will be the only means of attaining a parliamentary majority within the framework of the multiparty system. Coalitions are by nature more heterogeneous and more unstable than a grouping made up of one party, but their effectiveness varies greatly according to the discipline and organization of the parties involved. In the case of flexible parties that are undisciplined and that allow each legislator to vote on his own, the coalition will be weak and probably short-lived. The instability and weakness of governments is at its maximum in such situations, of which the Third French Republic provides a good example. If, on the other hand, the parties involved in a coalition are rigid and disciplined, it is possible for a system quite similar to the two-party system to develop. This is often the case when two opposing alliances are formed, one on the left and one on the right, and when both are strong enough to endure through the legislative session. This type of coalition, referred to as bipolarized, introduces elements of the two-party system into a multiparty framework. A situation of this type has developed in Sweden, where conservative, liberal, and agrarian parties have been aligned against the Social Democrat Party, which eventually allied itself with the Communist Party (1970). The system of bipolar alliances may be contrasted with the system of a centrist alliance. Rather than the parties on the right forming a centre-right coalition to oppose a centre-left coalition, there is the possibility that the centre-left and the centre-right will join forces and reject the extremes at both ends of the political spectrum. Such a situation occurred in Germany during the Weimar Republic, when the government rested on a majority formed of a coalition of Catholic Centrists and Social Democrats, with opposition coming from the Communists and the nationalists on the extreme left and right. Centrist coalitions all tend to give the average citizen a sense of political alienation. In rejecting both extremes, coalitions may well be isolating the radical, unstable elements, but the governing coalition may tend to be unresponsive to new ideas, uninspiringly pragmatic, and too ready to compromise. This situation gives rise to a more or less permanent breach between practical politics and political ideals. An advantage of bipolarization or of the two-party system is that the moderates of both sides must collaborate with those who are more extreme in their views, and the extremists must be willing to work with those who are more moderate; the pressure from the extremists prevents the moderates from getting bogged down, while collaboration with the moderates lends a touch of realism to the policies of the extremists.
Two-party systems.
A fundamental distinction must be made between the two-party system as it is found in the United States and as it is found in Great Britain. Although two major parties dominate political life in the two countries, the system operates in quite different ways.
The American two-party system.
The United States has always had a two-party system, first in the opposition between the Federalists and the Anti-Federalists, then in the competition between the Republicans and the Democrats. There have been frequent third-party movements in the history of the country, but they have always failed. Presidential elections seem to have played an important role in the formation of this type of two-party system. The mechanism of a national election in so large a country has necessitated very large political organizations and, at the same time, relatively simplified choices for the voter. American parties are different from their counterparts in other Western countries. They are not tied in the same way to the great social and ideological movements that have so influenced the development of political life in Europe during the last two centuries. There have been Socialist parties at various times in the history of the United States, but they have never challenged the dominance of the two major parties. It can be argued that the main reason for the failure of Socialist parties in America has been the high degree of upward mobility permitted by a rich and continually expanding economy. The consequence of this mobility has been that class consciousness has never developed in the United States in a manner that would encourage the formation of large Socialist or Communist parties. In comparison with European political movements, therefore, American parties have appeared as two varieties of one liberal party, and within each party can be found a wide range of opinion, going from the right to the left. The American parties have a flexible and decentralized structure, marked by the absence of discipline and rigid hierarchy. This was the structure of most of the cadre-type parties of the 19th century, a structure that most liberal parties have retained. Federalism and a concern for local autonomy accentuate the lack of rigid structure and the weakness of lines of authority in the parties. Organization may be relatively strong and homogeneous at the local level, but such control is much weaker on the state level and practically nonexistent on the national level. There is some truth to the observation that the United States has not two parties but 100--that is, two in each state. But it is also true that each party develops a certain degree of national unity for the presidential election and that the leadership of the president within his party gives the victorious party some cohesion. In voting, Republicans and Democrats are usually found on both sides. An alliance between liberal Republicans and Democrats against conservative Republicans and Democrats tends to develop. But neither bloc is stable, and the alignment varies from one vote to another. As a consequence, despite the existence of a two-party system, no stable legislative majority is possible. In order to have his budget adopted and his legislation passed, the president of the United States must carefully try to gather the necessary votes on every question, bearing the wearisome task of constantly forming alliances. The American two-party system is thus a pseudo-two-party system, because each party provides only a loose framework within which shifting coalitions are formed.
The British two-party system.
Another form of the two-party system is operative in Great Britain and in New Zealand. The situation in Australia is affected somewhat by the presence of a third party, the Country Party. A tight alliance between the Australian Liberal Party and the Country Party introduces, however, a rather rigid bipolarization with the Labour Party. The system thus tends to operate on a two-party basis. Canada also possesses what is essentially a two-party system, Liberals or Conservatives usually being able to form a working majority without the help of the small, regionally based parties. Great Britain has had two successive two-party alignments: Conservative and Liberal prior to 1914 and Conservative and Labour since 1935. The period from 1920 to 1935 constituted an intermediate phase between the two. Britain's Conservative Party is actually a Conservative-Liberal Party, resulting from a fusion of the essential elements of the two great 19th-century parties. Despite the name Conservative, its ideology corresponds to political and economic liberalism. A similar observation could be made about the other major European conservative parties, such as the German Christian Democratic Party and the Belgian Social Christian Party. The British two-party system depends on the existence of rigid parties; that is, parties in which there is effective discipline regarding parliamentary voting patterns. In every important vote, all party members are required to vote as a bloc and to follow to the letter the directives that they agreed upon collectively or that were decided for them by the party leaders. A relative flexibility may at times be tolerated, but only to the extent that such a policy does not compromise the action of the government. It may be admissible for some party members to abstain from voting if their abstention does not alter the results of the vote. Thus, the leader of the majority party (who is at the same time the prime minister) is likely to remain in power throughout the session of Parliament, and the legislation he or she proposes will likely be adopted. There is no longer any real separation of power between the executive and legislative branches, for the government and its parliamentary majority form a homogeneous and solid bloc before which the opposition has no power other than to make its criticisms known. During the four or five years for which a Parliament meets, the majority in power is completely in control, and only internal difficulties within the majority party can limit its power. Since each party is made up of a disciplined group with a recognized leader who becomes prime minister if his or her party wins the legislative elections, these elections perform the function of selecting both the legislature and the government. In voting to make one of the party leaders the head of the government, the British assure the leader of a disciplined parliamentary majority. The result is a political system that is at once stable, democratic, and strong; and many would argue that it is more stable, more democratic, and stronger than systems anywhere else. This situation presupposes that both parties are in agreement with regard to the fundamental rules of a democracy. If a Fascist party and a Communist party were opposed to one another in Great Britain, the two-party system would not last very long. The winner would zealously suppress the opponent and rule alone. The system, of course, does have its weak points, especially insofar as it tends to frustrate the innovative elements within both parties. But it is possible that this situation is preferable to what would happen if the more extreme elements within the parties were permitted to engage in unrealistic policies. The risk of immobility is in fact a problem for any party in a modern industrial society, and not just for those in a two-party situation. The problem is related to the difficulties involved in creating new organizations capable of being taken seriously by an important segment of the population and in revitalizing long-standing organizations encumbered by established practices and entrenched interests.
Single-party systems.
There have been three historical forms of the single-party system: Communist, Fascist, and that found in the developing countries.
The Communist model.
In Communist countries the party is considered to be the spearhead of the urban working class and of other workers united with it (peasants, intellectuals, etc.). Its role is to aid in the building of a Socialist regime during the transitory phase between capitalism and pure Socialism, called the dictatorship of the proletariat. An understanding of the exact role of the party requires an appreciation of the Marxist conception of the evolution of the state. In countries based on private ownership of the means of production, the power of the state, according to the Marxist point of view, is used to further the interests of the controlling capitalists. In the first stage of revolution the power of the state is broken. Power, however, still has to be wielded to prevent counterrevolution and to facilitate the transition to Communism, at which stage coercion will no longer be necessary. Thus, the party, in effect, assumes the coercive functions of the state during the dictatorship of the proletariat or, to be more accurate, during the dictatorship of the party in the name of the proletariat. In all Communist countries, the structure of the party has been determined largely by the need for it to govern firmly while at the same time maintaining its contact with the masses of the people. Party members are a part of the general public, of which they are the most active and most politically conscious members. They remain in contact with the masses by means of a network of party cells that are present everywhere. Party leaders are thus always "listening in on the masses," and the masses are always informed of decisions of party leaders, as long as the communication network is working in both directions. The party is not only a permanent means of contact between the people and party leaders but also a propaganda instrument. Political indoctrination is essential to the survival of Communist parties, and many resources are devoted to it. Indoctrination is accomplished in training schools, by means of "education" campaigns, by censorship, and through the untiring efforts of militants, who play a role similar to that of the clergy in organized religion. The party is thus the guardian of orthodoxy and has the power to condemn and to excommunicate. In the traditional Communist model, the party hierarchy, then, and not the official state hierarchy, has the real power. The first secretary of the party is the most important figure of the regime, and, whether the party leadership is in the hands of one man or several, the party remains the centre of political power. Near the end of the 20th century, however, the Communist model began to change as the centre of power began shifting toward a popularly elected state hierarchy. A younger generation of Communist leaders, openly critical of the party's inefficient, unresponsive, and domineering management of the government--particularly the economy--sought a return to Lenin's original concepts of democratic centralism and socialism. In some countries, democratic concepts were emphasized, and constitutional amendments eliminated the party's official control, clearing the way for a multiparty system.
The Fascist model.
Fascist parties in a single-party state have never played as important a role as Communist parties in an analogous situation. In Italy, the Fascist party was never the single most important element in the regime, and its influence was often secondary. In Spain the Falange never played a crucial role, and in Portugal the National Union was a very weak organization even at the height of dictator António Salazar's strength. Only in Germany did the National Socialist Party have a great influence on the state. But, in the end, Hitler's dictatorship was dependent on his private army, the SS (Schutzstaffel), which formed a separate element within the party and which was closed to outside influences, and on the Gestapo, which was a state organization and not an organization of the party. The Fascist party in the single-party state has a policing or military function rather than an ideological one. After their rise to power, the Fascist parties in both Germany and Italy gradually ceased to perform the function of maintaining contact between the people and the government, a function that is usually performed by the party in a single-party situation. It was possible to observe a tendency for the party to close in upon itself while suppressing its deviant members. The renewal of the party was then assured through recruitment from youth organizations, from which the most fanatical elements, the products of a gradual selection process starting at a very early age, entered the party. The party tended, therefore, to constitute a closed order.
The single party in the developing countries.
Some of the Communist parties in power in developing countries do not differ significantly from their counterparts in industrialized countries. This is certainly true of the Communist Party of the Socialist Republic of Vietnam and the Workers' Party of North Korea. There have always been, however, countries in which the single party in power could not be characterized in terms of a traditional European counterpart. This observation applies to, for example, the former Arab Socialist Union in Egypt, the Neo-Destour Party in Tunisia (renamed the Destour Democratic Rally), and the National Liberation Front in Algeria, as well as many other parties in black Africa. Most of these parties claimed to be more or less Socialist or at least progressive, while remaining far removed from Communism and, in some cases, ardent foes of Communism. President Nasser attempted to establish a moderate and nationalistic Socialism in Egypt. In Tunisia the Neo-Destour Party was more republican than Socialist and was inspired more by the example of the reforms in Turkey under Kemal Atatürk than by Nasserism. In black Africa, single parties have often claimed to be Socialist, but with few exceptions they rarely are in practice. Single parties in developing countries are rarely as well organized as Communist parties. In Turkey the Republican People's Party was more a cadre party than a mass-based party. In Egypt it has been necessary to organize a core of professional politicians within the framework of a pseudoparty of the masses. In sub-Saharan Africa the parties are most often genuinely mass based, but the membership appears to be motivated primarily by personal attachment to the leader or by tribal loyalties, and organization is not usually very strong. It is this weakness in organization that explains the secondary role played by such parties in government. Some regimes, however, have endeavoured to develop the role of the party to the fullest extent possible. The politics of Atatürk in Turkey were an interesting case study in this regard. It was also Nasser's goal to increase the influence of the Arab Socialist Union, thereby making it the backbone of the regime. This process is significant in that it represents an attempt to move away from the traditional dictatorship, supported by the army or based on tribal traditions or on charismatic leadership, toward a modern dictatorship, supported by one political party. Single-party systems can institutionalize dictatorships by making them survive the life of one dominant figure.
FUTURE OF POLITICAL PARTIES
It has often been said in the West that political parties are in a state of decline. Actually, this has been a long-standing opinion in certain conservative circles, arising largely out of a latent hostility to parties, which are viewed as a divisive force among citizens, a threat to national unity, and an enticement to corruption and demagoguery. In certain European countries--France, for example--right-wing political organizations have even refused to call themselves parties, using instead such terms as movement, union, federation, and centre. And it cannot be denied that to some extent the major European and American parties of the late 20th century do appear old and rigid in comparison with their condition at the turn of the century or immediately following World War I. Even relatively new parties, such as the Christian Democratic parties of Germany and Italy (founded in 1945), seem somewhat lifeless. In terms of size and number, however, political parties are not declining but growing. At the turn of the century they were confined mainly to Europe and North America; elsewhere they were quite weak or nonexistent. In the late 20th century, parties are found practically everywhere in the world. And in Europe and North America there are generally far more people holding membership in parties than prior to 1914. Parties of the late 20th century are larger, stronger, and better organized than those of the late 19th century. In the industrialized nations, especially in western Europe, parties have become less revolutionary and innovative, and this factor may explain the rigid and worn-out image that they sometimes present. But even this phenomenon is found only in a limited area and may, perhaps, pass. The growth of parties into very large organizations may be responsible for the feelings of powerlessness on the part of many individuals who are involved in them. This is a problem experienced by people who find themselves part of any large organization, whether it be a political party, business enterprise, corporation, or union. The difficulties involved in reforming or changing political parties that have become large and institutionalized, coupled with the next-to-impossible task of creating new parties likely to reach sufficient strength to be taken seriously by the electorate, have resulted in much frustration and impatience with the party system. But it is difficult to imagine how democracy could function in a large industrialized country without political parties. In the modern world, democracy and political parties are two facets of the same reality, the inside and outside of the same fabric.
Interest groups
TYPES OF INTEREST GROUP
Categories defined by purpose.
Within the broad definition of interest groups, two polar types are recognizable: first, interest groups proper, such as trade unions, farmers' unions, and employers' associations, which have as their primary purpose the enhancement of the advantage of their members; and, second, promotional groups, such as the societies for the prevention of cruelty to children or various voluntary relief agencies, which exist primarily or entirely to enhance the advantage not of their own members but of the population, even perhaps to the discomfort or disadvantage of their own members. Some of these, such as churches or various evangelizing groups, exist to promulgate a distinctive set of values to be applied to society as a whole. The distinction between interest groups proper and promotional groups is not sharp for two reasons. In the first place, most interest groups proper sincerely believe that in furthering their own material advantage they are also serving that of society as a whole--by promoting "free enterprise" or a healthy and wealthy body of farmers or a well-paid and enthusiastic corps of schoolteachers. But the propagation of such beliefs is certainly not the primary purpose of such organizations, thus distinguishing them from promotional groups. The second reason is that some groups--for instance, organized churches--fall between the two types; they can simultaneously pursue advantages for their own sect and seek to inculcate a distinctive set of values in a whole society.
Categories defined by structure.
In primitive or developing societies, the most prominent type of interest group is the natural (i.e., primordial or communal) one--that is, one based on kinship, lineage, neighbourhood, or religious confession. In Western, industrialized societies, though such groups do sometimes retain influence (as do the nationalities in Latvia and Belgium), the most prominent interest group is the associational (i.e., secondary or factitious) type, like the trade union or Campaign for Nuclear Disarmament, which is deliberately created to serve defined purposes. Often, associational (or factitious) groups are created for the sake of the specialized purposes of the first type; the Indian Workers Union, for instance, was created from the community of Indian persons in Britain.
Within the class of associational groups, further qualifications must be made:
1. Not all associational groups possess formal structure. "Wall Street" in the United States, or the "City" in London, though consisting of a loose network of persons or functions, may nevertheless exert powerful collective pressures.
2. Some associational groups are collectivities; but others are single, discrete organizations. Thus General Motors Corporation exerts its own strong influence vis-r-vis the U.S. government irrespective of the influence of the more general employers' organization to which it possibly belongs, like the National Association of Manufacturers.
3. Some associational groups are temporary or ad hoc. Such are the so-called anomic groups, such as enraged French farmers who come together briefly to put logs across roads in order to draw governmental attention to their grievances.
4. Some associational groups are "latent." There may be a common interest among certain members of the public even though these individuals may not have combined into a formal or informal organization. The individuals may be unaware that they have a common interest or, if aware, see no reason to defend or promote it. Or, even if the members consciously wish to defend or promote an interest, the laws may restrict or control their ability to associate for such a purpose.
Categories defined by political activity.
If or when any interest group tries to influence the government in the pursuit of its aims, it becomes a "pressure group." Not all interest groups proper try to exert influence on governments; many (such as businesses and trade unions) do so only as a part of their more general activities of promoting their own interests. Promotional groups, on the other hand, spend much or all their time precisely in trying to influence the government to favour their aims. Groups such as an anglers' association may, therefore, turn into pressure groups for a time--the time when they seek to influence the government for one of their purposes--and then revert to simple interest-group status. A pressure group is therefore definable as "any interest group that is not a part of the government and does not itself seek to govern the country in its own name, but does seek to influence that government for its own purposes." Difficulties of definition arise, however. Some groups are neither a governmental agency nor entirely a private group. In autocratic states, Communist or otherwise, for instance, trade unions are often controlled by the government or the governing party. In the Western liberal democracies, again, agencies like the Tennessee Valley Authority (in the U.S.) or the British Broadcasting Corporation, though subject to the overriding control of the government, enjoy substantial autonomy in certain broad areas. Also, as noted at the beginning of this article, some pressure groups eventually turn into political parties, or vice versa.
CHARACTERISTICS OF PRESSURE GROUPS
Power elements.
Even in the most pluralistic of the Western liberal democratic states, it is wrong to picture public policy as simply the result of a parallelogram of group forces. The groups are themselves restrained by institutions, procedures, and public beliefs. Among the institutions, the most important are the public bureaucracy, the political parties, and the independent branches of the government (the executive, legislature, and judiciary--or some combination of these, depending on the structure of government). To the extent that each or all of these institutions have strong traditions, no interest group supplants them but instead has to deal with them. The governmental procedures in force also affect groups' performance. To the extent that public issues are traditionally subject to publicity and wide discussion, groups are limited in the kind of activities that they can pursue. They are constrained by public beliefs as to what is in "the public interest," by what is a proper or improper procedure, or by what causes are respectable and what are not. If any of these three entities--institutions, procedures, or public beliefs--become feeble, interest groups can intrude into them. By allying with or gaining power over the parties, the legislature, or the bureaucracy, for instance, groups can tend to substitute themselves for such organs in the decision-making process.
Inside every country the power that pressure groups wield against the government and that each group wields relative to its rivals depends on a combination of the following variables, some of which are mutually dependent:
1. Density is the ratio of actual membership to potential membership. The higher the density, the more "representative" is the group of all the people whose interests it purports to represent and the greater will be the inclination for governments to recognize and consult it. On the other hand, too wide a membership brings with it internal cleavages, so that on certain issues the organization may not be able to tender clear-cut advice or, indeed, may have to refrain from offering advice altogether.
2. Wealth not only helps a group to develop a skilled management and bureaucracy but also enables it to propagandize and to finance political parties.
3. Prestige lends a group the ability to get a favourable initial hearing from government and public, even though its numbers may be small and its wealth meagre.
4. Organization consists notably of the ability to brief legislators and administrators well and quickly, to mobilize members and the public rapidly, and to receive advance intelligence of likely trends in policy.
5. Socioeconomic leverage is strong among some groups (such as trade unions) that can disrupt social life and low among others (such as consumers associations).
6. Militancy consists of making an effective nuisance of oneself, so that, hopefully, governments will be willing to "buy" time or peace.
7. Specialized information and skills add the weight of authority.
8. Electoral strength refers to the power of some groups that, though poorly organized or having a low density, nevertheless command wide support in the electorate and so find themselves courted by rival political parties.
Strategy and tactics.
Although all groups seek out the most influential agencies of government, the most influential may not be accessible; and resort must be had to the next most influential organ that is accessible. Because the Communist trade unions in Italy, for instance, are not welcome at the Roman Catholic controlled Ministry of Labour, they try to penetrate the legislature through political election. Indeed, in any system the influence of the various organs of government varies. In France the president and bureaucracy are more influential than the majority party and Parliament; in the United States, the president and Congress balance each other, with control of the bureaucracy shared between the two. Strategy, for an interest group, consists of determining and going to the most influential organ that is accessible. The tactics of an interest group range from the constitutional to the unconstitutional (or "direct action"), the legal to the illegal--all subject, as noted above, to the restraints of institutions, public procedures, and public beliefs. When the target of the tactics is the executive and the governmental bureaucracy, the following are the prime methods: Constitutional operations include (1) advice via advisory bodies attached to the ministries (as in Britain and France), (2) official hearings outside the ministries (as in Royal Commissions in the U.K. and presidential commissions in the U.S.) or inside the ministries (as in Germany or Sweden), and (3) ad hoc consultations and cooperation. Semiconstitutional operations include (1) recruitment of state civil servants into the private bureaucracies of the interest groups, or vice versa, and (2) bribery and favours, which need not necessarily mean passing of money but can take the form of providing entertainment, gifts, or meals. Semidirect operations include such measures as refusing to provide information or to cooperate in administering legislation and thus generally withdrawing from advisory functions. Direct action includes such measures as the withdrawal of labour (the British Medical Association, for instance, advised its members to withdraw from the state medical service in 1965 unless its demands were met) or even violence such as the roadblocking activities of enraged French farmers in the 1960s). When the target is the legislature, the following are the chief kinds of tactics used by interest groups: Constitutional operations include (1) testimony before legislative committee hearings (extremely important in the U.S. and somewhat important in Sweden, the German Federal Republic, Japan, and Italy); (2) direct representation in the legislature, which involves having individual businessmen, financiers, farmers, school teachers, journalists, and other professionals representing the larger interests of their profession or sponsoring group (in Great Britain in 1955 some 30 percent of Labour's MP's were trade-union sponsored); and (3) lobbying, which refers to the activities of salaried or nonsalaried persons who try to promote their interest groups' aims by seeking personal contacts with legislators, by sending communications or information to legislators or persuading others to do so, and by rendering campaign assistance to favoured legislators. (In the U.S., lobbying is conducted not only by private interest groups but also by certain members of the executive branch and the bureaucracy.) Semiconstitutional operations include subvention or payment of retainers as well as providing campaign contributions, secretarial help, office accommodations, and the like, which are restricted but not forbidden by law. Semidirect action includes mass lobbying, such as promoting mass demonstrations before legislators, ostensibly to relate grievances but in fact to impress public opinion. Direct action includes threatening legislators with a withdrawal of financial assistance, with physical violence, or with riots (as in Japan, where snake dances and riots become a means of protest). When political parties are powerful, they may prove a highly preferred target. Tactics in such cases include the following: Constitutional operations, such as, (1) exacting election pledges, which is most important and fruitful in countries (such as the U.S.) where there is relatively little national-party discipline, where representatives owe a certain allegiance to local-party groups and constituents, and where, most important, representatives do possess legislative power; (2) financing the party, which in all systems is perhaps the most effective operation and which in most Western parliaments--and in Western-style parliaments like Japan's--is systematically done by trade unions, employers associations, and individual firms; and (3) lobbying the party machinery, a method that is virtually nonexistent in the United States but is significant in such countries as Great Britain and Germany. A final target of interest groups is public opinion. The general opinion of the public at large can be of importance in issues where questions of "fairness" or "justice" arise (on which most people feel they can pronounce). These questions involve such matters as capital punishment, the use of nuclear weapons, or certain wars, about which large numbers of people feel very strongly.
ROLE OF INTEREST GROUPS IN VARIOUS POLITICAL SYSTEMS
The Anglo-American and Swedish patterns.
In the United States, Great Britain, and Sweden, the general population is not irreparably divided on ideological or cultural lines. Although there arise from time to time some small extremist groups, the population at large is not split into irreconcilable blocks. Given this situation, the most influential and prominent groups are "secondary" associations that have highly specialized objectives, form freely without the requirement of prior governmental permission, and carry out their activities autonomously. With the exception of the affiliation of the trade-union movement to the Labour Party in Britain and in Sweden, the groups are politically neutral; and even the alignment of British and Swedish trade unions and cooperatives does not prevent them from cooperating with other parties nor hinder their free access to government departments. Latent groups are few, since freedom of speech and association and the right to petition the government permit most interests to organize, while good communication media facilitate such organization. Public participation in such groups is, by world standards, high. The pressure groups play highly specialized roles and are sharply differentiated from the political parties. Although American and British means of influencing the executive are similar (by advisory committees, special inquiries, and day-to-day consultation and mutual assistance), these relations are more institutionalized in Britain than in the U.S. British groups seek to influence the parties by affiliation or by securing their members' nomination as candidates, neither mode being employed in the U.S., and by financial assistance, which occurs in both states but in quite different ways owing to the very different legislation on this matter in the two countries. British groups seek to influence the legislature by securing direct representation through participation in party caucuses and by promoting amendments in the committee stage. In the U.S. the methods employed consist of lobbying influential congressmen and appearing at committee hearings, which are far more important in Congress than in the House of Commons. In influencing public opinion, American groups spend far more than their British counterparts--one reason being that purchase of time on radio and television networks is permissible in the U.S., whereas in Britain it is not. In addition, access to the presidency can prove decisive in the U.S.; and some groups such as the National Association for the Advancement of Colored People have scored notable successes by seeking court action. In Sweden the tactics are somewhat different, owing to three factors: the existence of a multiparty system and the existence of coalition cabinets, the structure of the bureaucracy, and the much greater institutionalization of pressure groups. Sweden, Denmark, and Norway each possess a multiparty system; but when coalitions are formed, they are highly stable. Consensus is achieved in a three-tier operation--first at interparty (electoral) level, then at the interparty-coalition (legislative) level, and finally at the bureaucratic level. In Sweden groups seek to influence the parties by affiliation (the trade unions being affiliated to the Labour Party), by financing them (trade unions giving to the Labour Party, employers groups to the antisocialist parties), and by securing direct representation through the nomination of members as parliamentary candidates. The parties respond by trying to compose a balanced ticket of the spectrum of interests. Hence the groups can affect the legislature through their representatives inside each of the parties and may, on occasion, form a cross-party legislative pressure group in defense of their common interest; and they also seek access to the party caucus and influence the committee stage of legislation. In the latter case they are assisted by the standard Swedish procedure by which the "comments" of outside interests are attached to the government's bill, even if they contradict the bill's purposes. Groups have ready access to the legislature in the same ways that Anglo-American groups do, except that the procedure is highly institutionalized; the "Royal Commission" with representatives of the bureaucracy, the parties, and the interest groups seek to reach initial agreement on a bill to be presented to the legislature; and when this device is not used, "comments" appended to the bill serve to put the measure in the context of the avowed interests of various groups. Not unlike the system in Britain, the U.S., and Sweden is the system in Japan, which, despite sharp ideological divisions, has a strong and stable two-party arrangement. This has led to the emergence of a pattern of highly institutionalized pressure groups of the "secondary" type, the most influential of these being business and organized labour. Business, on the whole, is aligned with the conservative Liberal-Democratic party, supplies the bulk of its funds, and has a large say in policy formation. Organized labour constitutes a powerful element within the Japanese Socialist Party. In an earlier day, rural farm groups carried considerable political weight--for the conservatives--but the increasing industrialization and urbanization of the country have tended to reduce its importance.
The French and Italian patterns.
In France and Italy the political pattern is characterized by deep ideological cleavages. The Roman Catholic Church, for example, operates through both its own political party and its own interest groups, such as the Catholic Action Society and Catholic youth and women's group. By the same token, the highly ideological and sectarian Communist Party establishes its own pressure groups, such as trade unions, farmers associations, and youth movements. Several rival groups thus compete for the same clientele aligned or affiliated with rival political parties. Under France's Fifth Republic, the executive branch currently controls the majority party in the legislature, and the role of the legislature has been reduced; whereas, under Italy's current system, feeble and fragile coalition cabinets have weakened executive leadership of the legislature, and the legislature itself is highly fragmented among numerous parties. Because contacts between interest groups on the one hand and the parties, civil service departments, and legislature on the other are poorly institutionalized, semidirect action or even direct action against the executive and the legislature are more common, and lawless activities of crowds and violent organizations have proved more widespread. The means of influencing the chosen targets also vary. In France attention has shifted from the legislature (under the Fourth Republic) to the president and bureaucracy (under the Fifth); interest groups now act through the numerous advisory bodies, private contacts, and such official institutions as the Economic and Social Council. Interest groups secure contacts by putting former civil servants on their own payrolls. The fact that many civil servants and business executives come from the same schools facilitates private collusion. In Italy interest groups direct their attention mainly to three targets. First, the bureaucracy, even though it is highly fragmented and provides few formal advisory channels of communication, is open to ad hoc and personal consultations (except to groups deemed ideologically distasteful, such as the Communists). Second, the parties are often twinned to interest groups, as noted earlier; and thus the groups seek and achieve direct representation in the legislature. Third, the legislature, because it is composed of interest groups, is heavily influenced in specialized legislative committees. In general, therefore, interest groups have tended to "intrude" into the organs of government, forming close alliances with certain departments and legislative commissions and inserting themselves into others via their membership in political parties. In short, interest groups are not "contained" as they are in Anglo-American and Scandinavian countries--political institutions are fragmented and weak, procedures are irregular or personal and not formal, and public beliefs are polarized into uncompromising ideologies.
Patterns in developing countries.
Although there is no one typical pattern for all developing countries, which of course embrace more than two-thirds of the world's sovereign states, there are a few common characteristics that can be suggested. First, political culture in each of these countries is fragmented, sometimes because of ideological differences, sometimes because of the mutual hostility of "natural" groupings based on kinship, lineage, tribe, or language. Second, nascent interest groups representing new modernizing and industrializing forces tend to range against rural natural groupings. The modernizers have defined and specialized objectives, whereas the traditionalists usually represent a spectrum of attitudes, beliefs, values, and interests. Both, in any case, tend to sponsor or generate their own political parties. Third, during preindependence days in some countries, trade unions and other movements (such as the Somali Youth League) carried on activities that would otherwise have been carried on by political parties; when independence came, these groups continued such activities, thus blurring the functional distinctions between parties and interest groups. Fourth, associations in these countries tend to have low membership densities; and in most of these countries the principal "interest"--that is, the peasantry--is hardly organized at all. Attempts to develop widely represented peasant movements have had only limited success. Fifth, although organization and established procedures may be poor, latent interest is usually high. In a particularly divisive and administratively feeble country, this interest latency may reveal itself in lawless and violent group activity--such as strikes, riots, guerrilla movements, and assassinations. In some countries "parties" in elections are not really parties but simply electoral coalitions of various interest groups--the most influential groups consisting of cliques of landlords; leaders of religious, ethnic, or linguistic groups; and the like. Legislatures tend to reflect these divisions and temporary arrangements in society and so enjoy only feeble authority. In countries that have had single-party regimes, such as Kenya and Tanzania, the parties tended to lose their mass following and fairly well-defined organization in the years after independence. To enhance their authority, the party leaders tried to limit or abolish the autonomy of such interest groups as trade unions, cooperative movements, and youth and women's movements and tried to turn these groups into ancillaries of the party. In some countries the military has taken over, either alone or with civilian elements, and imposed an authoritarian rule. In such cases, the most prominent groups are governmental--the military and the executive. Unless interest groups enjoy a long history of organization (as does the Roman Catholic hierarchy in Latin America), they are often turned into governmental ancillaries or suppressed. In these countries ruled by the military or single parties, the political process turns into a highly informal medley of pressures and personal contacts between the government, the military forces, the various "natural" groups, and some of the more strategically placed groups (such as the church hierarchy or private industry). The "system" is constantly threatened with government coercion or violent outbreaks by sections of the population.
Patterns in former Communist states.
From World War II to 1989, most of the Communist nations in eastern Europe were ruled by a single Communist party (as in Albania, Hungary, Romania, and the Soviet Union), or by a Communist party that dominated one or more satellite parties in a hegemonic multiparty system (as in Bulgaria, Poland, Czechoslovakia, and East Germany). Falling somewhere between these categories was Yugoslavia, which was governed by a League of Communists composed of Communist parties based in its several ethnic republics. Following the fall of the Berlin Wall in November 1989, these party systems were entirely transformed. By 1990, each country (Albania in 1991) quickly held relatively free elections that shattered the old regime. In most cases, power was transferred to those with little connection to the old leadership or who were dissident Communists. In most cases, the former Communist parties soon disbanded or reformed under different names to compete with new parties for votes and political influence. The parties and party systems in these countries are not yet institutionalized and will need time, perhaps decades, to achieve stability and acquire popular value. This slow process is common to countries seeking democratic government after authoritarian rule. The first wave of elections (1989-90) tended to go heavily against Communist candidates and toward candidates backed by mass popular movements. In Poland, for example, Lech Walesa's labour-based Solidarity movement swept nearly all the offices it contested in 1989. In Czechoslovakia, Václav Havel's Civic Forum (and its Slovak counterpart) decisively defeated the Communist candidates in the 1990 assembly elections. Old-line Communist rulers were also ousted that year in Hungary and East Germany. Although Communist governments were reelected in Albania and Bulgaria, even these hard-line regimes were defeated by opposition forces in the second round of elections--Bulgaria in 1991 and Albania in 1992. In Russia only the Communist Party was allowed to participate as a party in the 1990 elections for the 1,068 seats in the Congress of People's Deputies. Nevertheless, many candidates were backed by popular fronts, interest groups, and political clubs that had arisen under glasnost (the Soviet policy of "openness" that began in the late 1980s). Democratic Russia, an organization of progressive forces, claimed 190 seats after the election. In Russia's historic popular election for president of the republic in 1991, Boris Yeltsin won 57 percent of the vote against five other candidates, some of whom were backed by the Communist Party of the Soviet Union. Only in Romania did voters keep former Communists in power through 1992, although old-line Communists also won power in most of the former Soviet republics. This was particularly true in the Asian republics, where elections were less free and marked by a high turnout of government-mobilized voters, but old-line Communists also won elections in Ukraine, the largest republic after Russia. However, three small Baltic republics (Estonia, Latvia, and Lithuania) ousted their former Communist leaders, most convincingly in Lithuania, where the mass popular movement Sajudis won about 65 percent of the parliamentary seats in early elections. Despite the initial landslides toward mass-based democratic movements in some cases, the most characteristic feature of free elections in these former Communist nations was the proliferation of political parties, as political entrepreneurs sought to take advantage of an uprooted electorate. For example, Poland soon had more than 100 registered parties, Romania more than 80, and Bulgaria more than 50. A survey of parties in eastern Europe and the Soviet Union published in 1991 listed more than 500 different parties. Most of these were known as "couch" parties (the entire membership would fit on a sofa), and they had little structure or staff. The proliferation of ephemeral parties produced political confusion as voters faced a bewildering array of choices in an unfamiliar market. In Romania, for instance, citizens who were new to free elections could choose among the National Democrats, Romanian Democrats, Free Democrats, Social Democrats, Liberal Democrats, Constitutional Democrats, and Christian Democrats--to name a few. One consequence was disillusionment with the electoral process and low voter turnout. In Poland, for example, only 43 percent of the eligible electorate voted in the parliamentary elections of 1991, which saw 29 different parties elected to the lower house, including the Polish Party of the Friends of Beer (Beer Lovers' Party), which won 16 seats in the lower parliament in 1991. In general terms, the nascent parties that sprouted in the former Communist countries can be classified into seven types. First, there were the parties of mass democratic movements--Solidarity in Poland, Civic Forum in Czechoslovakia, and Sajudis in Lithuania, for instance--that were often instrumental in forcing the Communist authorities to schedule free elections. However, most parties of this type dramatically lost support in the second wave of elections. (Civic Forum had split into two wings by then.) Second were the remnants of the former Communist Party operating with names like the Socialist Party (Albania, Bulgaria, and Hungary) or the National Salvation Front (Romania). These parties may change their names as they develop. For instance, the Democratic National Salvation Front in Romania became the Party for Social Democracy in July 1993. In Lithuania, the former Communists--reorganized as the Democratic Labour Party--actually outpolled the Sajudis in the November 1992 parliamentary election and regained the government. A third type consisted of parties that took up the mantles of pre-World War II parties, such as various farmers' and liberal parties. A fourth kind represented nationalist parties promoting ethnic interests, as, for example, the Hungarian Democratic Union in Romania. Fifth were religious parties, typically Christian Democrats. A sixth category consisted of parties modeled after Western political values, such as environmentalism, feminism, and capitalism. Finally, there were the frivolous parties, like the Beer Lovers' and Volcano parties in Poland. As explained above, the nature of the electoral system affects the number of parties that win representation to parliament. Countries using proportional representation and having few electoral barriers to discourage minor parties sustained severely fragmented party systems. Poland, for example, did not require parties to achieve any minimum vote (threshold) to gain representation in 1991, and none of its 29 parliamentary parties had more than 13 percent of the vote. This fragmentation in the Polish parliament made it difficult to form a governing coalition. Hungary, on the other hand, required that parties win 4 percent of the national vote in 1990, and only six out of more than 65 registered parties entered parliament. Countries that did not use proportional representation, such as Russia, usually required that candidates win an absolute majority of the vote or face a runoff election. This two-ballot system, also used in France, favours party fragmentation by encouraging minor parties to form for the purpose of denying the leading candidate a majority on the first ballot and thus costing him the election. Minor parties can then bargain their support, in exchange for favours, on the second ballot, often held one week after the first. The alternative system, used in most Anglo-American democracies, requires only a simple plurality of the vote and tends to produce two-party rather than multiparty systems. The new democracies that have emerged from the former Communist countries are certain to experiment with different electoral systems as they seek to develop institutionalized parties and stable party systems.
2. The History of Western Political Philosophy.
The central problem of political philosophy is how to deploy or limit public power so as to maintain the survival and enhance the quality of human life. Like all aspects of human experience, it is conditioned by environment and by the scope and limitations of mind; and the answers given by successive political philosophers to perennial problems reflect the knowledge and the assumptions of their times. Political philosophy, as distinct from the study of political and administrative organization, is more theoretical and normative than descriptive. It is inevitably related to general philosophy and is itself a subject of social anthropology, sociology, and the sociology of knowledge. As a normative discipline it is thus concerned with what ought, on various assumptions, to be and how this purpose can be promoted, rather than with a description of facts--although any realistic political theory is necessarily related to these facts. The political philosopher is thus not concerned so much, for example, with how pressure groups work or how, by various systems of voting, decisions are arrived at, as with what the aims of the whole political process should be in the light of a particular philosophy of life. There is thus a distinction between political philosophy, which reflects the world outlook of successive theorists and which demands an appreciation of their historical settings, and modern political science proper, which, insofar as it can be called a science, is empirical and descriptive. Political philosophy, however, is not merely unpractical speculation, though it may give rise to highly impractical myths: it is a vitally important aspect of life, and one that, for good or evil, has had decisive results on political action; for the assumptions on which political life is conducted clearly must influence what actually happens. Political philosophy may thus be viewed as one of the most important intellectual disciplines, for it sets standards of judgment and defines constructive purposes for the use of public power. Such consideration of the purposes for which power should be used is in a sense more urgent today than it has been in earlier periods, for mankind has at its disposal the power either to create a world civilization in which modern technology can benefit the human race or to destroy itself in pursuit of political myths. The scope for political philosophy is thus great, the clarification of its purpose and limitations urgent--an aspect, indeed, of civilization's survival.
The history of political philosophy in the West to the end of the 19th century
ANTIQUITY
Although in antiquity great civilizations arose in Egypt and Mesopotamia, in the Indus Valley, and in China, there was little speculation about the problems of political philosophy as formulated in the West and since predominant. The laws of Hammurabi of Babylon (c. 1750 BC) are rules propounded by the monarch as a representative of God on Earth and are mainly concerned with order, trade, and irrigation; the Admonitions of the Egyptian vizier Ptahhotep (c. 2300 BC) are shrewd advice on how to prosper in a bureaucracy; and the Arthashastra of Kautilya, grand vizier to the Indian Candragupta Maurya in the late 4th century BC, are Machiavellian precepts on how to survive under an arbitrary power. To be sure, the Buddhist concept of dharma (social custom and duty), which inspired the Indian emperor Ashoka in the 3rd century BC, implies a moralization of public power, and the teachings of Confucius in the 6th century BC are a code of conduct designed to stabilize society; but there is not, outside Europe, much speculation about the basis of political obligation and the purpose of the state, with both of which Western political philosophy is mainly concerned. An authoritarian society is taken for granted, backed by religious sanctions, and a conservative and arbitrary power is generally accepted. In contrast to this overwhelming conservatism, paralleled by the rule of custom and tribal elders in most primitive societies, the political philosophers of ancient Greece question the basis and purpose of government; and, though they do not separate political speculation from shrewd observations that today would be regarded as empirical political science, they created the vocabulary of Western political thought.
Plato
The first elaborate work of European political philosophy is The Republic of Plato (c. 378 BC), a masterpiece of insight and feeling, superbly expressed in dialogue form and probably meant for recitation. Further development of Plato's ideas is undertaken in his Statesman and Laws, the latter prescribing the ruthless methods whereby they might be imposed. Plato grew up during the great war between Athens and Sparta in which Athens suffered defeat and, like many political philosophers, tried to find remedies for prevalent political injustice and decline. Indeed, The Republic is the first of the utopias, though not one of the more attractive; and it is the first classic attempt of a European philosopher to moralize political life. Cast as a lively discussion between Socrates, whose wisdom Plato is recounting, and various leisured Athenians, Books V, VII-VIII, and IX of The Republic state the major themes of political philosophy with poetic power. Plato's work has been criticized as static and class bound, reflecting the moral and aesthetic assumptions of an elite in a slave-owning civilization and bound by the narrow limits of the city-state. The work is indeed a classic example of a philosopher's vivisection of society, imposing by relatively humane means the rule of a high-minded minority. The Republic is a criticism of current Hellenic politics--often an indictment. It is based upon a metaphysical act of faith, for Plato believes that a world of permanent Forms exists beyond the limitations of human experience and that morality and the good life, which the state should promote, are reflections of these ideal Forms. The point is best made in the famous simile of the cave, in which men are chained with their faces to the wall and their backs to the light, so that they see only the shadows of reality. So constrained, they shrink from what is truly "real" and permanent and need to be forced to face it. This idealistic doctrine, known misleadingly as Realism (in nontechnical language it is hardly realistic), pervades all Plato's philosophy: its opposite doctrine, Nominalism, declares that only particular and observed "named" data are accessible to the mind. On his Realist assumption, Plato, who was perhaps influenced by Indian thought, regards most ordinary life as illusion and the current evils of politics as the result of men pursuing brute instinct. It follows that unless philosophers bear kingly rule in cities or those who are now called kings and princes become genuine and adequate philosophers, and political power and philosophy are brought together . . . there will be no respite from evil for cities.
Only philosopher-statesmen can apprehend permanent and transcendant Forms and turn to "face the brightest blaze of being" outside the cave, and only philosophically minded men of action can be the saviours and helpers of the people. Plato is thus indirectly the pioneer of modern beliefs that only a party organization, inspired by correct and "scientific" doctrines, formulated by the written word and interpreted by authority, can rightly guide the state. His rulers would form an elite, not responsible to the mass of the people. Thus, in spite of his high moral purpose, he has been called an enemy of the open society and the father of totalitarian lies. But he is also an anatomist of the evils of unbridled appetite and political corruption and insists on the need to use public power to moral ends. Having described his utopia, Plato turns to analyze the existing types of government in human terms with great insight. Kingly government is the best but impracticable; in oligarchies the rule of the few and the pursuit of wealth divide societies--the rich become demoralized and the poor envious, and there is no harmony in the state. In democracy, in which the poor get the upper hand, demagogues distribute "a peculiar kind of equality to equals and unequals impartially," and the old flatter the young, fawning on their juniors to avoid the appearance of being sour or despotic. The leaders plunder the propertied classes and divide the spoils among themselves and the people until confusion and corruption lead to tyranny, a worse form of government. For the tyrant becomes a wolf instead of a man and "lops off" potential rivals and starts wars to distract the people from their discontent. "Then, by Zeus," Plato concludes, "the public learns what a monster they have begotten." In the Statesman Plato admits that, although there is a correct science of government, like geometry, it cannot be realized, and he stresses the need for the rule of law, since no man can be trusted with unbridled power. He then examines which of the current forms of government is the least difficult to live with, for the ruler, after all, is an artist who has to work within the limits of his medium. In the Laws, purporting to be a discussion of how best to found a polis in Crete, he presents a detailed program in which a state with some 5,000 citizens is ruled by 37 curators of laws and a council of 360. But the keystone of the arch is a sinister and secret Nocturnal Council to be "the sheet anchor of the state," established in its "central fortress as guardian." Poets and musicians will be discouraged and the young subjected to a rigid, austere, and exacting education. The stark consequence of Plato's political philosophy here becomes apparent. He had, nonetheless, stated, in the dawn of European political thought, the normative principle that the state should aim at promoting the good life and social harmony and that the rule of law, in the absence of the rule of philosopher-kings, is essential to this purpose.
Aristotle.
Aristotle, who was a pupil in the Academy of Plato, remarks that "all the writings of Plato are original: they show ingenuity, novelty of view and a spirit of enquiry. But perfection in everything is perhaps a difficult thing." Aristotle was a scientist rather than a prophet, and his Politics (c. 335-322 BC), written while he was teaching at the Lyceum at Athens, is only part of an encyclopaedic account of nature and society, in which he analyzes society as if he were a doctor and prescribes remedies for its ills. Political behaviour is here regarded as a branch of biology, as well as of ethics; in contrast to Plato, Aristotle was an empirical political philosopher. He criticizes many of Plato's ideas as impracticable, but, like Plato, he admires balance and moderation and aims at a harmonious city under the rule of law. The book is composed of lecture notes and is arranged in a confusing way--a quarry of arguments and definitions of great value but hard to master. The first book, though probably the last written, is a general introduction; Books II, III, and VII-VIII, probably the earliest, deal with the ideal state; and Books IV-VII analyze actual states and politics. The treatise is thus, in modern terms, a mixture of political philosophy and political science Like Plato, Aristotle naturally thinks in terms of the city-state, which he regards as the natural form of civilized life, social and political, and the best medium in which men's capacities can be realized. Hence his famous definition of man as a "political animal," distinguished from the other animals by his gift of speech and power of moral judgment. "Man, when perfected," he writes, is the best of animals, but when separated from law and justice he is the worst of all, since armed injustice is the most dangerous, and he is equipped at birth with the arms of intelligence and wit, moral qualities which he may use for the worst ends.
Since all nature is pervaded by purpose and since men "aim at the good," the city-state, which is the highest form of human community, aims at the highest good. Like sailors with their separate functions, who yet have a common object in safety in navigation, citizens, too, have a common aim--in modern terms survival, security, and the enhancement of the quality of life. In the context of the city-state, this high quality of life can be realized only by a minority, and Aristotle, like Plato, excludes those who are not full citizens or who are slaves; indeed, he says that some men are "slaves by nature" and deserve their status. Plato and Aristotle aim at an aristocratic and exacting way of life, reflecting, in more sophisticated forms, the ideas of the warrior aristocracies depicted by Homer. Having stated that the aim of the city-state is to promote the good life, Aristotle insists that it can be achieved only under the rule of law.
The rule of law is preferable to that of a single citizen; if it be the better course to have individuals ruling, they should be made law guardians or ministers of the laws.
The rule of law is better than that even of the best men, for "he who bids law rule may be deemed to bid God and reason alone rule, but he who bids men rule adds the element of the beast; for desire is a wild beast, and passion perverts the minds of rulers, even if they are the best of men." This doctrine, which distinguishes between lawful government and tyranny, survived the Middle Ages and, by subjecting the ruler to law, became the theoretical sanction of modern constitutional government. Aristotle also vindicates the rule of custom and justifies the obligations accepted by members of society: the solitary man, he writes, "is either a beast or a God." This outlook at once reflects the respect for custom and solidarity that have promoted survival in primitive tribal societies, even at the price of sacrificing individuals, and gives a theoretical justification for the acceptance of political obligation. Like Plato, Aristotle analyzes the different kinds of city-states. While states are bound, like animals, to be different, he considers a balanced "mixed" constitution the best--it reflects the ideal of justice (dike) and fair dealing, which gives every man his due in a conservative social order in which citizens of the middle condition preponderate. And he attacks oligarchy, democracy, and tyranny. Under democracy, he argues, demagogues attain power by bribing the electorate and waste accumulated wealth. But it is tyranny that Aristotle most detests; the arbitrary power of an individual above the law who is "responsible to no-one and who governs all alike with a view to his own advantage and not of his subjects, and therefore against their will. No free man can endure such a government." The Politics contains not only a firm statement of these principles but also a penetrating analysis of how city-states are governed, as well as of the causes of revolutions, in which "inferiors revolt in order that they may be equal, and equals that they may be superior." The treatise concludes with an elaborate plan for educating the citizens to attain the "mean," the "possible," and the "becoming." The first implies a balanced development of body and mind, ability and imagination; the second, the recognition of the limits of mind and the range and limitations of talent; the third, an outcome of the other two, is the style and self-assurance that come from the resulting self-control and confidence. While, therefore, Aristotle accepts a conservative and hierarchic social order, he states firmly that public power should aim at promoting the good life and that only through the rule of law and justice can the good life be attained. These principles were novel in the context of his time, when the great extra-European civilizations were ruled, justly or unjustly, by the arbitrary power of semidivine rulers and when other peoples, though respecting tribal custom and the authority of tribal elders, were increasingly organized under war leaders for depredation.
Cicero and the Stoics.
Both Plato and Aristotle had thought in terms of the city-state. But Aristotle's pupil Alexander the Great swamped the cities of old Greece and brought them into a vast empire that included Egypt, Persia, and the Levant. Though the civilization of antiquity remained concentrated in city-states, they became part of an imperial power that broke up into kingdoms under Alexander's successors. This imperial power was reasserted on an even greater scale by Rome, whose empire at its greatest extent reached from central Scotland to the Euphrates and from Spain to eastern Anatolia. Civilization itself became identified with empire, and the development of eastern and western Europe was conditioned by it. Since the city-state was no longer self-sufficient, universal philosophies developed that gave men something to live by in a wider world. Of these philosophies, Stoicism and Epicureanism were the most influential. The former inspired a rather grim self-sufficiency and sense of duty, as exemplified by the writings of the Roman emperor Marcus Aurelius; the latter, a prudent withdrawal from the world of affairs. The setting for political philosophy thus became much wider, relating individuals to universal empire, thought of, as in China, as coterminous with the civilization itself. Its inspiration remained Hellenic; but derivative Roman philosophers reinterpreted it, and Roman legists enclosed the old concepts of political justice in a carapace of legal definitions, capable of surviving their civilization's decline.
Cicero lived in a time of political confusion during which the old institutions of the republic were breaking down before military dictators. His De republica and Laws are both dialogues and reflect the classical sense of purpose: "to make human life better by our thought and effort." Cicero defined the res publica (commonwealth) as an association held together by law; he further asserted, as Plato had maintained with his doctrine of Forms manifest in the just city, that government was sanctioned by a universal natural law that reflected the cosmic order. Cicero expresses the pre-Christian Stoic attempt to moralize public power, apparent in the exacting sense of public responsibility shown by Hadrian and Marcus Aurelius in the 2nd century AD.
St. Augustine.
With the conversion of the emperor Constantine (AD 312), when Christianity, long influential, became the predominant creed of the empire, and, under Theodosius (379-395), the sole official religion, political philosophy changed profoundly. St. Augustine's City of God (413-426), written when the empire was under attack by barbarians within and without, sums up and defines a new division between church and state and a conflict between "matter" and "spirit" resulting from the Fall of man and original sin. St. Augustine, whose Confessiones are a record of a new sort of introspection, combined a classical and Hebraic dualism. From the Stoics and Virgil he inherited an austere sense of duty, from Plato and the Neoplatonists a contempt for the illusions of appetite, and from the Pauline and patristic interpretation of Christianity a sense of the conflict between Light and Darkness that reflects Zoroastrian and Manichaean doctrines emanating from Iran. In this context worldly interests and government itself are dwarfed by the importance of attaining salvation and of escaping from an astrologically determined fate and from the demons who embody the darkness. Life becomes illuminated for the elect minority by the prospect of eternal salvation or, for those without grace, shrivels under the glare of eternal fires. St. Augustine regarded salvation as predestinate and the cosmic process as designed to "gather" an elect to fill the places of the fallen angels and so "preserve and perhaps augment the number of the heavenly inhabitants." The role of government and indeed of society itself becomes subordinated into a "secular arm," part of an earthly city, as opposed to the "City of God." The function of government is to keep order in a world intrinsically evil. Since Christianity had long played the main role in defense of the veneer of a precarious urban civilization in antiquity, this claim is not surprising. Constantine came of crude Balkan origins, a soldier putting to rights a breakdown in government that would continue in the West with the abdication of the last Western emperor in 476, though in the East the empire would carry on with great wealth and power, centred in the new capital of Constantinople (Byzantium). St. Augustine thus no longer assumed, as did Plato and Aristotle, that a harmonious and self-sufficient good life could be achieved within a properly organized city-state; he projected his political philosophy into a cosmic and lurid drama working out to a predestinate end. The normal interests and amenities of life became insignificant or disgusting, and the Christian Church alone exercised a spiritual authority that could sanction government. This outlook, reinforced by other patristic writings, would long dominate medieval thought, for with the decline of civilization in the West the church became more completely the repository of learning and of the remnants of the old civilized life.
THE MIDDLE AGES
The decline of ancient civilization in the West was severe; not, indeed, in technology, for the horse collar, the stirrup, and the heavy plow now came in; but political philosophy, like other intellectual interests, became elementary. In the Byzantine Empire, on the other hand, Justinian's lawyers in 529-533 produced the Codex Constitutionum, the Digest, the Institutes, which defined and condensed Roman law, and the Novels. The Byzantine basileus, or autocrat, had moral responsibility for guarding and harmonizing an elaborate state, a "colony" of heaven in which reason and not mere will ought to rule. And this autocracy and the orthodox form of Christianity were inherited by the Christianized rulers of the Balkans, of Kievan Russia, and of Muscovy. In the West, two essential principles of Hellenic and Christian political philosophy were transmitted, if only in elementary definitions, in rudimentary encyclopaedias. Isidore of Seville in his 7th-century Etymologiae, for example, asserts that kings rule only on condition of doing right and that the rule reflects a Ciceronic law of nature "common to all people and mankind everywhere by natural instinct." Further, the barbarians respected the civilization they took over and exploited. When converted, they revered the papacy, and in 800 the Frankish Charlemagne even revived the Western Empire as holy and Roman. The idea of Christian empire coterminous with civilization thus survived in Western as well as Eastern Christendom.
Aquinas.
It is a far cry from this practical 12th-century treatise by a man of affairs to the elaborate justification of Christian kingship and natural law created by St. Thomas Aquinas in the 13th century, during the climax of medieval Western civilization. His political philosophy is only part of a metaphysical construction of Aristotelian range--for Aristotle had now been assimilated from Arabic sources and given a new Christian content, with the added universality of the Stoic and Augustinian world outlook. Aquinas' Summa theologiae purports to answer all the major questions of existence, including those of political philosophy. Like Aristotle, Aquinas thinks in terms of an ethical purpose. Natural law is discussed in the first part of the second book as part of the discussion of original sin and what would now be termed psychology, while war comes under the second part of the second book as an aspect of virtue and vice. Law is defined as "that which is regulation and measure." It is designed to promote the "felicity and beatitude" that are the ends of human life. Aquinas agrees with Aristotle that "the city is the perfection of community" and that the purpose of public power should be to promote the common good. The only legitimate power is from the community, which is the sole medium of man's well being. In his De regimine he compares society to a ship in need of a helmsman and repeats Aristotle's definition of man as a social and political animal. Again following Aristotle, he considers oligarchy unjust and democracy evil. Rulers should aim to make the "life of the multitude good in accordance with the purpose of life which is heavenly happiness." They should also create peace, conserve life, and preserve the state--a threefold responsibility. Here is a complete program for a hierarchical society within a cosmic order. It combines the Hellenic sense of purpose with Christian aims and asserts that, under God, power resides in the community, embodied in the ruler but only for so long as he does right. Hence the comment that "St. Thomas Aquinas was the first Whig"--a pioneer of the theory of constitutional government. The society he envisages, however, is medieval, static, hierarchical, conservative, and based on limited agriculture and even more limited technology. Nonetheless, Thomism remains the most complete and lasting political doctrine of the Catholic Church, since modified and adapted but not in principle superseded.
Dante.
By the early 14th century the great European institutions, empire and papacy, were breaking down through mutual conflict and the emergence of national realms. But this conflict gave rise to the most complete political theory of universal and secular empire formulated in the medieval West. Dante's De monarchia (c. 1313), still in principle highly relevant, insists that only through universal peace can human faculties come to their full compass. But only "temporal Monarchy" can achieve this: "a unique princedom extending over all persons in time." The aim of civilization is to actualize human potentialities, and to achieve that "fullness of life which comes from the fulfillment of our being." Monarchy, Dante argues, is necessary as a means to this end. The imperial authority of the Holy Roman emperor, moreover, comes direct from God and not through the pope. The empire is the direct heir of the Roman Empire, a legitimate authority, or Christ would not have chosen to be born under it. In subjecting the world to itself, the Roman Empire had contemplated the public good.
This high-flown argument, part of the political warfare between the partisans of the emperor and pope that was then affecting Italy, drives to essentials: that world peace can be secure only under a world authority. That Dante's argument was impractical did not concern this medieval genius, who was writing more the epitaph than the prospectus of the Holy Roman Empire; he was concerned, like St. Thomas, to create a political philosophy with a clear-cut aim and a universal view. Out of the grand but impractical visions of the High Middle Ages in the 13th-century climax of Christian civilization there emerged by early modern times the idea of a well-governed realm, its authority derived from the community itself, with a program designed to ensure the solvency and administrative efficiency of a secular state. In spite of the decline of the civilization of antiquity in the West, the Greco-Roman sense of purpose, of the rule of law, and of the responsibility of power survived in Christian form.
THE 16TH TO THE 18TH CENTURIES
Machiavelli.
In the thought of the Italian political philosopher Niccoln Machiavelli may be seen a complete secularization of political philosophy. Machiavelli was an experienced diplomat and administrator, and, since he stated flatly how the power struggle was conducted in Renaissance Italy, he won a shocking reputation. He was not, however, without idealism about the old Roman republic, and he admired the independent spirit of the German and Swiss cities. This idealism made him all the more disgusted with Italian politics, of which he makes a disillusioned and objective analysis. Writing in retirement after political disgrace, Machiavelli states firmly that,
Since this is to be asserted in general of men, that they are ungrateful, fickle, false, cowards, covetous, and as long as you succeed they are yours entirely: they will offer you their blood, property, life, and children . . . when the need is far distant; but when it approaches they turn against you.
And again,
since the desires of men are insatiable, nature prompting them to desire all things and fortune permitting them to enjoy but few, there results a constant discontent in their minds, and a loathing of what they possess.
This view of human nature, already expressed by Plato and St. Augustine, is here unredeemed by Plato's doctrine of form and illusion or by St. Augustine's dogma of salvation through grace. Machiavelli accepts the facts and advises the ruler to act accordingly. The prince, he states, must combine the strength of the lion with the cunning of the fox: he must always be vigilant, ruthless, and prompt, striking down or neutralizing his adversaries without warning. And when he does an injury it must be total. For "men ought to be either well treated or crushed, because they can avenge themselves of lighter injuries, of more serious ones they cannot." Moreover, "irresolute princes who follow a neutral path are generally ruined." He advises that it is best to come down at the right moment on the winning side and that conquered cities ought to be either governed directly bythe tyrant himself residing there or destroyed. Princes, furthermore, unlike private men, need not keep faith: since politics reflects the law of the jungle, the state is a law unto itself, and normal moral rules do not apply to it. Machiavelli had stated with unblinking realism how, in fact, tyrants behave; and, far from criticizing their conduct or distinguishing between the just prince who rules by law and the tyrant whose laws are in his own breast, he considers that the successful ruler has to be beyond morality since the safety of and expansion of the state are the supreme objective. In this myopic view, the cosmic visions of Aquinas and Dante are disregarded, and politics becomes a fight for survival. Within his terms of reference, Machiavelli made a convincing case, although as an experienced diplomat he might have realized that dependability in fact pays and that systematic deceit, treachery, and violence usually bring about their own nemesis.
Hobbes.
The 17th-century English political philosopher Thomas Hobbes, who spent his life as a tutor and companion to great noblemen, was a writer of genius with a greater power of phrase than any other English political philosopher. He was not, as he is sometimes misrepresented, a prophet of "bourgeois" individualism, advocating free competition in a capitalistic free market. On the contrary, he was writing in a preindustrial, if increasingly commercial, society and did not much admire wealth as such but rather "honours." He was socially conservative and anxious to give a new philosophical sanction to a hierarchical, if businesslike, commonwealth in which family authority was most important. Philosophically, Hobbes was influenced by nominalist scholastic philosophy, which had discarded Thomist metaphysics and had accepted a strict limitation of mind. He therefore based his conclusions on the rudimentary mathematical physics and psychology of his day and aimed at practical objectives--order and stability. He believed that the fundamental physical law of life was motion and that the predominant human impulses were fear and, among those above the poverty level, pride and vanity. Men, Hobbes argued, are strictly conditioned and limited by these laws, and he tried to create a science of politics that would reflect them. "The skill of making, and maintaining Common-wealths," therefore, "consisteth in certain Rules, as doth Arithmetique and Geometry; not (as Tennis play) on Practise onely: which Rules, neither poor men have the leisure, nor men that have had the leisure, have hitherto had the curiosity, or the method to find out." Hobbes ignores the classical and Thomist concepts of a transcendent law of nature, itself reflecting divine law, and of a "chain of being" whereby the universe is held harmoniously together and, following Descartes's practical method of investigation, states plainly that power creates law, not law power. For law is law only if it can be enforced, and the price of security is one supreme sovereign public power. For, without it, such is the competitive nature of men, that once more than subsistence has been achieved they are actuated by vanity and ambition, and there is a war of all against all. The true law of nature is self-preservation, he argues, which can be achieved only if the citizens make a compact among themselves to transfer their individual power to the "leviathan" (ruler), who alone can preserve them in security. Such a commonwealth has no intrinsic supernatural or moral sanction: it derives its original authority from the people and can command loyalty only so long as it succeeds in keeping the peace. He thus uses both the old concepts of natural law and contract, often invoked to justify resistance to authority, as a sanction for it. Hobbes, like Machiavelli, starts from an assumption of basic human folly, competitiveness, and depravity, and contradicts Aristotle's assumption that man is by nature a "political animal." On the contrary, he is naturally antisocial; and, even when men meet for business and profit, only "a certain market-fellowship" is engendered. All society is only for gain or glory, and the only true equality among men is their power to kill each other. Hobbes sees and desires no other equality. Indeed, he specifically discouraged "men of low degree from a saucy behaviour towards their betters." The Leviathan horrified most of his contemporaries; Hobbes was accused of atheism and of "maligning the Human Nature." But, if his remedies were tactically impractical, in political philosophy he had gone very deep by providing the sovereign nation-state with a pragmatic justification and directing it to utilitarian ends.
Spinoza.
The 17th-century Dutch philosopher Benedict de Spinoza also tried to make a scientific political theory, but it was more humane and more modern. Hobbes assumes a preindustrial and economically conservative society, but Spinoza, a Portuguese Jew born in Amsterdam, assumes a more urban setting. Like Hobbes, he is Cartesian, aiming at a scientific basis for political philosophy; but, whereas Hobbes was dogmatic and authoritarian, Spinoza desired toleration and intellectual liberty, by which alone human life achieves its highest quality. Spinoza, reacting against the ideological wars of religion and skeptical of both metaphysics and religious dogma, was a scientific humanist who justified political power solely by its usefulness. If state power breaks down and can no longer protect him or if it turns against him, frustrates, or ruins his life, then any man is justified in resisting it, since it no longer fulfills its purpose. It has no intrinsic divine or metaphysical authority. In Tractatus Theologico-Politicus and the Tractatus Politicus Spinoza develops this theme. He intends, he writes, "not to laugh at men or weep over them or hate them, but to understand them." In contrast to St. Augustine, he glorifies life and holds that governments should not try to "change men from rational beings into beasts or puppets, but enable them to develop their minds and bodies in security and to employ their reason unshackled." The more life is enjoyed, he declares, the more the individual participates in the divine nature. God is immanent in the entire process of nature, in which all creatures follow the laws of their own being to the limit of their powers. All are bound by their own consciousness, and man creates his own values. It seems that Spinoza thought good government approximated to that of the free burgesses of Amsterdam, a city in which religious toleration and relative political liberty had been realized. He is thus a pioneer of a scientific humanist view of government and of the neutrality of the state in matters of belief.
Richard Hooker's adapted Thomism.
While out of the breakup of the medieval social order there emerged the humanist but sceptical outlook of Machiavelli, then the scientific humanist principles of Descartes, Hobbes, and Spinoza, from which the utilitarian and pragmatic outlook of modern times derives, another influential and politically important strain of political philosophy also emerged. During the Reformation and Counter-Reformation, Protestant and Catholic dogmatists denounced each other and even attacked the authority of princes who, from interest or conviction, supported one side or the other. Political assassination became endemic, for both Protestant and Catholic divines declared that it was legitimate to kill an heretical ruler. Appeal was made to rival religious authority as well as to conscience. Men would resist authority and suffer execution rather than risk damnation, and in the resulting welter Hobbes and Spinoza advocated a sovereign state as the remedy. But other political philosophers salvaged the old Thomist concept of a divine cosmic order and of natural and human laws sanctioning the state. They also put forth the classical and medieval idea of the derivation of public power from the commonwealth as a whole and the responsibility of princes to the law. When Hobbes wrote that might makes right, he outraged such critics, who continued to assert that public power was responsible to God and the laws and that it was right to resist a tyrant who declared that the laws were in his own breast. This political theory was most influentially developed in England, where it inspired the constitutionalism that would also predominate in the United States. Richard Hooker, an Anglican divine who wrote Of the lawes of ecclesiasticall politie (1593-1662), reconciled Thomist doctrines of transcendent and natural law, binding on all men, with the authority of the Elizabethan Anglican Church, which he defended against the Puritan appeal to conscience. Society, he argued, is itself the fulfillment of natural law, of which human and positive law are reflections, adapted to society. And public power is not something personal, for it derives from the community under law. Thus,
The lawful power of making laws to command whole politic societies of men belongeth so properly unto the same entire societies, that for any prince . . . to exercise the same of himself . . . is no better than mere tyranny.
Such power can derive either directly from God or else from the people. The prince is responsible to God and the community; he is not, like Hobbes's ruler, a law unto himself. Law makes the king, not the king law. Hooker, indeed, insisted that "the prince has a delegated power, from the Parliament of England, together with the convocation (of clergy) annexed thereto . . . whereupon the very essence of all government doth depend." This is the power of the crown in parliament in a balanced constitution. Hence an idea of harmonious government by consent. The Thomist medieval universal harmony had been adapted to the nation-state.
Locke.
It was John Locke, politically the most influential English philosopher, who further developed this doctrine. His Two Treatises of Government (1690) were written to justify the Glorious Revolution of 1688-89, and his Letter Concerning Toleration (1689) was written with a plain and easy urbanity, in contrast to the baroque eloquence of Hobbes. Locke was a scholar, physician, and man of affairs, well-experienced in politics and business. As a philosopher he accepted strict limitations for mind, and his political philosophy is moderate and sensible, aimed at a balance among executive, judicial, and legislative powers, although with a bias toward the last. His first Treatise was devoted to confuting the Royalist doctrine of patriarchal divine right by descent from Adam, an argument then taken very seriously and reflecting the idea of government as an aspect of a divinely ordained chain of being. If this order were broken, chaos would come about. The argument was part of the contemporary conflict of the ancients and the moderns. Locke tried to provide an answer by defining a limited purpose for political power, which purpose he considered to be "a right of making laws with penalties of death, and consequently all less penalties, for the regulating and preserving of property, and of employing the force of the community in execution of such laws, and in the defense of the commonwealth from foreign injury, and all this only for the public good." The authority of government derives from a contract between the rulers and the people, and the contract binds both parties. It is thus a limited power, proceeding according to established laws and "directed to no other end but the peace, safety, and public good of the people." Whatever its form, government, to be legitimate, must govern by "declared and reasoned laws," and, since every man has a "property" in his own person and has "mixed his labour" with what he owns, government has no right to take it from him without his consent. It was the threat of attack on the laws, property, and the Protestant religion that had roused resistance to James II. Locke is expressing the concerns and interests of the landed and moneyed men by whose consent James's successor, William III, came to the throne, and his commonwealth is strictly conservative, limiting the franchise and the preponderant power to the propertied classes. Locke was thus no democrat in the modern sense and was much concerned to make the poor work harder. Like Hooker, he assumes a conservative social hierarchy with a relatively weak executive power and defends the propertied classes both against a ruler by divine right and against radicals. In advocating toleration in religion he was more liberal: freedom of conscience, like property, he argued, is a natural right of all men. Within the possibilities of the time, Locke thus advocated a constitutional mixed government, limited by parliamentary control of the armed forces and of supply. Designed mainly to protect the rights of property, it was deprived of the right of arbitrary taxation or imprisonment without trial and was in theory responsible to all the people through the politically conscious minority who were thought to represent them. Though he was socially conservative, Locke's writings are very important in the rise of liberal political philosophy. He vindicates the responsibility of government to the governed, the rule of law through impartial judges, and the toleration of religious and speculative opinion. He is an enemy of the totalitarian state, drawing on medieval arguments and deploying them in practical, modern terms.
Burke.
The Irishman Edmund Burke, while elaborating Whig constitutional doctrine expressed with such common sense by Locke, wrote with more emotion and took more account of time and tradition. While reiterating that government is responsible to the governed and distinguishing between a political society and a mere mob, he thought that governments were trustees for previous generations and for posterity. He made the predominant political philosophy of the 18th-century establishment appear more attractive and moral, but he wrote no great single work of political philosophy, expressing himself instead in numerous pamphlets and speeches. In his early Vindication of Natural Society Burke is critical of the sufferings imposed by government, but his " Thoughts on the Cause of the Present Discontents" defines and defends the principles of the Whig establishment. He invoked a transcendent morality to sanction a constitutional commonwealth, but he detested abstract political theories in whose name men are likely to vivisect society. He set great store by ordered liberty and denounced the arbitrary power of the Jacobins who had captured the French Revolution. In his Reflections on the Revolution in France (1790) and An Appeal from the New to the Old Whigs (1791), he discerned in the doctrine of sovereignty of the people, in whose name the revolutionaries were destroying the old order, another and worse form of arbitrary power. No one generation has the right to destroy the agreed and inherited fabric of society, and "Neither the few nor the many have the right to govern by their will." A country is not a mere physical locality, he argued, but a community in time into which men are born, and only within the existing constitution and by the consent of its representatives can changes legitimately be made. Once the frame of society is smashed and its law violated, the people become a "mere multitude told by the head," at the mercy of any dictator who can seize power. He was realistic in predicting the consequences of violent revolution, which usually ends up in some kind of dictatorship. Burke, in sophisticated accents, spoke for the ancient and worldwide rule of custom and conservatism and supplied a needed romanticism to the calculating good sense of Locke.
Vico.
The political philosophies hitherto surveyed contained little idea of progress. In antiquity the idea of cyclic recurrence predominated, and even 18th-century Christians believed that the world had been created in 4004 BC and would end in the Second Coming of Christ and a judgment. The 14th-century Arab philosopher of history Ibn Khaldun of Tunis, in the Muqaddimah to his Kitab al-'ibar, had pioneered a vast sociological view of the historical process; but in western Europe it was a neglected Neapolitan philosopher, Giambattista Vico (1668-1744), who first interpreted the past in terms of the changing consciousness of mankind. His Scienza nuova (1725; revised edition 1744) interpreted history as an organic process involving language, literature, and religion and attempted to reveal the mentality or ethos of earlier ages: the age of the gods, the heroic age, and the human age, its climax and decadence. These ages recur, and each is distinguished by mythology, heroic poetry, and rational speculation respectively. In contrast to the legalistic, contractual, and static political philosophies then prevalent, Vico had discerned new horizons.
Montesquieu.
This sort of vision was developed and elegantly popularized by the cosmopolitan French savant Montesquieu, whose work The Spirit of Laws (Eng. trans. 1750) won immense influence. It was an ambitious treatise on human institutions and a pioneer work of anthropology and sociology. Believing in an ordered universe--for "how could blind fate have produced intelligent beings?"--Montesquieu examined the varieties of natural law, varying customs, laws, and civilizations in different environments. He made the pedestrian good sense of Locke seem provincial, although he admired him and the British constitution. Unfortunately, he overemphasized the separation of executive, judicial, and legislative powers, considerable in Locke's day but by his own time tending to be concentrated in the sovereignty of Parliament. This doctrine much influenced the founders of the United States and the early French Revolutionaries.
Rousseau.
The revolutionary romanticism of the Swiss-French philosopher Jean-Jacques Rousseau may be interpreted in part as a reaction to the analytic rationalism of the Enlightenment. He was trying to escape the aridity of a purely empirical and utilitarian outlook and attempting to create a substitute for revealed religion. Rousseau's Émile (1762) and Du contrat social (1762) proved revolutionary documents, and his posthumous Considérations sur le gouvernement de Pologne ("Considerations on the Government of Poland") contains desultory but often valuable reflections on specific problems. There had been radical political slogans coined in medieval peasant revolts and in the 17th century, as in the Putney debates (1647) in the Cromwellian army, when a Puritan officer declared that "the poorest hee that is in England hath a life to live as the greatest hee," but the inspiration of these movements had been religion. Now Rousseau proclaimed a secular egalitarianism and a romantic cult of the common man. His famous sentence, "man is born free, but he is everywhere in chains," called into question the traditional social hierarchy: hitherto, political philosophers had thought in terms of elites, but now the mass of the people had found a champion and were becoming politically conscious Rousseau was a romantic, given to weeping under the willows on Lake Geneva, and the Social Contract and Discourses are hypnotically readable, flaming protests by one who found the hard rationality of the 18th century too exacting. But man is not, as Rousseau claims, born free. Man is born into society, which imposes restraints on him. Casting about to reconcile his artificial antithesis between man's purported natural state of freedom and his condition in society, Rousseau utilizes the old theories of contract and transforms them into the concept of the "general will." This general will, a moral will that aims at the common good and in which all participate directly, reconciles the individual and the community by representing the will of the community as deriving from the will of moral individuals, so that to obey the laws of such a community is in a sense to follow one's own will, assuming that one is a moral individual. Similar ideas to that of the general will became accepted as a basis for both the social-democratic welfare state and for totalitarian dictatorships. And, since the idea was misapplied from small village or civic communities to great sovereign nation-states, Rousseau was also a prophet of a nationalism that he never advocated. Rousseau himself wanted a federal Europe. He never wrote the proposed sequel to the Du contrat social in which he meant to deal with international politics, but he declared that existing governments lived in a state of nature, that their obsession with conquest was imbecilic, and that "if we could realize a European republic for one day, it would be enough to make it last for ever" (Political Writings I, pp. 365-388). But, with a flash of realism, he thinks the project impracticable, owing to the folly of men. The incursion of this revolutionary romantic into political philosophy changed the climate of political opinion, for it coincided with the breakdown of the old dynastic order and the emergence first of the middle classes and then of the masses to political consciousness and power. That the concept of general will was vague only increased its adaptability and prestige: it would both make constitutionalism more liberal and dynamic and give demagogues and dictators the excuse for "forcing people to be free" (that is, forcing people to follow the general will, as interpreted by the ruling forces). Rousseau could inspire liberals, such as the 19th-century English philosopher T.H. Green, to a creative view of a state helping people to make the best of their potential through a variety of free institutions. It could also play into the hands of demagogues claiming to represent the general will and bent on molding society according to their own abstractions.
THE 19TH CENTURY
Utilitarianism.
A major force in the political and social thought of the 19th century was Utilitarianism, the doctrine that the actions of governments should be judged simply by the extent to which they promoted the "greatest happiness of the greatest number." The founder of the Utilitarian school was Jeremy Bentham, an eccentric Englishman trained in the law. Bentham judged all laws and institutions by their utility thus defined. "The Fabric of Felicity," he wrote, "must be reared by the hands of reason and Law." Bentham's Fragment, on Government (1776) and Introduction to the Principles of Morals and Legislation (1789) elaborated a Utilitarian political philosophy. Bentham was an atheist and an exponent of the new laissez-faire economics of Adam Smith and David Ricardo, but he inspired the spate of legislation that, after the Reform Bill of 1832, had tackled the worst consequences of 18th-century inefficiency and of the Industrial Revolution. His influence, moreover, spread widely abroad. At first a simple reformer of law, Bentham attacked notions of contract and natural law as superfluous, "The indestructible prerogatives of mankind," he wrote, "have no need to be supported upon the sandy foundation of a fiction." The justification of government is pragmatic, its aim improvement and to release the free choice of individuals and the play of market forces that will create prosperity. Bentham thought men far more reasonable and calculating than they are and brushed aside all the Christian and humanist ideas rationalizing instinctive loyalty and awe. He thought society could advance by calculation of pleasure and pain, and his Introduction even tries to work out "the value of a lot of pleasure and pain, how now to be measured." He compared the relative gratifications of health, wealth, power, friendship, and benevolence, as well as those of "irascible appetite" and "antipathy." He also thought of punishment purely as a deterrent, not as retribution, and graded offenses on the harm they did to happiness, not on how much they offended God or tradition. If Bentham's psychology was nadve, that of his disciple James Mill was philistine. Mill postulated an economic man whose decisions, if freely taken, would always be in his own interest, and he believed that universal suffrage, along with Utilitarian legislation by a sovereign parliament, would produce the kind of happiness and well-being that Bentham desired. In his Essay on Government (1828) Mill thus shows a doctrinaire faith in a literate electorate as the means to good government and in laissez-faire economics as a means to social harmony. This Utilitarian tradition was humanized by James Mill's son, John Stuart Mill, one of the most influential of mid-Victorian liberals. Whereas James Mill had been entirely pragmatic, his son tried to enhance more sophisticated values. He thought that civilization depended on a tiny minority of creative minds and on the free play of speculative intelligence. He detested conventional public opinion and feared that complete democracy, far from emancipating opinion, would make it more restrictive. Amid the dogmatic and strident voices of mid-19th-century nationalists, utopians, and revolutionaries, the quiet, if sometimes priggish, voice of mid-Victorian liberalism proved extremely influential in the ruling circles of Victorian England. Accepting democracy as inevitable, J.S. Mill expressed the still optimistic and progressive views of an intellectual elite. Without complete liberty of opinion, he insisted, civilizations ossify. The quality of progress results not merely from the blind forces of economic competition but from the free play of mind. The worth of the state in the long run is only the worth of the individuals composing it, and without men of genius society would become a "stagnant pool." This militant humanist, unlike his father, was aware of the dangers of even benevolent bureaucratic power and declared that a state that "dwarfs its men" is culturally insignificant. Mill also advocated the legal and social emancipation of women, holding that ability was wasted by mid-Victorian conventions. He believed that the masses could be educated into accepting the values of liberal civilization, but he defended private property and was as wary of rapid extensions of the franchise as of bureaucratic power.
Tocqueville.
Mill's friend Alexis de Tocqueville, whose De la démocratie en Amérique ( Democracy in America) appeared in 1835-40, was a French civil servant also concerned with maintaining the standards and creativeness of civilization in face of the rising tide of mass democracy. Since the United States was then the only large-scale democracy extant, Tocqueville decided to go there, and as a result of his visit wrote a classic account of early 19th-century American civilization. "We cannot," he wrote, "prevent the conditions of men from becoming equal, but it depends upon ourselves whether the principle of equality will lead them to servitude or freedom, to knowledge or barbarism, to prosperity or wretchedness." He feared the possible abuse of power by centralized government, unrestrained by the power of the old privileged classes, and thought it essential to "educate democracy" so that, although it would never have the "wild virtues" of the old regimes, it would have its own dignity, good sense, and even benevolence. Tocqueville greatly admired American representative institutions and made a penetrating analysis of the new power of the press. He realized, as few people then did, that the United States and Russia would become world powers, and he contrasted the freedom of the one and the despotism of the other. He also foresaw that under democracy education would be respected more as a ladder to success than for its intrinsic content and might thus become mediocre. He was alive to the dangers of uniform mediocrity but believed, like Mill, that democracy could be permeated by creative ideas.
T.H. Green.
This kind of humanism was given a more elaborate philosophical content by the English philosopher T.H. Green, whose Lectures on the Principles of Political Obligation (1895; reprinted from Philosophical Works, vol. 2, 1885) greatly influenced the Liberals in the British governments of the period 1906-15. Green, like J.S. Mill and Tocqueville, wished to extend the minority culture to the people and even to use state power to "hinder hindrances to the good life." He had absorbed from Aristotle, Spinoza, Rousseau, and Hegel an organic theory of the state. The latter, by promoting the free play of spontaneous institutions, ought to help individuals both to "secure the common good of society [and] enable them to make the best of themselves." While hostile to the abuse of landed property, Green was not a Socialist. He accepted the idea that property should be private and unequally distributed and thought the operation of the free market the best way to benefit the whole society; for free trade would, he thought, diminish the inequalities of wealth in a common prosperity. But Green would have extended the power of the state over education, health, housing and town planning, and the relief of unemployment--a new departure in Liberal thought. These recommendations are embedded in the most elaborate and close-knit intellectual construction made by any modern British political philosopher, and they laid the foundation of the British welfare state.
Liberal nationalism.
Whereas Green shirked the extension of liberal and constitutional principles into international affairs, the Italian patriot and revolutionary prophet Giuseppe Mazzini made it his vision and became the most influential prophet of liberal nationalism. In his The Duties of Man and Essays he envisaged a harmony of free peoples--a "sisterhood of nations," in which the rule of military empires would be thrown off, the destruction of clerical and feudal privileges accomplished, and in which the emancipated peoples would be regenerated by means of education and universal suffrage. This vision inspired the more idealistic aspects of the Italian Risorgimento (national revival or resurrection) and of nationalistic revolts in Europe and beyond. Though, in fact, fervid nationalism often proved destructive, Mazzini advocated a united Europe of free peoples, in which national singularities would be transcended in a pan-European harmony. This sort of liberal democratic idealism was catching, and even if it frequently inspired Machiavellian policies, it also inspired President Woodrow Wilson of the United States, who, had he not been thwarted by domestic opposition, might well have made a Mazzinian-type League of Nations a success. Moreover, the Europe of the Common Market owes much to the apparently impractical liberal idealism of Mazzini.
American constitutionalism.
The United States was founded by men deeply influenced by republicanism, by Locke, and by the optimism of the French Enlightenment. George Washington, John Adams, and Thomas Jefferson all concurred that laws, rather than men, should be the final sanction and that government should be responsible to the governed. But the influence of Locke and the Enlightenment was not entirely happy. John Adams, who followed Washington as president, prescribed a constitution with a balance of executive and legislative power checked by an independent judiciary. The federal constitution, moreover, could be amended only by a unanimous vote of the states. Anxious to safeguard state liberties and the rights of property, the founding fathers gave the federal government insufficient revenues and coercive powers, as a result of which the constitution was stigmatized as being "no more than a Treaty of Alliance." Yet the federal union was preserved. The civil power controlled the military, and there was religious toleration and freedom of the press and of economic enterprise. Most significantly, the concept of natural rights had found expression in the Declaration of Independence and was to influence markedly political and legal developments in the ensuing decades, as well as inspire the French Declaration of the Rights of Man.
Anarchism and utopianism.
While a liberal political philosophy within a framework of capitalistic free trade and constitutional self-government dominated the greatest Western powers, mounting criticism developed against centralized government itself. Radical utopian and anarchist views, previously expounded mainly by religious sects, became secularized in such works as William Godwin's Political Justice (1793), Robert Owen's New View of Society (1813), and Pierre-Joseph Proudhon's voluminous and anticlerical writings. The English philosopher William Godwin, an extreme individualist, shared Bentham's confidence in the reasonableness of mankind. He denounced the wars accepted by most political philosophers and all centralized coercive states. The tyranny of demagogues and of "multitudes drunk with power" he regarded as being as bad as that of kings and oligarchs. The remedy, he thought, was not violent revolution, which produces tyranny, but education and freedom, including sexual freedom. His was a program of high-minded, atheistic anarchy. The English Socialist Robert Owen, a cotton spinner who had made a fortune, also insisted that bad institutions, not original sin or intrinsic folly, caused the evils of society, and he sought to remedy them by changing the economic and educational system. He thus devised a scheme of model cooperative communities that would increase production, permit humane education, and release the naturally benevolent qualities of mankind. The French moralist and advocate of social reform Pierre-Joseph Proudhon attacked the "tentacular" nation-state and aimed at a classless society in which major capitalism would be abolished. Self-governing producers, no longer slaves of bureaucrats and capitalists, would permit the realization of an intrinsic human dignity, and federation would replace the accepted condition of war between sovereign states. Proudhon tried to transform society by rousing the mass of the people to cooperative humanitarian consciousness.
Saint-Simon and Comte.
Another revolt against the prevalent establishment, national and international, was made by the French social philosopher Henri de Saint-Simon. Saint-Simon wanted to develop the Industrial Revolution so as to ameliorate the condition of the poorest class. This would be achieved not through political revolution, but through a government of bankers and administrators who would supersede kings, aristocrats, and politicians. If France were suddenly deprived of three thousand leading scientists, engineers, bankers, painters, poets, and writers, he argued, the result would be catastrophic; but if all the courtiers and bishops and 10,000 landowners vanished, the loss, though deplorable, would be much less severe. Saint-Simon also demanded a united Europe, superseding the warring nation-states, with a European parliament and a joint development of industry and communication. He also invented a synthetic religion appropriate to a scientific phase of history, with a cult of Newton and the great men of science. Saint-Simon's disciple Auguste Comte went further. His Course of Positive Philosophy (1830-42) and System of Positive Polity (1851-54) elaborated a "religion of humanity," with ritual, calendar, and a priesthood of scientists, and secular saints, including Julius Caesar, Dante, and Joan of Arc. Society would be ruled by bankers and technocrats and Europe united into a Western republic. This doctrine, backed by pioneering sociology, won much influence among intellectuals. Comte, like Saint-Simon, tackled the essential questions: how to deploy the power of modern technology for the benefit of all mankind; how to avoid wars between sovereign states; and how to fill the void left by the waning of Christian beliefs.
Hegel.
Whereas the utopian reformers had discarded metaphysical arguments, the German philosopher G.W.F. Hegel claimed to apprehend the totality of the cosmos by speculative cognition. Like Vico, he saw the past in terms of changing consciousness, but he viewed the historical process as one of "becoming" rather than as one of eternal recurrence. Hegel had no adequate historical data for his intuitions, since the whole of world history was even less known then than it is today, but his novel sweep and range of theory proved an intoxicating substitute for religion. He divided world history into four epochs: the patriarchal Eastern empire, the brilliant Greek boyhood, the severe manhood of Rome, and the Germanic phase after the Reformation. The "Absolute," like a conductor, summons each people to their finest hour, and neither individuals nor states have any rights against them during their historically determined period of supremacy. Many felt some sense of anticlimax, however, when he claimed that the Prussian state embodied the hitherto highest self-realization of the "Absolute" Not since St. Augustine had so compelling a drama been adumbrated. Hegel's drama, moreover, culminates in this world, for "the state is the divine idea as it exists on earth."
Marx and Engels.
Hegel was a conservative, but his influence on the revolutionaries Karl Marx and his collaborator Friedrich Engels was profound. They inherited the Hegelian claim to understand the "totality" of history and life as it progressed through a dialectic of thesis, antithesis, and synthesis. But, whereas Hegel envisaged a conflict of nation-states, Marx and Engels thought that the dynamism of history was generated by inevitable class conflict economically determined. This was an idea even more dynamic than Hegel's and more relevant to the social upheavals that were a consequence of the Industrial Revolution. Marx was a formidable prophet whose writings lead up to an apocalypse and redemption. A deeply learned humanist, his ideal was the fullest development of the human personality. But, whereas Plato was concerned with an elite, Marx cared passionately for the elevation of whole peoples. The Marxist credo was all the more effective as it expressed with eloquent ferocity the grievances of the poor, while prophesying retribution and a happy ending. For the state, once captured by the class-conscious vanguard of the proletariat, would take over the means of production from the capitalists, and a brief "dictatorship of the proletariat" would establish a truly communist society. The state would then wither away and man at last become "fully human" in a classless society. The powerful slogans of Marx and Engels were a natural result of the unbridled capitalism of laissez-faire, but politically they were nadve. In classical, medieval, and humanistic political philosophy the essential problem is the control of power, and to imagine that a dictatorship, once established, will wither away is utopian. As even Marx's fellow revolutionary the Russian anarchist M.A. Bakunin observed,
The revolutionary dictatorship of the doctrinaires who put science before life would differ from the established state only in external trappings. The substance of both are a tyranny of the minority over the majority--in the name of the many and the supreme wisdom of the few.
The revolutionaries would vivisect society in the name of dogmas and "destroy the present order, only to erect their own rigid dictatorship among its ruins."
Political philosophy in the 20th century
Nineteenth-century European civilization had been the first to dominate and pervade the whole world and to create a new self-sustaining productivity in which all eventually might share. But, as Saint-Simon had pointed out, this civilization had a fatal flaw. The rule of law, accepted within the politically advanced states, had never been achieved among them. Heavily armed nations and empires remained in a Hobbesian "posture of war," and classical and medieval ideals of world order had long been discarded. Within states, also, laissez-faire capitalism had exacerbated class conflicts, while the decline of religious belief had undermined traditional solidarity. And in 1914, when a general European war broke out, the peoples, contrary to the hopes of cosmopolitan revolutionaries, rallied behind their national governments. When the victorious powers failed to promote world order through the League of Nations, a second global conflict followed, during which were developed weapons so destructive as to threaten life everywhere. In the aftermath of these catastrophes and the worldwide revulsion they occasioned, not least against the European colonial powers, three mainstreams of mid-20th-century political philosophy may be discerned. In liberal-constitutional states, with modified, managerial capitalism and various degrees of public welfare, a political pragmatism has emerged, still maintaining the Aristotelian distinction between the rule of law and government by consent, on the one hand, and tyranny on the other. Second, there has been a reaffirmation of religious or quasi-religious values appealing to conscience and the inner man, expressed persuasively in Existentialist writings. Third, revolutionary ideas have also developed, most of them along Marxist lines. Other revolutionary doctrines appeal to anarchist traditions and are elaborated with neo-Marxist and neo-Freudian insights. Within these categories many shades of opinion are expressed, and only a sampling of representative views is presented here.
POLITICAL PRAGMATISM
The first, pragmatist approach probably has been most powerfully asserted in the United States and Great Britain. The American writer Lewis Mumford, for example, has advocated a militant humanism, defending people against the alienations of megalopolitan life and attacking mechanization and materialism. Like the Greek philosophers and like Tocqueville, whom he admires, Mumford declares, "In the end, all our contrivances have but one object; the continued growth of human personalities and the cultivation of the best life possible." The American philosopher and educationist John Dewey, on the other hand, sought to counteract the dehumanization of industrial mass society by a freer form of education, liberating the personality. Both these writers criticize the existing structure of society and its modified capitalism, but try to work within it. Another humanist, the English philosopher Bertrand Russell, was more radical. Russell carried into political philosophy an aristocratic individualism, campaigning for toleration, sexual freedom, compassion, and common sense. He broadcast elite values to a mass society and attacked materialism, crass bureaucracy, and war. He twice went to prison in pacifist protest and was obsessed with the universal menace of nuclear weapons. He denounced warlike political theories: "Remember your humanity," he said, "and forget the rest." On political tactics often inept, Russell won wide influence as a man of principle, concerned to adapt archaic institutions to the changed environment of mankind. The Austrian-born British philosopher Sir Karl Popper has demonstrated the pretensions of the 19th-century determinist philosophies such as those of Hegel and Marx, while an English historian and philosopher, Sir Isaiah Berlin, has ridiculed the idea of a supposedly objective march of histoy. Berlin also rejects the Marxist belief that all values are conditioned by the place men occupy on the "moving stair of time." Marx, he points out, was as romantic as Hegel in envisaging a "world which moves from explosion to explosion in order to fulfil the great cosmic design." Moral values, he insists, are not just a "subjective gloss unworthy of consideration on the great hard edifice of historical construction." No single formula can be found, Berlin argues, whereby the various objectives of men can be harmoniously realized. There are many human goals, which may well be in conflict with one another. This empirical, pluralist, and liberal political philosophy has much in common with the approach of the Frenchman Émile Durkheim and the Englishman Graham Wallas, both founding fathers of modern sociology. Statesmen and political philosophers, they contend, should not play the part of prophets but rather confine themselves to investigating social patterns and the ideas that are part of them. Ways might thus be found of promoting the survival and vitality of a given society in its particular setting. Graham Wallas was concerned to adapt constitutional societies by consent. He wanted to nationalize many essential means of production, including transport and communications, and through increased taxation strengthen social democracy by greater economic and social equality. He was not a revolutionary but a reformer, who understood the precariousness of civilization and the dangers of nationalism, which could only bring, he prophesied, centuries of warfare and regression. He advocated a worldwide and constitutionalist scientific humanism, inspired by the idea of the solidarity of the whole species, for "the master task of civilized mankind is to promote the conditions leading to the good life." Other political sociologists who accepted the established order did not expect to improve it. The Italian Vilfredo Pareto, and Gaetano Mosca, a Sicilian-born lawyer, set themselves not to state what they wanted but to record what occurs in society. Pareto's Mind and Society (1916) is an elaborate, quasi-mathematical classification of nonlogical political myths. Its form is daunting, but its insights are penetrating, especially a hilarious dissection of Rousseau's General Will, of which, Pareto concludes, "the intrinsic logico-experimental value . . . is zero." Ranging sardonically over history, Pareto insists that elites will always manipulate society, power merely shifting from one set of rulers to another. Mosca, in The Ruling Class (1939), analyzed how political myths are exploited. He also concluded that elites everywhere are bound to rule and that the least bad government occurs when abuse of power is checked by legal means; that is, by the rule of law. Mosca admired the liberal constitutionalism of the 19th century, although he was aware of its precariousness and limitations. He argued that there is no total explanation of history, which has always been the unpredictable outcome of competing and interacting interests. One thing is certain, nevertheless: in various forms there will always be a struggle for predominance. Mosca's views, more clearly set out than Pareto's, have a salutary realism. The American philosopher and critic James Burnham also analyzed shifts of power. In The Managerial Revolution (1941) he propounded a theory of bureaucratic revolution: the rulers of the new society, the class with power and privilege, will be the bureaucratic managers of "super states." In The Machiavellians, Defenders of Freedom (1943), he reinterprets Machiavelli and cites Mosca as a modern Machiavellian. Following Pareto's idea of the "circulation of elites," he asserts that, when a ruling class becomes inadequate, frivolous, or bored, loses confidence in itself and its myths, and becomes irresolute in deploying necessary force, new elites are bound to take over--as in the managerial revolution of the 20th century.
RELIGIOUS AND EXISTENTIALIST APPROACHES
In the second religious and quasi-religious group of political philosophies, the Catholic hierarchy has reiterated its ancient neo-Thomist doctrine of original sin and redemption. Pope Leo XIII, in the encyclicals Inscrutabili Dei Consilio (1878), Immortale Dei (1885), and Rerum Novarum (1891), dismissed all anthropocentric political philosophies as new versions of old heresies. The world, "through an insatiable craving for things perishable," was "rushing wildly upon the straight road to destruction." Society is intelligible only in the light of the Christian revelation and a future life:
exclude the idea of futurity and forthwith the very notion of what is good and right would perish, nay, the whole scheme of the universe would become a dark and unfathomable mystery.
Such is the human condition that visionary innovations are fruitless, and "venomous" teachings can only bring "death-bearing fruit." Society, as St. Augustine had declared, if organized without God, can only be a present hell. Hierarchy, authority, and censorship can alone "control the excesses of the unbridled intellect, which unfailingly end in the oppression of the untutored multitude." Property is essential to the family, on which the social order depends, and inequality is inherent in all human societies. Only a harmonious Christian commonwealth can assuage the consequences of sin, and within that social order the state should therefore encourage Christian trade unions and promote the welfare of the poor. Thus, with these views the papacy, maintaining its monopoly of revelation, tried to come to terms with the demands of industrial civilization. During the rise of 19th-century nationalism and of Communist, Fascist, and Nazi dictatorships, and in face of the increasing dominance of governments and large-scale industry in all mass societies, the importance of individual responsibility with regard to moral issues was emphasized by a divergent group of thinkers who have come to be described as Existentialists. Srren Kierkegaard (died 1855), a Danish philosopher, declared that "truth is subjectivity" and that only by means of inward revelation can man know God. Jean-Paul Sartre, a brilliant French Existentialist, tried to come to terms with dialectical Materialism. His Existentialism and Humanism (1948) comprises an affirmation of human dignity. "If," he writes, "I have excluded God the Father, there must be someone to invent values." Man, who has abandoned God, "must liberate himself by some practical commitment," for only then can he become fully human. Sartre's elaborate L'Etre et le néant (1943; Eng. trans., Being and Nothingness, 1956) is at once Cartesian and laborious, complete with a "key" to its special and pedantic terms. It investigates the loneliness of the human condition, attitudes to others, love, masochism, indifference, desire, and hate. This intense introspection is even more vividly expressed in his fiction and drama. The Algerian-born Albert Camus in The Myth of Sisyphus (1942) and The Rebel (1951) also agonizes brilliantly over the current human condition, and in Man in Revolt he discards hope of pragmatic improvement.
REVOLUTIONARY DOCTRINES
The third stream of contemporary political philosophy is Marxist-Leninist totalitarian and neo-Marxist anarchist. Many of Marx's original insights into the socio-economic process and its effect on ideas are now generally accepted. His prophecies, on the other hand, have not been fulfilled. The proletarian revolution, for example, came not in an economically advanced country but in one of the most backward; and the state, far from withering away or being diminished by inexorable economic trends, has in fact become more powerful both in Communist and in social-democratic countries. Those who have accepted the total Marxist revelation as superseding all else have had thus to adapt and revise it. Hence, much tortuous and artificial debate has ensued. All orthodox Marxists accept the Hegelian position that one can get beyond empirical knowledge and perceive the historically revealed installments of a total explanation. They also start from Marx's 19th-century belief that economically determined conflicts among feudal, bourgeois, and proletarian classes are the dynamic of history and that the rule of law is not a safeguard for the whole society against arbitrary power but merely the expression of class interest.
Lenin.
The first and by far the most significant interpretation of Marx's doctrine as realized in the Soviet Union was made by Lenin and developed by Stalin and is entirely authoritarian. According to Marx and Engels, the revolution could occur only after the bourgeois phase of production had "contradicted" the tsarist order, but Lenin determined to take advantage of the opportunities provided by World War I and settle accounts directly with the "accursed heritage of serfdom, of Asiatic barbarism . . . an insult to mankind," and in 1917 he engineered a coup that secured the support of the peasantry and the industrial workers. He also adopted the revolutionary theorist Leon Trotsky's idea of a "permanent revolution" from above by a small revolutionary elite. Already in What Is To Be Done? (1902), Lenin had argued that an educated elite must direct the proletarian revolution, and when he came to power he dissolved the constituent assembly and ruled through a "revolutionary and democratic dictatorship supported by the state power of the armed workers." In asserting the need for an elite of professional revolutionaries to seize power, Lenin reverted to Marx's program in The Communist Manifesto rather than conforming to the fated pattern of economic development worked out in Das Kapital. In 1921 he further adapted theory to the times. His new economic policy sanctioned the development of a class of prosperous "kulak" peasantry to keep the economy viable. For Lenin always thought in terms of world revolution; and, in spite of the failure of the Marxists in central Europe and the defeat of the Red armies in Poland, he died in the expectation of a global sequel. Thus, in Imperialism, the Highest Stage of Capitalism (1917), he had extended the class war into an inevitable conflict between European imperialism and the colonial peoples involved. He had been influenced by the English historian J.A. Hobson's Imperialism, a Study (1902), which alleged that decadent capitalism was bound to turn from glutted markets at home to exploit the toil of "reluctant and unassimilated peoples." But, as observed by classical, medieval, and modern constitutionalist political philosophers, authoritarian regimes suffer the tensions of all autocracies. Marx himself might have thought that such planned autocracies had made the worst of his revelation.
Other Marxist approaches.
Many Marxist revisionists tend toward anarchism, stressing the Hegelian and utopian elements of his theory. The Hungarian György Lukács, for example, and the German Herbert Marcuse, who fled from the Nazis to the United States, have won some following among those in revolt against both authoritarian "peoples' democracies" and the diffused capitalism and meritocracy of the managerial welfare state. Lukács' Geschichte und Klassenbewusstsein (1923; Eng. trans., History and Class Consciousness, 1971), a neo-Hegelian work, claims that only the intuition of the proletariat can properly apprehend the totality of history. But world revolution is contingent, not inevitable, and Marxism is an instrument, not a prediction. Lukács renounced this heresy after residence in the Soviet Union under Stalin, but he maintained influence through literary and dramatic criticism. After Khrushchev's denunciation of Stalin, Lukács advocated peaceful coexistence and intellectual rather than political subversion. In The Meaning of Contemporary Realism (trans. 1963), he again relates Marx to Hegel and even to Aristotle, against the Stalinist claim that Marx made a radically new departure. Lukács' neo-Marxist literary criticism can be tendentious, but his neo- Hegelian insights, strikingly expressed, have appealed to those anxious to salvage the more humane aspects of Marxism and to promote revolution, even against a modified capitalism and social democracy, by intellectual rather than by political means. Marcuse also reached back to the more utopian Marx. Now that most of the proletariat has been absorbed into a conformist managerial capitalism or has been regimented into bureaucratic peoples' democracies, freedom, argues Marcuse, is in retreat. In Western affluent societies most employers and workers are equally philistine, dominated by the commercialized mass media, or "cogs in a culture machine." The former Soviet Union had reverted to an even more philistine monolithic repression, distorting art and literature. This enslavement of man by his own industrial productivity had been clinched by the colossal power of governments, which rendered the old brief and brisk class warfare a romantic, impracticable idea. Marcuse attacked all establishments and transferred the redeeming mission of the proletariat to a fringe of alienated minorities--radical students and the exponents of the "hippie" way of life--as well as to Viet Cong guerrillas and Black Power militants. Such groups, he declared, could apparently form liberating elites and destroy the managerial society. Thus reappeared the old Marxist-Hebraic pattern of redemption through struggle by a chosen people. The Italian Communist Antonio Gramsci deployed a vivid rhetorical talent in attacking existing society. Like Marcuse, Gramsci was alarmed that the proletariat was being assimilated by the capitalist order. He took his stand on the already obsolescent Marxist doctrine of irreconcilable class war between bourgeois and proletariat. He aimed to unmask the bourgeois idea of liberty and to replace parliaments by an "implacable machine" of workers' councils, which would destroy the current social order through a dictatorship of the proletariat. "Democracy," he wrote, "is our worst enemy. We must be ready to fight it because it blurs the clear separation of classes." Not only would parliamentary democracy and established law be unmasked, but culture, too, would be transformed. A workers' civilization, with its great industry, large cities, and "tumultuous and intense life," would create a new civilization with new poetry, art, drama, fashions, and language. Gramsci insisted that the old culture should be destroyed and that education should be wrenched from the grip of the ruling classes and the church. But this militant revolutionary was also a utopian. He turned bitterly hostile to Stalin's regime, for he believed, like Engels, that the dictatorship of the workers' state would wither away. "We do not wish," he wrote, "to freeze the dictatorship." Following world revolution, a classless society would emerge, and mankind would be free to master nature instead of being involved in a class war. Since World War II, Gramsci's notions have enjoyed a minor revival. They appeal to the fringe of revolutionaries who admire Marcuse and detest the embourgeoisement of an idealized proletariat. But, in a civilization in which, if total war can be avoided, material prospects are good, the destruction of the old culture out of rage, envy, and nadve idealism appears to be a pointless program. Like Marcuse's doctrine, it is a cry of pain, typical of the 1920s in Italy.
Conclusion
The history of political philosophy from Plato until the present day makes plain that modern political philosophy is still faced with the basic problems defined by the Greeks. The need to redeploy public power in order to maintain the survival and enhance the quality of human life, for example, has never been so essential. And, if the opportunities for promoting well-being are now far greater, the penalties for the abuse of power are nothing less than the destruction or gross degradation of all life on the planet. In these circumstances it is of no great importance that some analytical philosophers have declared themselves neutral; they have at least often discredited pretentious metaphysical myths. On the empirical evidence, constitutionalism and the rule of law, with the ancient classic, medieval, and humanist traditions behind them, have proved themselves a more successful response to the environment than tyranny and repression. In the current and more sophisticated view, there are no shortcuts to the millennium. As Mosca points out, utopian ideas become
dangerous when they succeed in bringing a large mass of intellectual and moral energies to bear upon an end that can never be achieved, and that in the day of purported achievement can mean nothing more than the triumph of the worst people and distress and disappointment for the good.
There will perhaps always be a struggle for preeminence in any society, and public laws are necessary to regulate it. Too much cannot be hoped of government, and the best society is that in which tyranny and caprice of power are prevented and in which men are free to create diverse and spontaneous institutions within the framework of law. Only within such a framework of a tolerably well-organized constitutionalism, gradually extended to relations between states, can the swiftly mounting opportunities provided by applied science be taken and the pattern of social life adjusted, so that the human species, instead of being thwarted and deformed by its institutions, can realize its full potentialities.
Political Systems
The term political system may be used narrowly or broadly. Narrowly defined, it is the set of formal legal institutions that constitute a "government" or a "state." This is the definition adopted by many studies of the legal or constitutional arrangements of advanced political orders. More broadly defined, it comprehends actual as well as prescribed forms of political behaviour, not only the legal organization of the state but also the reality of how the state functions. Still more broadly defined, the political system is seen as a set of "processes of interaction" or as a subsystem of the social system interacting with other nonpolitical subsystems, such as the economic system. This points to the importance of informal sociopolitical processes and emphasizes the study of political development. Traditional legal or constitutional analysis, using the first definition, has produced a huge body of literature on governmental structures, many of the specialized terms that are a part of the traditional vocabulary of political science, and several instructive classifying schemes. Similarly, empirical analysis of political processes and the effort to identify the underlying realities of governmental forms have yielded a rich store of data and an important body of comparative theory. The third definition has inspired much scholarly work that employs new kinds of data, new terms, and some new concepts and categories of analysis. The discussion that follows draws on all three approaches to the study of political systems.
Typologies of government
The most important type of political system in the modern world is the nation-state. The world today is divided territorially into more than 175 states, in each of which a national government claims to exercise sovereignty--or the power of final authority--and seeks to compel obedience to its will by its citizens. This fact of the world's political organization suggests the distinction employed in the following section among supranational, national, and subnational political systems.
SUPRANATIONAL POLITICAL SYSTEMS
The formation of supranational relationships is a principal result of the division of the world into a number of separate national entities, or states, that have contact with one another, share goals or needs, and face common threats. In some cases, as in many alliances, these relationships are short-lived and fail to result in significant institutional development. In other cases, they lead to interstate organizations and supranational systems. The discussion below examines several types of supranational political systems, together with historical and contemporary examples of each.
Empires.
Because they are composed of peoples of different cultures and ethnic backgrounds, all empires are ultimately held together by coercion and the threat of forcible reconquest. Imposing their rule on diverse political structures, they are characterized by the centralization of power and the absence of effective representation of their component parts. Although force is thus the primary instrument of imperial rule, it is also true that history records many cases of multiethnic empires that were governed peaceably for considerable periods and were often quite successful in maintaining order within their boundaries. The history of the ancient world is the history of great empires--Egypt, China, Persia, and imperial Rome--whose autocratic regimes provided relatively stable government for many subject peoples in immense territories over many centuries. Based on military force and religious belief, the ancient despotisms were legitimized also by their achievements in building great bureaucratic and legal structures, in developing vast irrigation and road systems, and in providing the conditions for the support of high civilizations. Enhancing and transcending all other political structures in their sphere, they could claim to function as effective schemes of universal order. In contrast to the empires of the ancient world, the colonial empires of recent times fell far short of universal status. In part, these modern European empires were made up of "colonies" in the original Greek sense; peopled by immigrants from the mother country, the colonies usually established political structures similar to those of the metropolitan centre and were often able to exercise a substantial measure of self-government. In part, also, the European empires were composed of territories inhabited by native populations and administered by imperial bureaucracies. The government of these territories was generally more coercive than in the European colonies and more concerned with protection and supervision of the commercial, industrial, and other exploitative interests of the imperial power. The disintegration of these empires occurred with astonishing speed. The two world wars of the 20th century sapped the power of the metropolitan centres, while their own doctrines of democracy, equality, and self-determination undermined the principle of imperial rule. Powers such as Britain and France found it increasingly difficult to resist claims to independence couched in terms of the representative concepts on which their home governments were based, and they lacked the military and economic strength to continue their rule over restive native populations. In the two decades after 1945, nearly all the major colonial territories won their independence; the great colonial empires that had once ruled more than half the world were finally dismembered.
Leagues.
One of the commonest forms of supranational organization in history is that of leagues, generally composed of states seeking to resist some common military or economic threat by combining their forces. This was the case with the early city leagues, such as the Achaean and Aetolian leagues in ancient Greece and the Hanseatic and the Swabian leagues in Europe; and to a great extent it was the case with the League of Nations. Other common features of leagues include the existence of some form of charter or agreement among the member states, an assembly of representatives of the constituent members, an executive organ for the implementation of the decisions of the assembly of representatives, and an arbitral or judicial body for adjudicating disputes. The League of Nations was one of the great experiments in supranational organization of the 20th century and the predecessor in several important respects of the United Nations. The Covenant of the League was drafted by a special commission of the Peace Conference after World War I, with Pres. Woodrow Wilson of the United States as its leading advocate, and approved by a plenary conference of the victorious powers in 1919. The initial membership of the League consisted of 20 states. The United States failed to take membership in the League, but by 1928 the organization had a total membership of 54. The machinery of the League consisted of an Assembly of all the member nations, acting through agents of their governments; a council on which the great powers were permanently represented and to which the other member powers were elected by the Assembly for three-year terms; a Secretariat to administer the internal affairs of the League; and a number of specialized agencies, such as the International Labour Organisation, that were responsible for implementing various economic and humanitarian programs on an international basis. The Covenant required that international disputes be submitted to peaceful settlement with a provision for adjudication or arbitration by the Permanent Court of International Justice or for intervention by the Council of the League. The Covenant also provided for the use of financial and economic penalties, such as embargoes, to enforce the decisions of the League and for joint military action against convicted aggressors. In practice, however, the League failed its most important tests and was unable to master the crises that led to World War II and its own collapse.
Confederations.
Confederations are voluntary associations of independent states that, to secure some common purpose, agree to certain limitations on their freedom of action and establish some joint machinery of consultation or deliberation. The limitations on the freedom of action of the member states may be as trivial as an acknowledgment of their duty to consult with each other before taking some independent action or as significant as the obligation to be bound by majority decisions of the member states. Confederations usually fail to provide for an effective executive authority and lack viable central governments; their member states typically retain their separate military establishments and separate diplomatic representation; and members are generally accorded equal status with an acknowledged right of secession from the confederation. Historically, confederations have often proved to be a first or second step toward the establishment of a national state, usually as a federal union. Thus, the federal union of modern Switzerland was preceded by a confederation of the Swiss cantons; Germany's modern federal arrangements may be traced to the German Confederation of the 19th century (the Deutsche Bund); and the federal constitution of the United States is the successor to the government of the Articles of Confederation. In some other cases, confederations have replaced more centralized arrangements, as, for example, when empires disintegrate and are replaced by voluntary associations of their former colonies. The British Commonwealth, or Commonwealth of Nations, and the French Community are cases of this type. An example of confederal arrangements that gave birth to a federal union is the Articles of Confederation (1781-89) that preceded the Constitution of the United States. The Articles established a Congress of the confederation as a unicameral assembly of ambassadors from the 13 states, each possessing a single vote. The Congress was authorized to appoint an executive committee of states
to execute, in the recess of Congress, such of the powers of Congress as the United States, in Congress assembled, by the consent of nine States, shall from time to time think expedient to vest them with;
in turn, the committee of states could appoint a presiding officer or president for a term of one year. The Congress could also appoint such other committees and "civil officers as may be necessary for managing the general affairs of the United States" and was given the authority to serve as "the last resort or appeal in all disputes and differences, now subsisting or that hereafter may arise between two or more states." Although the Congress was given authority in important areas such as the regulation of foreign affairs, the establishment of coinage and weights and measures, the appointment of officers in the confederation's land and naval forces, and the issuance of bills of credit, all its powers were in fact dependent for their enforcement upon the states. The Congress lacked both an independent source of revenue and the executive machinery to enforce its will directly upon individuals. As the language of the Articles summarized the situation,
each State retains its sovereignty, freedom and independence, and every power, jurisdiction and right, which is not by this Confederation expressly delegated to the United States in Congress assembled.
The Commonwealth of Nations is an example of a confederation born as the result of the decentralization and eventual disintegration of an empire. The original members were the United Kingdom, Australia, Canada, the Irish Free State, Newfoundland, New Zealand, and the Union of South Africa. In 1949 Newfoundland became a province of Canada, and the Irish Free State became an independent republic; South Africa became an independent republic in 1961. New commonwealth members in the latter half of the 20th century were newly independent former British colonies, such as Malaysia (1957), Cyprus (1961), and Kiribati (1979), and numbered well over 40. The Statute of Westminster (1931) established that all members were equal in status, although all recognized the British monarch as head of the commonwealth. Commonwealth governments were represented in the capitals of other commonwealth countries by high commissioners equal in status to ambassadors. In 1965 the commonwealth established its Secretariat to organize meetings, keep the membership informed, and implement its collective decisions. The Commonwealth Fund for Technical Cooperation, which is financed by all member states, was implemented to provide technical assistance to less-developed states. The nations of the commonwealth rarely acted in concert on the international scene, and, despite fairly regular meetings of the commonwealth prime ministers, there were at times severe strains in the relations among several of the member states. The fairly general use of the English language and of English common law, together with some common symbols and remaining cultural affinities, appeared to be the major ties binding together this loose association.
Federations.
The term federation is used to refer to groupings of states, often on a regional basis, that establish central executive machinery to implement policies or to supervise joint activities. In some cases such groupings are motivated primarily by political or economic concerns; in others, military objectives are paramount. Examples of the former include the European Communities (EC), actually a combination of three main structures -- the European Coal and Steel Community, established in 1952; the European Economic Community (Common Market), established in 1958; and the European Atomic Energy Community (Euratom), established in 1958. The Communities quickly developed executive machinery exercising significant regulatory and directive authority over the governments and private business firms of the member countries. Although each of the member governments retains a substantial measure of sovereignty, and a systematic effort by one or more of the governments to resist the authority of the Communities' agencies could endanger the whole fabric of cooperative effort, the Communities have developed significant supranational features. These include the staffing of executive organs with persons other than governmental representatives, the making of binding decisions on important matters by majority vote, and the capability of the Communities' agencies to deal directly and authoritatively with individuals and companies within the member states. For example, the high authority of the Coal and Steel Community acts by majority vote of its members, without instruction from any of the governments, to "assure the achievement of the purposes stated in the Treaty"; and in pursuing this function it involves itself deeply in the economies of each of the member nations. The North Atlantic Treaty Organization (NATO), established in April 1949, is an example of a modern military alliance endowed with complex and permanent executive machinery, employing multilateral procedures, and involving the continuous elaboration of plans for the conduct of joint military action by its member states (Belgium, Canada, Denmark, France, Germany, Greece, Iceland, Italy, Luxembourg, The Netherlands, Norway, Portugal, Spain, Turkey, the United Kingdom, and the United States). As stated in its treaty, the purpose of NATO is to maintain the security of the North Atlantic area by exercise of the right of collective security recognized in the Charter of the United Nations. An impressive array of institutional mechanisms was established, including a secretary-general and a permanent staff, a council, a military command structure, and liaison staffs; and an ongoing system of collaboration in planning and joint military exercises was brought into being. With the continued development of its organization, NATO gradually added a number of economic and cultural activities to its functions until it came to possess several of the features of a multipurpose supranational organization.
The United Nations organization.
A supranational political system that does not fit precisely any of the conventional classifications of such systems is the United Nations, a voluntary association of most of the world's nation-states. Its membership had grown from an original 51 states to more than 175 by the late 20th century. (The government of the People's Republic of China was admitted in place of the government of Taiwan in 1971.) The United Nations was founded in 1945 at a conference in San Francisco that was attended by representatives of all the nations that had declared war on Germany or Japan. The purposes of the organization are declared in its Charter to be the maintenance of international peace and security, the development of friendly relations among states, and international cooperation in solving the political, economic, social, cultural, and humanitarian problems of the world. Its organizational structure consists of a Security Council of five permanent members (China, France, Russia, the United Kingdom, and the United States) and 10 nonpermanent members elected for two-year terms, a General Assembly, a secretary-general and a Secretariat, an Economic and Social Council, a Trusteeship Council, and the International Court of Justice. Attached to the United Nations are a number of specialized agencies, including the Food and Agriculture Organization, the International Atomic Energy Agency, the International Civil Aviation Organization, the International Labour Organisation, the International Monetary Fund, the International Telecommunications Union, the Universal Postal Union, the United Nations Educational, Scientific and Cultural Organization, the World Health Organization, and the International Bank for Reconstruction and Development (World Bank). Aside from the rather generally stated and decidedly elusive aims of the Charter, the member states of the United Nations cannot be said to have any common goal, and they have often failed to unify in the face of common external threats to security. There also has been difficulty in reaching and implementing decisions. Two different formulas are employed for voting in the two principal organs, the General Assembly and the Security Council. In the General Assembly a two-thirds majority decides on important matters, but, since the Assembly's decisions are not binding and are merely recommendations, this qualified majority principle must be viewed as of little significance. Although, on the other hand, the decisions of the Security Council may be binding, a unanimous vote of all five of the permanent members joined by the votes of at least four of the nonpermanent members is required; whenever important questions of peace and security are at stake, it has rarely been possible to achieve agreement among the five great powers of the council. Although these difficulties might be fatal to the survival of many supranational organizations, they are not in fact totally debilitating for the United Nations. The United Nations continues to serve as a very important forum for international debate and negotiation, and its specialized agencies play an important role in what is sometimes referred to as "the functional approach to peace."
NATIONAL POLITICAL SYSTEMS
The term nation-state is used so commonly and yet defined so variously that it will be necessary to indicate its usage in this article with some precision and to give historical and contemporary examples of nation-states. To begin with, there is no single basis upon which such systems are established. Many states were formed at a point in time when a people sharing a common history, culture, and language discovered a sense of identity. This was true in the cases of England and France, for example, which were the first nation-states to emerge in the modern period, and of Italy and Germany, which were established as nation-states in the 19th century. In contrast, however, other states, such as India, the Soviet Union, and Switzerland, came into existence without a common basis in race, culture, or language. It must also be emphasized that contemporary nation-states are creations of different historical periods and of varied circumstances. Before the close of the 19th century, the effective mobilization of governmental powers on a national basis had occurred only in Europe, the United States, and Japan. It was not until the 20th century and the collapse of the Ottoman, Habsburg, French, and British empires that the world could be fully organized on a national basis. This transformation was completed in 1991 with the dissolution of the U.S.S.R. In 1920 the League of Nations recognized seven nation-states as "Great Powers" (Britain, France, the United States, Germany, Italy, Japan, and Russia) and eventually admitted more than 40 other states to membership; the United Nations had more than 175 member states in the late 20th century. States in the post-Cold War world include the United States as the preeminent power; the established powers of Britain, France, China, Japan, Germany, and Russia; emerging powers such as Ukraine and Brazil; and a host of old and new states such as Denmark, Namibia, Kazakstan, Switzerland, Egypt, Turkey, Malaysia, and Chile. The characteristics that qualify these variously composed and historically differing entities as nation-states and distinguish them from other forms of social and political organization amount in sum to the independent power to compel obedience from the populations within their territories. The state is, in other words, a territorial association that may range in size from Russia to Singapore, in population from China to Luxembourg, and that claims supremacy over all other associations within its boundaries. As an association, the state is peculiar in several respects: membership is compulsory for its citizens; it claims a monopoly of the use of armed force within its borders; and its officers, who are the government of the state, claim the right to act in the name of the land and its people. A definition of the state in terms only of its powers over its members is not wholly satisfactory, however. Although all states make a claim to supremacy within their boundaries, they differ widely in their ability to make good their claims. States are, in fact, often challenged by competing associations within their boundaries; their supremacy is often more formal than real; and they are sometimes unable to maintain their existence. Moreover, a definition in terms of power alone ignores the fact that there are great differences among states in the structures they employ for the exercise of power, in the ways they use power, and in the ends to which they turn their power. Some of these differences are explored in the discussion that follows of two general categories of nation-states: the unitary state and the federal state. Partly from administrative necessity and partly because of the pressures of territorial interests, nearly all modern states provide for some distribution of governmental authority on a territorial basis. Systems in which power is delegated from the central government to subnational units and in which the grant of power may be rescinded at the will of the central government are termed unitary systems. Systems in which a balance is established between two autonomous sets of governments, one national and the other provincial, are termed federal. In federal systems, the provincial units are usually empowered to grant and take away the authority of their own subunits in the same manner as national governments in unitary systems. Thus, although the United States is federally organized at the national level, each of the 50 states is in a unitary relationship to the cities and local governments within its own territory.
Unitary nation-states.
A great majority of all the world's nation-states are unitary systems, including Belgium, Bulgaria, France, Great Britain, The Netherlands, Japan, Poland, Romania, the Scandinavian countries, Spain, and many of the Latin-American and African countries. There are great differences among these unitary states, however, specifically in the institutions and procedures through which their central governments interact with their territorial subunits. In one type of unitary system, decentralization of power among subnational governments goes so far that in practice, although not in constitutional principle, they resemble federal arrangements. In Great Britain, for example, there are important elements of regional autonomy in the relationship between Northern Ireland, Wales, and Scotland and the national government in London; and the complex system of elected local governments, although in constitutional theory subject to abrogation by Parliament, is in practice a fixed and fairly formidable part of the apparatus of British government. In other unitary systems of this type, decentralization on a territorial basis is actually provided for constitutionally, and the powers of locally elected officials are prescribed in detail. Thus, the Japanese constitution, for example, specifies certain autonomous functions to be performed by local administrative authorities. A second type of unitary system makes substantially less provision for territorial decentralization of authority and employs rather strict procedures for the central supervision of locally elected governments. The classic example of this type is France. Until March 1982, when a law on decentralization went into effect, the French administrative system was built around départements, each headed by a préfet, and subdivisions of the départements, termed arrondissements, each headed by a sous-préfet. The préfets and sous-préfets were appointed by the government in Paris to serve as agents of the central government and also as the executives of the divisional governments, the conseils généraux, which were composed of elected officials. The system thus combined central supervision of local affairs through appointed officials with territorial representation through locally elected governments. (Following the passage of the decentralization law, the executive powers of the préfets were transferred to the conseils généraux.) Yet a third type of unitary system provides for only token decentralization. In such cases, the officials responsible for managing the affairs of the territorial subdivisions are appointees of the central government, and the role of locally elected officers is either minimal or nonexistent. Examples of this kind of arrangement include Germany under Adolf Hitler and also several formerly Communist countries. The Third Reich was divided into 42 Gaue, each headed by a gauleiter chosen for his personal loyalty to Hitler. In eastern Europe, the people's councils or people's committees were named by the centrally organized Communist parties; their appointment was confirmed by elections with one slate of candidates.
Federal systems.
In federal systems, political authority is divided between two autonomous sets of governments, one national and the other subnational, both of which operate directly upon the people. Usually a constitutional division of power is established between the national government, which exercises authority over the whole national territory, and provincial governments that exercise independent authority within their own territories. Of the eight largest countries in the world, seven--Argentina, Australia, Brazil, Canada, India, Russia, and the United States--are organized on a federal basis. Federal states also include Austria, Germany, Malaysia, Mexico, Nigeria, Switzerland, and Venezuela. The governmental structures and political processes found in these federal systems show great variety. One may distinguish, first, a number of systems in which federal arrangements reflect rather clear-cut cultural divisions. A classic case of this type is Switzerland, where the people speak four different languages--German, French, Italian, and Romansh--and the federal system unites 26 historically and culturally different entities, known as cantons and demicantons. The Swiss constitution of 1848, as modified in 1874, converted into the modern federal state a confederation originally formed in the 13th century by the three forest cantons of Uri, Schwyz, and Unterwalden. The principal agencies of federal government are a bicameral legislature, composed of a National Council representing the people directly and a Council of States representing the constituent members as entities; an executive branch (Bundesrat) elected by both houses of the legislature in joint session; and a supreme court that renders decisions on matters affecting cantonal and federal relations. The Russian Federation's arrangements, although of a markedly different kind, also reflect the cultural and linguistic diversity of the country. Depending on their size and on the territories they have historically occupied, ethnic minorities may have their own autonomous republic, province, or district. These divisions provide varying degrees of autonomy in setting local policies and provide a basis for the preservation of the minorities' cultures. Some of these areas were integrated into the Russian Empire centuries ago, after the lands were taken from the Mongols of the Golden Horde, and others resisted occupation even late in the 19th century. It is not uncommon for Russians to constitute a plurality of the population in these areas. The national government consists of the executive branch, led by the nationally elected president; the parliament; and a judicial branch that resolves constitutional matters. In other systems, federal arrangements are found in conjunction with a large measure of cultural homogeneity. The Constitution of the United States delegates to the federal government certain activities that concern the whole people, such as the conduct of foreign relations and war and the regulation of interstate commerce and foreign trade; certain other functions are shared between the federal government and the states; and the remainder are reserved for the states. Although these arrangements require two separate bodies of political officers, two judicial systems, and two systems of taxation, they also allow extensive interaction between the federal government and the states. Thus, the election of Congress and the president, the process of amending the Constitution, the levying of taxes, and innumerable other functions necessitate cooperation between the two levels of government and bring them into a tightly interlocking relationship.
SUBNATIONAL POLITICAL SYSTEMS
Although national government is the dominant form of political organization in the modern world, an extraordinary range of political forms exists below the national level--tribal communities, the intimate political associations of villages and towns, the governments of regions and provinces, the complex array of urban and suburban governments, and the great political and administrative systems of the cities and the metropolises. These subnational entities are, in a sense, the basic political communities--the foundation on which all national political systems are built.
Tribal communities.
The typical organization of mankind in its early history was the tribe. Today, in many parts of the world, the tribal community is still a major form of human political organization. Even in advanced systems, traces can still be found of its influence. Some of the Länder of modern Germany, such as Bavaria, Saxony, or Westphalia, have maintained their identity since the days of the Germanic tribal settlements. In England, too, many county boundaries can be explained only by reference to the territorial divisions in the period after the end of the Roman occupation. In many African states, the tribe is still an effective community and a vehicle of political consciousness. Most of these states are the successors to the administrative units established by colonial regimes and owe their present boundaries to the often arbitrary decisions of imperial bureaucracies or to the territorial accommodations of rival colonial powers. The result was often the splintering of the tribal communities or their aggregation in largely artificial entities. Tribal loyalties continue to hamper nation-building efforts in some parts of the world where tribes were once the dominant political structure. Tribes may act through formal political parties like any other interest group. In some cases they simply act out their tribal bias through the machinery of the political system, and in others they function largely outside of formal political structures. In its primary sense, the tribe is a community organized in terms of kinship, and its subdivisions are the intimate kindred groupings of moieties, gentes, and totem groups. Its territorial basis is rarely defined with any precision, and its institutions are typically the undifferentiated and intermittent structures of an omnifunctional social system. The leadership of the tribe is provided by the group of adult males, the lineage elders acting as tribal chiefs, the village headmen, or the shamans, or tribal magicians. These groups and individuals are the guardians of the tribal customs and of an oral tradition of law. Law is thus not made but rather invoked; its repository is the collective memory of the tribal council or chief men. This kind of customary law, sanctioned and hallowed by religious belief, nevertheless changes and develops, for each time it is declared something may be added or omitted to meet the needs of the occasion.
Rural communities.
The village has traditionally been contrasted with the city: the village is the home of rural occupations and tied to the cycles of agricultural life, while the inhabitants of the city practice many trades, and its economy is founded on commerce and industry; the village is an intimate association of families, while the city is the locus of a mass population; the culture of the village is simple and traditional, while the city is the centre of the arts and sciences and of a complex cultural development. The village and the city offer even sharper contrasts as political communities. Historically, the village has been ruled by the primitive democracy of face-to-face discussion in the village council or by a headman whose decisions are supported by village elders or by other cooperative modes of government; urban government has never been such a simple matter, and monarchical, tyrannical, aristocratic, and oligarchic forms of rule have all flourished in the city. In the village, the boundaries among political, economic, religious, and other forms of action have not been as clearly drawn as in cities. The origins and development of the apparatus of government can be seen most clearly in the simple political society of the rural community. The transformation of kin-bound societies with their informal, folk-sustained systems of sociopolitical organization into differentiated, hierarchical societies with complex political structures began with the enlargement of the rural community--an increase in its population, the diversification of its economy, or its interaction with other communities. The rudimentary organs of communal government were then elaborated, the communal functions received more specialized direction, and leadership roles were institutionalized. This was sometimes a process that led by gradual stages to the growth of cities. Elsewhere, however, as in the case of ancient Attica, the city was established as the result of a process of synoikismos, or the uniting of a number of tribal or village communities. This was undoubtedly the origin of Athens, and, according to its legendary history, Rome also was established as a result of the forcible unification of the tribes that dwelt on the hills surrounding the Palatine Hill. Even in the nation-states of today's world, the contrasts between the village or the town and the city as centres of human activity are readily apparent. In the country, life is more intimate, human contacts more informal, the structure of society more stable. In the city, the individual becomes anonymous, the contacts between people are mainly formal, and the standing of the individual or the family in society is subject to rapid change. In many contemporary systems, however, the differences in the forms of government of rural and urban communities appear to be growing less pronounced. In the United States, for example, rural institutions have been seriously weakened by the movement of large numbers of people to the city. The township meeting of New England and other forms of direct citizen participation in the affairs of the community have declined in importance and have often been displaced by more formal structures and the growth of local governmental bureaucracies.
Cities.
Cities first emerged as complex forms of social and political organization in the valleys of the Euphrates and the Tigris, the Nile, the Huang Ho, and the Yangtze. These early cities broke dramatically with the patterns of primitive life and the rural societies from which they sprang. Kinship as the basis of society was replaced by status determined by class and occupation; the primitive magical leaders of the tribe were displaced by temple priesthoods presiding over highly developed religious institutions and functioning as important agencies of social control; earlier systems of rule by the tribal chieftains and the simple forms of communal leadership gave way to kingships endowed with magical powers and important religious functions; and specialized functionaries in the royal courts became responsible for supervising new kinds of governmental activity. Many other developments contributed to the growing centralization of power in these city civilizations. Barter was replaced by more effective systems of exchange, and the wealth generated in commerce and the specialized city trades became both an object of taxation and an instrument of power. Class distinctions emerged as the result of a division of labour and advances in technical development. A military order and a professional soldiery were created and trained in new techniques of warfare, and a slave class provided the work force for large-scale projects of irrigation, fortification, and royal architecture. As these developments proceeded, the city was able to project its power even further into the surrounding countryside, to establish its rule over villages and other cities in its sphere, and finally to become the centre of such early empires as those of Sumeria, Egypt, China, Babylonia, Assyria, and Persia. A very different form of city life emerged among the Greeks. The Greek polis also broke with the folkways of primitive society, but its political development was in striking contrast to the despotism of the Oriental city empires and their massive concentrations of power in the hands of king and priest. As the polis transcended its origins in village life, the powers of the tribal chief dwindled and passed into the hands of aristocratic families. The kingship of Homeric tradition vanished, the "kings" who remained became mere dignitaries in the religious and ceremonial life of the city, and new magistracies and other civic offices were founded. These offices became the focus of factional struggle among the aristocratic families and later, with the weakening of aristocratic rule, the chief prizes in a contest of power between the nobility and the common citizens. Eventually, these developments issued in the characteristic form of Greek city government. A citizen body, always a much narrower group than the total population but often as numerous as the population of freeborn males, acquired power in the direction of the city government through the election of its officers and direct participation in the city councils. Although often interrupted by episodes of oligarchic or tyrannical rule and by periods of civic dissension and class rivalry, the main theme of governmental development in the Greek city was the elaboration of structures that permitted the control of political affairs by its citizens. Autonomous cities also sprang up in Europe in the later Middle Ages. Medieval city life, although it differed from that of the polis and was coloured by the forms of feudal society, also emphasized the principle of cooperative association. Indeed, for the first time in the history of city civilization, the majority of the inhabitants of the city were free. The development of trades, the growth of commerce, and the mobilization of wealth emancipated the city from its feudal environment, and the merchant and craft guilds became the matrices of a new kind of city democracy. In time, the guilds were transformed into closed corporations and became a basis for oligarchic control; and the city's independence was threatened by the rise of the new nation-states. Tempting targets for the ambition of kings, Venice, Genoa, Florence, Milan, Cologne, Amsterdam, Hamburg, and other free cities of Europe eventually succumbed to monarchical control. Theirs was an important legacy, however, for the political order of the medieval city was a powerful influence in the development of the constitutional structures of the modern democratic state. Although cities are no longer independent, the almost universal increase in urban population has made them more important than ever before as centres of human activity. The political organization of modern cities differs from country to country. Even within the same nation-state, there are often important contrasts in the structures of city government. In the United States, for example, three principal types of city government are usually distinguished: the council-manager form, the mayor-council form, and the commission form. More than half of all American cities with populations between 25,000 and 250,000 operate under council-manager governments. In council-manager systems the council is generally small, elected at large on a nonpartisan ballot for overlapping four-year terms; no other offices are directly elected, and the mayor, who presides at council meetings and performs mainly ceremonial functions, is chosen by the council from among its members. The manager, a professional city administrator, is selected by the council, serves at the council's pleasure, and is responsible for supervising the city departments and municipal programs, preparing the budget, and controlling expenditures. Mayor-council governments are found in two basic forms, the "weak" mayor and the "strong" mayor. The former was typical of the 19th-century municipal organization and is now mainly confined to cities of less than 25,000 population; the latter is a common arrangement in cities with significantly larger populations. In weak-mayor-council governments, a number of officials, elected or appointed for lengthy terms, wield important administrative powers; the council, typically elected by divisions of the city called wards, is responsible for the direction of the major city agencies; and the mayor's powers of appointment and removal and his control over the city budget are severely limited. In many cases, strong-mayor-council governments evolved from weak-mayor-council systems as an independently elected mayor won the power of veto over council ordinances, strengthened his control over appointment and removal, and established himself as the city's chief budgetary officer; at the same time, also, the elective administrative officers and the semi-autonomous appointive boards and commissions were often eliminated and the number of councilmen reduced. The commission plan, which is now found in fewer than 200 cities of more than 10,000 population, concentrates legislative and executive powers in the hands of a small group of commissioners. The commissioners serve individually as the heads of administrative departments and choose one of their number to act as a ceremonial mayor without executive authority. The variety in the governmental structures of American cities is paralleled in many other countries, for everywhere in the modern world the government of the city continues to challenge man's political invention. Although no longer sovereign, cities are the centres of modern civilization and--both in terms of the services demanded of them and the range and importance of the functions they exercise--the most important of contemporary subnational political systems. Moreover, it is in the cities that most of the problems of modern industrial society seem to have their focus. These problems are not only governmental but also technological, cultural, and economic. They are found in their most acute form in the great metropolitan centres and in that vast urban agglomeration known as the megalopolis. In political terms, the issue that is posed appears to be whether these huge centres of population can continue as effective communities with democratically manageable governments.
Regions.
In many contemporary national political systems the forces of history and administrative necessity have joined to produce regional communities at an intermediate level between the local and the national community. In some cases--the Swiss canton, the English county, the German Land, and the American state--these regional communities possess their own political institutions and exercise governmental functions. In other cases, however, the territorial community is a product of ethnic, cultural, linguistic, physiographic, or economic factors and maintains its identity without the support of political structures. As subnational political systems, regional communities are sometimes based in tradition, even tracing their origin to a period prior to the founding of the nation; in other cases, they are modern administrative units created by national governments for their own purposes. Examples of both types may be found in the history of regionalism in France and its complex pattern of internal territorial divisions. Before the French Revolution, France was divided into ancient provinces--Burgundy, Gascony, Brittany, Normandy, Provence, Anjou, Poitou, and others. After the Revolution, in what seems to have been an effort to discourage regional patriotism and threats of separatism, the Napoleonic government superimposed a new regional structure of départements on the old provincial map. More than a century and a half later, in the era of rapid communications and national economic planning, the French national government announced a regrouping of the Napoleonic départements into much larger Gaullist régions. Recognizing, perhaps, the continuing strength of the provincial attachments of Gascon, Breton, Norman, and Provençal and the survival of old regional folk cultures with their distinctive patterns of speech, the new régions were given boundaries similar in many cases to the traditional provincial boundaries of pre-republican France. The history of the French regional communities is not a special case, for political, administrative, economic, and technical forces have led many other national governments to replace traditional territorial divisions with new regional units. In England, for example, the traditional structure of county governments (52 in number) was replaced by a system of administrative counties (61 plus London); and, in 1969, a royal commission proposed a further reform that would abolish 39 counties. Attempts have also been made to use older regional communities as the infrastructure for new systems of regional government. Thus, the Italian constitution provides for semi-autonomous government in five special regions--Valle d'Aosta, Sardinia, Sicily, Trentino-Alto Adige, and Friuli-Venezia Giulia--which, in different ways, are historically distinct from the rest of Italy. In yet other cases the fear of competition from regional governments or of separatist movements has led national governments to make various efforts to resist the development of regional political structures. Again, Italy provides a convenient example, for its constitution requires the establishment of 14 other autonomous regions, but Italian governments refused to implement this provision of the 1947 constitution until recently. It should be noted that the Italian republic of 1870-1922 and its Fascist successor state also made similar efforts to combat regional political development, the former by the creation of a large number of administrative provinces and the latter by establishing corporazione to represent occupations regardless of geographic location. In several modern states the growth of vast conurbations and the rise of the megalopolis have prompted the development of new kinds of regional governmental structures. The Port of London Authority, the Port of New York Authority, and the San Francisco Bay Area Transit Authority are examples of regional systems designed to serve the needs of urban communities that have outgrown the boundaries of existing city governments. New regional structures have also resulted from the increased responsibility of national governments for the administration of comprehensive social and economic programs. The Tennessee Valley Authority, for example, is both a national agency and a regional government whose decisions affect the lives of the inhabitants of all the states and cities in its sphere. Other examples of new regional administrative structures include the zonal councils established in India for social and economic planning purposes, the districts of the Interstate Commerce Commission in the United States, and the governmental and economic units established in Britain to deal with the problems of industrially depressed areas.
ISSUES OF CLASSIFICATION
Types of classification schemes.
The almost infinite range of political systems has been barely suggested in this brief review. Confronted by the vast array of political forms, political scientists have attempted to classify and categorize, to develop typologies and models, or in some other way to bring analytic order to the bewildering variety of data. Many different schemes have been developed. There is, for example, the classical distinction between governments in terms of the number of rulers--government by one man (monarchy or tyranny), government by the few (aristocracy or oligarchy), and government by the many (democracy). There are schemes classifying governments in terms of their key institutions (for example, parliamentarism, cabinet government, presidentialism). There are classifications that group systems according to basic principles of political authority or the forms of legitimacy (charismatic, traditional, rational-legal, and others). Other schemes distinguish between different kinds of economic organization in the system (the laissez-faire state, the corporate state, and Socialist and Communist forms of state economic organization) or between the rule of different economic classes (feudal, bourgeois, and capitalist). And there are modern efforts to compare the functions of political systems (capabilities, conversion functions, and system maintenance and adaptation functions) and to classify them in terms of structure, function, and political culture. Although none is comprehensive, each of these principles of analysis has some validity, and the classifying schemes that are based on them, although in some cases no longer relevant to modern forms of political organization, have often been a major influence on the course of political development. The most influential of such classifying schemes is undoubtedly the attempt of Plato and Aristotle to define the basic forms of government in terms of the number of power holders and their use or abuse of power. Plato held that there was a natural succession of the forms of government: an aristocracy (the ideal form of government by the few) that abuses its power develops into a timocracy (in which the rule of the best men, who value wisdom as the highest political good, is succeeded by the rule of men who are primarily concerned with honour and martial virtue), which through greed develops into an oligarchy (the perverted form of government by the few), which in turn is succeeded by a democracy (rule by the many); through excess, the democracy becomes an anarchy (a lawless government), to which a tyrant is inevitably the successor. Abuse of power in the Platonic typology is defined by the rulers' neglect or rejection of the prevailing law or custom ( nomos); the ideal forms are thus nomos observing (ennomon), and the perverted forms are nomos neglecting (paranomon). Although disputing the character of this implacable succession of the forms of government, Aristotle also based his classification on the number of rulers and distinguished between good and bad forms of government. In his typology it was the rulers' concern for the common good that distinguished the ideal from perverted forms of government. The ideal forms in the Aristotelian scheme are monarchy, aristocracy, and polity (a term conveying some of the meaning of the modern concept of "constitutional democracy"); when perverted by the selfish abuse of power, they are transformed respectively into tyranny, oligarchy, and ochlocracy (or the mob rule of lawless democracy). The concept of the polity, a "mixed" or blended constitutional order, fascinated political theorists for another millennium. To achieve its advantages, innumerable writers from Polybius to St. Thomas Aquinas experimented with the construction of models giving to each social class the control of appropriate institutions of government. Another very influential classifying scheme was the distinction between monarchies and republics. In the writings of Machiavelli and others, the tripartism of classical typologies was replaced by the dichotomy of princely and republican rule. Sovereignty in the monarchy or the principality is in the hands of a single ruler; in republics, sovereignty is vested in a plurality or collectivity of power holders. Reducing aristocracy and democracy to the single category of republican rule, Machiavelli also laid the basis in his analysis of the exercise of princely power for a further distinction between despotic and nondespotic forms of government. In the work of Montesquieu, for example, despotism, or the lawless exercise of power by the single ruler, is contrasted with the constitutional forms of government of the monarchy and the republic. As a result of the decline of monarchies and the rise of new totalitarian states terming themselves republics, this traditional classification is now, of course, of little more than historical interest.
Modern classifying systems.
The usefulness of all the traditional classifications has been undermined by the momentous changes in the political organization of the modern world. Typologies based on the number of power holders or the formal structures of the state are rendered almost meaningless by the standardization of "democratic" forms, the deceptive similarities in the constitutional claims and governmental institutions of regimes that actually differ markedly in their political practices, and the rise of new political orders in the non-Western world. A number of modern writers have attempted to overcome this difficulty by constructing classifying schemes that give primary importance to social, cultural, economic, or psychological factors. The most influential of such schemes is the Marxist typology, which classifies types of rule on the basis of economic class divisions and defines the ruling class as that which controls the means of production in the state. A monistic typology that also emphasized the importance of a ruling class was developed by an Italian theorist of the early 20th century, Gaetano Mosca. In Mosca's writings all forms of government appear as mere facades for oligarchy or the rule of a political "elite" that centres power in its own hands. Another classification, which distinguishes between "legitimate" and "revolutionary" governments, was suggested by Mosca's contemporary Guglielmo Ferrero. Using a sociopsychological approach to the relations between rulers and ruled, Ferrero held that a legitimate government is one whose citizens voluntarily accept its rule and freely give it their loyalty; in revolutionary systems, the government fears the people and is feared by them. Legitimacy and leadership are also the basis of a typology developed by the German sociologist Max Weber. In Weber's scheme there are three basic types of rule: charismatic, in which the authority or legitimacy of the ruler rests upon some genuine sense of calling and in which the followers submit because of their faith or conviction in the ruler's exemplary character; traditional, in which, as in hereditary monarchy, leadership authority is historically or traditionally accepted; and rational-legal, in which leadership authority is the outgrowth of a legal order that has been effectively rationalized and where there is a prevailing belief in the legality of normative rules or commands. The Weberian typology has been elaborated by a number of recent writers who have found it particularly useful for comparing and classifying the emergent political orders of the non-Western world. A serviceable classification of political systems must penetrate beneath formal appearances to underlying realities; these realities, however, do not consist only of the facts of social and economic organization. Important differences often exist between political systems having very similar socioeconomic structures. That is why some recent sociological classifications and schemes of analysis fail as tools of political inquiry: they cannot effectively distinguish between certain societies whose political orders are full of contrasts. The political system itself must be the primary focus of inquiry and the phenomena of politics the principal facts of investigation. Such an approach may involve many different kinds of analysis, but it must begin with an examination of the ways in which power is acquired and transferred, exercised, and controlled. This is important for comparing advanced political orders and also for drawing important distinctions between regimes in the underdeveloped areas of the world.
GOVERNMENTS CLASSIFIED BY MODE OF SUCCESSION
A key problem of all political orders is that of succession. "The king is dead; long live the king" was the answer, not always uncontested, of European hereditary monarchy to the question of who should rule after the death of the king. A second, closely related problem is in what manner and by whom a present ruler may be replaced or deprived of power. To this second question hereditary monarchy gave no definite answer, although the concept of diffidatio, or the severance of the bond of allegiance between king and feudal lord, was invoked more than once in the medieval period. Political systems, even those of primitive tribal societies, have approached both problems in a variety of ways. Anthropological records show that tribal chiefs or kings were sometimes selected as a result of ritual tests or the display of magical signs and proofs of divine origin, usually as determined by the tribal elders or magical leaders; in other cases, a principle of heredity, often diluted by a choice among heirs in terms of physique or warrior ability, was applied; in still other cases, the chief was elected, often from among the adult males of a select group of families. Techniques for the removal of tribal rulers were equally varied. Sometimes the ruler would be killed after a specified period or when his magical powers weakened or when his physical prowess or health failed; in other cases the chief was exposed to periodic tests of his magical powers or required to accept challenges to combat from other qualified candidates for rule; and in some cases the elders could remove him from office. Techniques for assuring the succession are also varied in the modern world. Succession procedures range from the complex hieratic process of identifying a reincarnated Dalai Lama, which was practiced until quite recently in Tibet, to the subtle, informal procedures by which parliamentary majorities choose a successor to the office of prime minister in Britain. In fact, however, the succession practices of modern political systems appear to be of four main types: (1) heredity, (2) constitutional prescription, (3) election, and (4) force.
Hereditary succession.
Although dictators still occasionally seek to establish their sons as their heirs, they usually rely on force rather than the claims of heredity to achieve their object. Apart from a few states, mostly in the Arab world, where the dynastic ruler is the effective head of the government, the hereditary principle of succession is now almost exclusively confined to the constitutional monarchies of western Europe. There is some irony in the fact that the line of succession is more securely established in these monarchies now than at any point in their earlier history: intradynastic struggle, it appears, is much less likely when kingship is mainly ceremonial. Heredity may be reinforced or modified by constitutional prescription: this was the case, for example, of the famous Act of Settlement that secured the Hanoverian succession in Britain.
Succession by constitutional prescription.
A leading example of succession by constitutional prescription is the United States. Article II, Section 1, of the Constitution of the U.S. provides:
In case of the removal of the President from office, or of his death, resignation, or inability to discharge the powers and duties of the said office, the same shall devolve on the Vice President, and the Congress may by law provide for the case of removal, death, resignation, or inability, both of the President and Vice President, declaring what officer shall then act as President, and such officer shall act accordingly, until the disability be removed, or a President shall be elected.
A constitutional amendment was ratified in 1967 elaborating these procedures to include further arrangements for dealing with the problem of presidential disability. The original language of the Constitution has been the basis for the peaceful succession of Vice Presidents John Tyler, Millard Fillmore, Andrew Johnson, Chester Arthur, Theodore Roosevelt, Calvin Coolidge, Harry S. Truman, and Lyndon Johnson. Constitutionally prescribed arrangements for assuring the succession are not always so successful, and many states whose constitutions contain very similar provisions have experienced succession crises that were resolved only by violence.
Succession by election.
Election is a principle of succession also frequently combined with force. In cases of closely contested elections or where there is doubt as to the validity or proper form of the election, the result is often a disputed succession. The Great Schism in the papacy in the 14th century and the disputed succession to the elective kingship of Hungary in the 16th century are examples of the failure of elective systems to assure an orderly succession. Force is the effective basis of succession in several contemporary states in which pro forma electoral confirmation is given to a ruler who seizes power. The problem of succession imposes great strains on any political order: the continuity of rule is broken, established patterns of action are interrupted, and the future suddenly becomes uncertain. This political crisis tests the character of regimes in ways that are of some importance for comparative political analysis. A number of interesting comparisons may be drawn from the study of succession practices, but perhaps the most important is the distinction between those systems in which the problem is resolved primarily by force and those systems in which heredity, constitutional prescription, or election assure a peaceful and orderly succession. Political orders are subjected to another kind of strain when the rule of their present power holders is challenged and the question arises of depriving them of authority. This is the problem of the transfer of power: whether, in what way, and by whom a present ruler may be displaced. Like succession, it is a recurrent problem in all political systems, and, as in the case of succession practices, the ways in which political systems respond to the strains involved offer important clues to their character. It is, in a sense, the fundamental political crisis, for all systems are in some way shaken, often violently, sometimes to the point of destruction, by the struggles between established rulers and their rivals.
Succession by force.
Revolutions, which are the result of the crisis in its most extreme form, involve the overthrow not merely of the government but of the political order itself. Typically, a revolution is preceded by a series of strains within the system: challenges to the authority of the government mount, and its legitimacy is increasingly questioned; the exercise of power becomes coercive, and the challenge to rule assumes ever more violent forms; eventually, the struggle comes to a dramatic climax in the destruction of the old order. The coup d'etat is another form of violent response to the crisis of rule, but it is distinguished from the revolution in that it involves the overthrow only of the government: the political order is not immediately affected, for the coup is managed by an individual or group within the government or within the ruling class. In some cases, however, the coup d'etat is merely a preliminary stage to revolution. Sometimes this happens when the new ruler leads a governmentally imposed revolution: this was the role played by Napoleon I, Napoleon III, Mussolini, and Hitler. At other times, coups are actually prompted by fear of revolution but succeed only in further weakening the claims to legitimacy of the existing order: this has recently been the case in some countries in the non-Western world where conservative-led coups were quickly overthrown by revolutionary movements. In addition to revolutions and coups d'etat, the crisis of rule may prompt other forms of violent political reaction, including civil war and secession, resistance movements and rebellions, guerrilla warfare and terrorism, class warfare, and peasant revolts. `The causes of internal conflict leading to the forcible overthrow of governments are extremely varied. They include tensions created by rapid social and economic development; the rise of new social classes and the refusal of established elites to share their power; problems of the distribution of wealth and the grievances of different economic groups and interests; the rise of corrosive social and political philosophies and the estrangement of intellectuals; conflict of opinions over the ends of government; factional struggles among power holders or within the ruling class; the rise of a charismatic leader; oppressive rule that alienates powerful groups; weak rule that tolerates antigovernmental or revolutionary movements; and many different combinations of these and other social, economic, and political factors. All political systems experience some of these conditions with some frequency. Yet there are a number of modern states that have avoided internal wars and the forcible overthrow of their governments for considerable periods. It appears that rulers in the contemporary world are generally safe from violent challenges if they possess an effective monopoly of military, economic, and political power, linked with certain important social controls; or, alternatively, if they are obliged to exercise limited powers for specified periods and are required to yield office to rivals who meet certain qualifications. The first is the definition of a modern totalitarian regime, fully and efficiently organized; the second describes the governments of several contemporary constitutional democracies. In the first case, the government secures itself by force combined with social and psychological means of preventing the formation of opposition. In the second case, alternatives to internal war are provided by the opportunities for oppositions to influence the exercise of power and ultimately to replace the government. The great achievement of constitutional democracy has been to give reasonable security to governments from forcible overthrow by compelling them to accept limitations on their power, by requiring them to forgo the use of force against rivals who agree to accept the same limitations, and by establishing well-known legal procedures through which these rivals may themselves constitute the government.
Autocratic versus nonautocratic rule.
The foregoing discussion has suggested a distinction among political systems in terms of the role played by force in the acquisition and transfer of power. The role of force is vital, also, in distinguishing among political systems in terms of the exercise and control of power. Here the contrast is essentially between "autocratic" and "nonautocratic" governments, for totalitarianism is only a recent species of autocracy, to which constitutionalism is the principal contemporary antithesis. Autocracy is characterized by the concentration of power in a single centre, be it an individual dictator or a group of power holders such as a committee or a party leadership. This centre relies on force to suppress opposition and to limit social developments that might eventuate in opposition. The power of the centre is not subject to effective controls or limited by genuine sanctions: it is absolute power. In contrast, nonautocratic government is characterized by the existence of several centres, each of which shares in the exercise of power. Nonautocratic rule allows the development of social forces that generate a variety of interests and opinions. It also subjects the power holders to reciprocal controls and to effective sanctions of law. In appearance, autocracy may sometimes be difficult to distinguish from nonautocratic rule. Often, autocracies attempt to borrow legitimacy by adopting the language of the constitutions of nonautocratic regimes or by establishing similar institutions. It is a common practice, for example, in many modern totalitarian states to establish institutions--parliaments or assemblies, elections and parties, courts and legal codes--that differ little in appearance from the institutional structures of constitutional democracies. Similarly, the language of totalitarian constitutions is often couched in terms of the doctrines of popular rule or democracy. The difference is that in totalitarian regimes neither the institutions nor the constitutional provisions act as effective checks on the power of the single centre: they are essentially facades for the exercise of power through hierarchical procedures that subject all the officials of the state to the commands of the ruling individual or group. The underlying realities of autocratic rule are always the concentration of power in a single centre and the mobilization of force to prevent the emergence of opposition. Totalitarianism, as already noted, has been a chief form of autocratic rule; it is distinguished from previous forms in its use of state power to impose an official ideology on its citizens. Nonconformity of opinion is treated as the equivalent of resistance or opposition to the government, and a formidable apparatus of compulsion, including various kinds of state police or secret police, is kept in being to enforce the orthodoxy of the proclaimed doctrines of the state. A single party, centrally directed and composed exclusively of loyal supporters of the regime, is the other typical feature of totalitarianism. The party is at once an instrument of social control, a vehicle for ideological indoctrination, and the body from which the ruling group recruits its members. In the modern world, constitutional democracy is the chief type of nonautocratic government. The minimal definition in institutional terms of a constitutional democracy is that it should provide for a regularized system of periodic elections with a free choice of candidates, the opportunity to organize competing political parties, adult suffrage, decisions by majority vote with protection of minority rights, an independent judiciary, constitutional safeguards for basic civil liberties, and the opportunity to change any aspect of the governmental system through agreed procedures. Two features of constitutional democracy require emphasis in contrasting it with modern totalitarian government: the constitution, or basic law, and the political party. A constitution, as the example of British constitutional democracy suggests, need not be a single written instrument; indeed, the essence of a constitution is that it formalizes a set of fundamental norms governing the political community and determining the relations between the rulers and the people and the interaction among the centres of power. In most modern constitutional democracies, however, there is a constitutional document providing for fixed limitations on the exercise of power. These provisions usually include three major elements: an assignment of certain specified state functions to different state organs or offices, the delimitation of the powers of each organ or office, and the establishment of arrangements for their cooperative interaction; a list of individual rights or liberties that are protected against the exercise of state power; and a statement of the methods by which the constitution may be amended. With these provisions a concentration of power in the hands of a single ruler is prevented, certain areas of political and social life are made immune to governmental intervention, and peaceable change in the political order is made possible. The political party is the other chief instrument of constitutional democracy, for it is the agency through which the electorate is involved in both the exercise and transfer of power. In contrast with the centralized, autocratic direction of the totalitarian single-party organization, with its emphasis on ideological conformity and restricted membership, the political parties of constitutional democracy are decentralized, concerned with the integration of many interests and beliefs, and open to public participation. In constitutional democracies there is usually some measure of competition among two or more parties, each of which, if it cannot hope to form a future government, has some ability to influence the course of state action. The party in a constitutional democracy is at once a means of representing a mass electorate in the exercise of power and also a device for allowing the peaceful replacement of one set of power holders with another. The distinction between autocratic and nonautocratic rule should not conceal the existence of intermediate types that combine elements of both. In these cases, also, the best procedure for comparative purposes is to investigate the power configurations underlying the formal structures and to examine the extent to which power is concentrated in a single centre or the role that is played by force in the maintenance of the regime. It is a type of analysis that, by guiding attention to the relative weight of coercive and consensual power and the scope of individual freedom in the political order, allows comparisons between systems in terms of their most important attributes.
GOVERNMENTS CLASSIFIED BY STAGE OF DEVELOPMENT
Analyzing political change.
Political life is shaped by a wide variety of factors, including social and cultural conditions, economic organization, intellectual and philosophical influences, geography or climate, and historical circumstance. Recurrent attempts have been made to reduce this range of variables to analytically manageable dimensions. This is partly the motive, for example, of Marxist and other efforts to relate specific types of political systems to stages of economic development or particular kinds of socioeconomic organization. Although interesting interrelations between political and economic development have been discovered, such monistic, or single-factor, approaches are inadequate to the task of explaining political change. The problem is not only that there are many factors that should be examined but also that they are found in different combinations from one society to another. All political orders are unique as products of history and creations of the peculiar forces and conditions of their environment. A second problem that confronts comparative analysis is the difficulty of devising measures of political development. The definition of what is modern or what constitutes an advanced or developed political system has troubled many recent writers. Clearly, the older notions of development toward the goals of constitutionalism or democracy must now be seriously questioned, and to judge the maturity of a political system in terms of the extent to which it adopts any particular set of institutions or techniques of rule is an equally doubtful procedure. Another difficulty is that political change is not simply a reaction to "objective" factors such as economic forces but also the product of conscious manipulation. In explaining the growth and development of political systems it is impossible to ignore the fact that men, having considered the advantages and disadvantages of different forms of government, often decide to adopt one form rather than another. A similar problem arises from the fact that the nature of the interaction between political systems and their environment is extremely complex. For example, to treat the political system as merely the outgrowth of particular patterns of social or economic organization is to ignore the fact that changes in social and economic structures are often the product, sometimes the intended product, of governmental action.
Emergence of advanced nation-states.
These difficulties of analysis have prevented the emergence of any satisfactory theory to explain the processes of political change or growth. In the absence of such a theory, however, several writers have recently attempted to identify certain basic phases in the development of national political systems. For example, five major steps in the emergence of the advanced nation-states of the modern world are often distinguished: (1) unification and independence or autonomy; (2) development and differentiation of political institutions and political roles; (3) transfer of power from traditional elites; (4) further institutional and political role differentiation accompanied by the development of a number of organized social interests and growth in governmental functions; and (5) use of state power in attempts to guide or control social and economic activity, extensive exploitation of resources as the result of technological development, and full participation in the international political system. Other writers distinguish among "traditional," "transitional," and "modern" societies in an effort to identify differences and regularities in social, economic, cultural, and political development. The social structure of the traditional society is described as hierarchical, class bound, based on kinship, and divided into relatively few effectively organized social groupings; its economic basis is primarily agricultural, and industry and commerce are relatively undeveloped; its political institutions are those of sacred monarchy, rule by a nobility, and various forms of particularism. The social system of the transitional society is typified by the formation of new classes, especially a middle class and a proletariat, and conflict among ethnic, religious, and cultural groupings; its economic system experiences major tensions as the result of technological development, the growth of industry, urbanization, and the use of rapid communications; its political institutions are typically authoritarian, although constitutional forms also make their appearance. Modernity is seen as the age of high social mobility, equality, universal education, mass communications, increasing secularism, and sociocultural integration; in its economic system, the modern society experiences a further technological revolution, massive urbanization, and the development of a fully diversified economy; its political institutions are those of democracy and modified totalitarianism, and, in either case, a specialized bureaucracy is used to carry on the expanding functions of government. These efforts to identify stages of "modernization" are poor substitutes for a general theory of political change, but they serve to emphasize the increasing complexity of all the structures--social, economic, and political--of the modern state. The elaboration of the institutions and procedures of modern government appears to be partly a reflection of the social and economic forces at work in the contemporary world and partly the result of efforts to control these forces through governmental action. The complex structures of advanced political orders are treated in the discussion that follows.
The structure of government
The study of governmental structures must be approached with great caution, for political systems having the same kind of legal arrangements and using the same type of governmental machinery often function very differently. A parliament, for example, may be an important and effective part of a political system; or it may be no more than an institutional facade of little practical significance. A constitution may provide the framework within which the political life of a state is conducted; or it may be no more than a piece of paper, its provisions bearing almost no relationship to the facts of political life. Political systems must never be classified in terms of their legal structures alone: the fact that two states have similar constitutions with similar institutional provisions and legal requirements should never, by itself, lead to the conclusion that they represent the same type of political system. To be useful, the study of governmental structures must always proceed hand in hand with an investigation of the actual facts of the political process: the analyst must exercise the greatest care in distinguishing between form and reality and between prescription and practice. Approached in this way, an examination of the organizational arrangements that governments use for making decisions and exercising power can be a valuable tool of political inquiry.
CONTEMPORARY FORMS OF GOVERNMENT
Few states in the modern world have constitutional arrangements that are more than a century old. Indeed, the vast majority of all the world's states have constitutions written in the 20th century. This is true of states, such as Germany, Italy, and Japan, that were defeated in World War II and of other states, such as the successor states of the Soviet Union, Spain, and China, that have experienced civil war and revolutions in the course of the century. Great Britain and the United States are almost alone among major contemporary nation-states in possessing constitutional arrangements that predate the 20th century. Even in Britain and the United States, the 20th century has seen much change in the governmental system. In the United States, for example, the relationship of legislature and executive at both the national and the state levels has been significantly altered by the growth of bureaucracies and the enlargement of the executive's budgetary powers. In Britain, even more far-reaching changes have occurred in the relationship between the prime minister and Parliament and in Parliament's role in supervising the executive establishment. In both countries, the appearance of the welfare state, the impact of modern technology on the economy, and international crises have resulted in major alterations in the ways in which the institutions of government function and interact. The modern student of constitutional forms and institutional arrangements confronts an endlessly changing world. In many parts of the world, in countries as different as France, Pakistan, Argentina, and Tanzania, there have been continuing experiments with new constitutions. The adoption of new constitutions is also a major aspect of political change in almost all of the states of eastern Europe and in the successor states of the Soviet Union. All systems, moreover, even without formal constitutional change, undergo a continual process of adjustment and mutation as their institutional arrangements respond to and reflect changes in the social order and the balance of political forces.
Monarchy.
The ancient distinction among monarchies, tyrannies, oligarchies, and constitutional governments, like other traditional classifications of political systems, is no longer very descriptive of political life. A king may be a ceremonial dignitary in one of the parliamentary democracies of western Europe, or he may be an absolute ruler in one of the emerging states of North Africa, the Middle East, or Asia. In the first case his duties may be little different from those of an elected president in many republican parliamentary regimes; in the second his role may be much the same as that of countless dictators and strongmen in autocratic regimes throughout the less-developed areas of the world. It may be said of the reigning dynasties of modern Europe that they have survived only because they failed to retain or to acquire effective powers of government. Royal lines have been preserved only in those countries of Europe in which royal rule was severely limited prior to the 20th century or in which royal absolutism had never firmly established itself. More successful dynasties, such as the Hohenzollerns in Germany, the Habsburgs in Austria-Hungary, and the Romanovs in Russia, which continued to rule as well as to reign at the opening of the 20th century, have paid with the loss of their thrones. Today in countries such as Great Britain or The Netherlands or Denmark the monarch is the ceremonial head of state, an indispensable figure in all great official occasions and a symbol of national unity and of the authority of the state, but is almost entirely lacking in power. Monarchy in the parliamentary democracies of modern Europe has been reduced to the status of a dignified institutional facade behind which the functioning mechanisms of government--cabinet, parliament, ministries, and parties--go about the tasks of ruling. The 20th century has also seen the demise of most of the hereditary monarchies of the non-Western world. Thrones have toppled in Turkey, in China, in most of the Arab countries, in the principates of India, in the tribal kingdoms of Africa, and in several countries of Southeast Asia. The kings who maintain their position do so less by the claim of legitimate blood descent than by their appeal as popular leaders responsible for well-publicized programs of national economic and social reform or as national military chieftains. In a sense, these kings are less monarchs than monocrats, and their regimes are little different from several other forms of one-man rule found in the modern world.
Dictatorship.
While royal rule, as legitimized by blood descent, had almost vanished as an effective principle of government in the modern world, monocracy--a term that comprehends the rule of the remaining non-Western royal absolutists, of the generals and strongmen of Latin America and Asia, of the messianic leaders of postcolonial Africa, and of the totalitarian heads of Communist states--still flourished. Indeed, the 20th century, which has witnessed the careers of Atatürk, Benito Mussolini, Adolf Hitler, Joseph Stalin, Francisco Franco, Mao Tse-tung, Juan Perón, Tito, Gamal Abdel Nasser, Sukarno, Kwame Nkrumah, and Charles de Gaulle, could appear in history as the age of plebiscitary dictatorship. In many of the states of Africa and Asia, for example, dictators quickly established themselves on the ruins of constitutional arrangements inherited from Western colonial powers. In some of these countries, presidents and prime ministers captured personal power by banning opposition parties and building primitive replicas of the one-party systems of the Communist world. In other new countries, the armies seized power, and military dictatorships were established. Whether as presidential dictatorships or as military dictatorships, the regimes that came into being appear to have had common roots in the social and economic problems of the new state. The constitutional systems inherited from the colonial powers proved unworkable in the absence of a strong middle class; local traditions of autocratic rule retained a powerful influence; the army, one of the few organized forces in society, was also often the only force capable of maintaining order; and a tiny intellectual class was impatient for economic progress, frustrated by the lack of opportunity, and deeply influenced by the example of authoritarianism in other countries. The dictatorships that resulted proved highly unstable, and few of the individual dictators were able to satisfy for long the demands of the different groups that supported their bids for power. Although similar in some respects to the dictatorships of the new nations, the caudillos of 19th- and 20th-century Latin America represent a very different type of monocratic rule. In its 19th-century form, caudillismo was the result of the breakdown of central authority. After a brief period of constitutional rule, each of the former Spanish colonies in the Americas experienced a collapse of effective national government. A self-proclaimed leader, usually an army officer, heading a private army typically formed from the peasantry with the support of provincial landowners, established his control over one or more provinces, and then marched upon the national capital. The famous 19th-century caudillos--Antonio López de Santa Anna of Mexico or Juan Manuel de Rosas of Argentina, for example--were thus essentially provincial leaders who seized control of the national government to maintain the social and economic power of provincial groups. The 20th-century dictatorships in Latin-American countries have had different aims. The modern caudillo is less a provincial than a national leader. The Perón regime, for example, was established by nationalistic army officers committed to a program of national reform and ideological goals. Often, too, recent dictators in Latin America have allied themselves with a particular social class, attempting either to maintain the interests of established economic groupings or to press social reforms. Dictatorship in the technologically advanced, totalitarian regimes of modern Communism is distinctively different from the authoritarian regimes of either Latin America or the new states of Africa and Asia. Nazi Germany under Hitler and the Soviet Union under Stalin are the leading examples of modern totalitarian dictatorships. The crucial elements of both were the identification of the state with the single mass party and of the party with its charismatic leader, the use of an official ideology to legitimize and maintain the regime, the employment of a terroristic police force and a controlled press, and the application of all the means of modern science and technology to control the economy and individual behaviour. The two systems, however, may be distinguished in several ways. Fascism, in its National Socialist form, was primarily a counterrevolutionary movement that mobilized middle- and lower middle-class groups to pursue nationalistic and militaristic goals and whose sole principle of organization was obedience to the Führer. By contrast, Soviet Communism grew out of a revolutionary theory of society, pursued the goal of revolutionary overthrow of capitalist systems internationally, and employed the complex bureaucratic structures of the Communist Party as mechanisms of governmental organization. Western constitutional democracies have provided examples of another type of contemporary dictatorship. At various points in the 20th century, during periods of domestic or foreign crisis, most constitutional regimes have conferred emergency powers on the executive, suspending constitutional guarantees of individual rights or liberties or declaring some form of martial law. Indeed, the constitutions of some Western democracies explicitly provide for the grant of emergency powers to the executive in a time of crisis to protect the constitutional order. In many cases, of course, such provisions have been the instruments with which dictators have overthrown the regime. Thus, the proclamation of emergency rule was the beginning of the dictatorships of Mussolini in Italy, of Kemal Atatürk in Turkey, of Józef Pilsudski in Poland, of António de Olveira Salazar in Portugal, of Franz von Papen and Hitler in Germany, and of Engelbert Dollfuss and Kurt von Schuschnigg in Austria. In other democracies, however, constitutional arrangements have survived quite lengthy periods of crisis government. After World War II, for example, in both the United States and Britain, the use of extraordinary powers by the executive came to a halt with the end of the wartime emergency. Similarly, although the 1958 constitution of the Fifth Republic of France contained far-reaching emergency powers conferred on the president--"when the institutions of the Republic, the independence of the nation, the integrity of its territory or the fulfillment of its international obligations are threatened with immediate and grave danger, and when the regular functioning of the constitutional authority is interrupted"--their implicit threat to the constitutional order has not been realized. Many forces at work in the 20th century appear to lend impetus to the rise of monocratic forms of rule. In nearly all political systems, the powers of chief executives have increased in response to the demanding social, economic, and military crises of the age. The complex decisions required of governments in a technological era, the perfectionist impulses of the great bureaucratic structures that have developed in all industrialized societies, and the imperatives of national survival in a nuclear world continue to add to the process of executive aggrandizement. The question for many constitutional regimes is whether the limitation and balance of power that are at the heart of constitutional government can survive the growing enlargement of executive power.
Oligarchy.
In the Aristotelian classification of government, there were two forms of rule by the few: aristocracy and its debased form, oligarchy. Although the term oligarchy is rarely used to refer to contemporary political systems, the phenomenon of irresponsible rule by small groups has not vanished from the world. Many of the classical conditions of oligarchic rule were found until recently in those parts of Asia in which governing elites were recruited exclusively from a ruling caste--a hereditary social grouping set apart from the rest of society by religion, kinship, economic status, prestige, and even language. In the contemporary world, in some countries that have not experienced the full impact of industrialization, governing elites are still often recruited from a ruling class--a stratum of society that monopolizes the chief social and economic functions in the system. Such elites have typically exercised power to maintain the economic and political status quo. The simple forms of oligarchic rule associated with pre-industrial societies are, of course, rapidly disappearing. Industrialization produces new, differentiated elites that replace the small leadership groupings that once controlled social, economic, and political power in the society. The demands of industrialization compel recruitment on the basis of skill, merit, and achievement rather than on the basis of inherited social position and wealth. New forms of oligarchic rule have also made their appearance in many advanced industrial societies. Although governing elites in these societies are no longer recruited from a single class, they are often not subjected to effective restraints on the exercise of their power. Indeed, in some circumstances, the new elites may use their power to convert themselves into a governing class whose interests are protected by every agency of the state. Oligarchic tendencies of a lesser degree have been detected in all the great bureaucratic structures of advanced political systems. The growing complexity of modern society and its government thrusts ever greater power into the hands of administrators and committees of experts. Even in constitutional regimes, no fully satisfactory answer has been found to the question of how these bureaucratic decision makers can be held accountable and their powers effectively restrained without, at the same time, jeopardizing the efficiency and rationality of the policy-making process.
Constitutional government.
Constitutional government is defined by the existence of a constitution--which may be a legal instrument or merely a set of fixed norms or principles generally accepted as the fundamental law of the polity--that effectively controls the exercise of political power. The essence of constitutionalism is the control of power by its distribution among several state organs or offices in such a way that they are each subjected to reciprocal controls and forced to cooperate in formulating the will of the state. Although constitutional government in this sense flourished in England and in some other historical systems for a considerable period, it is only recently that it has been associated with forms of mass participation in politics. In England, for example, constitutional government was not harnessed to political democracy until after the Reform Act of 1832 and subsequent 19th-century extensions of the suffrage. In the contemporary world, however, constitutional governments are also generally democracies, and in most cases they are referred to as constitutional democracies or constitutional-democratic systems. The contemporary political systems that combine constitutionalism and democracy share a common basis in the primacy they accord to the will of the majority of the people as expressed in free elections. In all such systems, political parties are key institutions, for they are the agencies by which majority opinion in a modern mass electorate is mobilized and expressed. Indeed, the history of the political party in its modern form is coincidental with the development of contemporary constitutional-democratic systems. In each case, the transition from the older forms of constitutionalism to modern constitutional democracy was accompanied by the institutionalization of parties and the development of techniques of party competition. The essential functions of political parties in a constitutional democracy are the integration of a multitude of interests, beliefs, and values into one or more programs or proposals for change and the nomination of party members for elective office in the government. In both functions, the party serves as a link between the rulers and the ruled: in the first case by allowing the electorate to register an opinion on policy and in the second by giving the people a chance to choose their rulers. Of course, the centralized, autocratically directed, and ideologically orthodox one-party systems of totalitarian regimes perform neither of these functions. The two major types of constitutional democracy in the modern world are exemplified by the United States and Great Britain. The United States is the leading example of the presidential system of constitutional democracy; Britain, although its system is sometimes referred to as a cabinet system in recognition of the role of the Cabinet in the government, is the classic example of the parliamentary system. The U.S. presidential system is based on the doctrine of separation of powers and distinguishes sharply between the personnel of the legislature and the executive; the British parliamentary system provides for the integration or fusion of legislature and executive. In the U.S. system the separation of legislature and executive is reinforced by their separate election and by the doctrine of checks and balances that provides constitutional support for routine disagreements between the branches; in the British system the integration of legislature and executive is reinforced by the necessity for their constant agreement, or for a condition of "confidence" between the two, if the normal processes of government are to continue. In the U.S. system reciprocal controls are provided by such devices as the presidential veto of legislation (which may be overridden by a two-thirds majority in Congress), the Senate's role in ratifying treaties and confirming executive nominations, congressional appropriation of funds and the exclusive ability to declare war, and judicial review of legislation; in the British system the major control device is the vote of "no confidence" or the rejection of legislation that is considered vital. The prestige of constitutional democracy was once so great that many thought all the countries of the world would eventually accede to the examples of the United States or Britain and establish similar arrangements. However, the collapse of the Weimar Constitution in Germany in the 1930s and the recurrent political crises of the Fourth Republic in France after World War II suggested that constitutional democracy carries no guarantee of stability. The failure of both presidential and parliamentary systems to work as expected in less-advanced countries that modelled their constitutions on those of the United States and Britain resulted in a further diminution in the prestige of both systems. Functioning examples are located throughout the world, though these are generally poorly institutionalized outside of those countries with direct historical ties to western Europe. Japan is a notable exception to this generalization, as are Costa Rica, India, and several other states to a lesser degree.
CONTEMPORARY LEVELS OF GOVERNMENT
Most national societies have passed through a stage in their social and political development, usually referred to as feudalism, in which a weak and ineffectively organized national government competes for territorial jurisdiction with local power holders. In medieval England and France, for example, the crown was perennially threatened by the power of the feudal nobles, and a protracted struggle was necessary before the national domain was subjected to full royal control. Elsewhere, innumerable societies continued to experience this kind of feudal conflict between local magnates and the central government well into the modern era. The warlords of 19th- and 20th-century China, for example, were just as much the products of feudal society as the warring barons of 13th-century England and presented the same kind of challenge to the central government's claim to exercise sovereign jurisdiction over the national territory. By the 1970s, feudalism was almost extinct. The social patterns that had formerly supported the power of local landowners were rapidly disappearing, and central governments had generally acquired a near monopoly of communications and military technology, enabling them to project their power into areas once controlled by local rulers. In nearly all national political systems, central governments are better equipped than ever before to exercise effective jurisdiction over their territories. In much of the developing world, nationalist political movements and a variety of modern economic forces have swept away the traditional structures of local government, and the quasi-autonomous governments of village and tribe and province have been replaced by centrally directed systems of subnational administration. Even in the heavily industrialized states of the modern world, there has been an accelerating tendency toward greater centralization of power at the national level. In the United States, for example, the structure of relationships among the governments at the national, state, and local levels has changed in a number of ways to add to the power of the federal government in Washington. Even though the system of national grants-in-aid appears to have been designed as a means of decentralizing administration, the effect has been decidedly centralist, for the conditional character of the grants has allowed the federal government to exercise influence on state policies in fields that were once invulnerable to national intervention.
National government.
The nation-state is the dominant type of political system in the contemporary world, and nationalism, or the creed that centres the supreme loyalty of the people upon the nation-state, is the dominating force in international politics. The national ideal triumphed as a result of the wars of the 19th and 20th centuries. The Napoleonic Wars, which spread the doctrines of the French Revolution, unleashed nationalism as a force in Europe and led to the Risorgimento in Italy and the emergence of Bismarck's Germany. The two world wars of the 20th century carried the principles of national self-determination and liberal democracy around the world and gave birth to the independence movements that resulted in the foundation of new states in eastern Europe in 1919 and the emergence from colonial status of countries in Asia and Africa after 1945. The collapse of the Warsaw Pact and the Soviet Union itself completed this process of moving from multinational empires to truly sovereign national states. All the major forces of world politics-- e.g., war, the development of national economies, and the demand for social services--have reinforced the national state as the primary focus of people's loyalties. Wars have played the major part in strengthening national governments and weakening political regionalism and localism. The attachments that people have to subnational political communities are loosened when they must depend for their security on the national power. Even in the new age of total war--which few nations are capable of waging and even fewer of surviving--people look for their security to national governments rather than to international organizations. In nearly all contemporary states, the national budget is dominated by expenditures for defense, the military employs the largest fraction of the work force, and questions of national security pervade the discussion of politics. One of the lessons of the late 20th century is that national sovereignty continues to be the most important obstacle not only to the emergence of new forms of supranational government but to effective international cooperation as well. Almost everywhere, attempts to achieve federation and other forms of multinational communication have foundered on the rocks of nationalism. The collapse of the Federation of Rhodesia and Nyasaland and the Federation of Malaya, for example, were paralleled by the seeming ineffectiveness of the Organization of American States and the Arab League. On another level is the collapse of the Warsaw Pact when the nations of eastern Europe reclaimed their sovereignty in the late 1980s, after decades of domination by the Soviet Union. In western Europe, nations have joined together to form a confederation known as the European Union (EU). These countries are united not only by a long history and a common cultural inheritance but also by the expectation of mutual economic advantage. Even in this case, nationalism has proved to be an obstacle to the most ambitious goals of unification, which would severely limit national sovereignty in some spheres. At the international level, anarchy is the principal form of contemporary rule, for the nation-state's freedom of action is limited only by its power. While the state's freedom of action may not be directly threatened, the effectiveness of the state's action in the economic realm is increasingly being called into question. The development of national industries in the 19th and early 20th centuries played a major part in strengthening national as against regional and local political entities, but the scale of economic activity has now outgrown national markets. Industrial combines and commercial groupings have emerged that cross national frontiers and require international markets. This tight integration of the world economy has limited the effectiveness of some traditional instruments used to influence national trends in capitalist economies. It is increasingly clear that some aspects of traditional sovereignty may be affected by serious efforts to confront some issues that act on the entire international system. National frontiers can no longer be adequately defended in an era of intercontinental ballistic missiles, especially with the rapid diffusion of the technology required for delivery systems as well as for nuclear weapons themselves. Action in this area is, by definition, an attempt to shape the national security policy of states, something very near the core of a state's sovereignty. Concern over environmental matters could lead to more restrictive regimes than any arms-control provisions, ultimately shaping the way in which nations evolve economically. Destruction of major ecosystems, wasteful use of energy, and industrialization based on the use of fossil fuels are all national policies with international repercussions. As technology empowers more countries to directly affect the state of the planet as well as other nations, there are increasing incentives to limit the domestic policy choices of all nations. Although the failure of efforts to achieve world government and to develop an effective system of international law may be regretted, it should perhaps be remembered that the nation-state continues to function as an extremely effective system for maintaining order within its boundaries. In some cases, this is achieved with remarkably little coercion and in such a way that the progress of civilization is encouraged. Under present-day conditions, world government might well involve much higher levels of coercion and much less civilization.
Regional and state government.
The 18th-century political philosopher Montesquieu wrote that governments are likely to be tyrannical if they are responsible for administering large territories, for they must develop the organizational capacity characteristic of despotic states. It was partly this fear that led the American founding fathers to provide for a federal system and to divide governmental functions between the government in Washington and the state governments. Modern technology and mass communication are often said to have deprived Montesquieu's axiom of its force. Yet the technology that makes it possible for large areas to be governed democratically also holds out the spectre of an even greater tyranny than Montesquieu foresaw. In all political systems the relationships between national and regional or state governments have been affected by technology and new means of communication. In the 18th century Thomas Jefferson--in arguing that local government, or the government closest to the people, was best--could claim that citizens knew most about their local governments, somewhat less about their state governments, and least about the national government. In the present-day United States, however, the concentration of the mass media on the issues and personalities of national government has made nonsense of this proposition. As several recent studies have demonstrated, people know much less about local government than national government and turn out to vote in much larger numbers in national elections. The necessity for employing systems for the devolution of political power is reduced when a central government can communicate directly with citizens in all parts of the national territory, and the vitality of subnational levels of government is sapped when public attention is focussed on national problems. Another general development that has lessened the importance of regional or state government is the rise of efficient national bureaucracies. In nearly all political systems, there has been some tendency toward bureaucratic centralization, and in some cases national bureaucracies have almost completely replaced older systems of regional and provincial administration. In the United States, for example, complex programs of social security, income taxes, agricultural subsidies, and many others that bear directly on individuals are centrally administered. Even in systems in which a division of functions between national and subnational governments is constitutionally prescribed, the prevailing trend in intergovernmental relations is toward increasing involvement of the national government in areas once dominated by regional or state governments. Thus, the original constitutional arrangements prescribed by the Allied powers for the West German republic in 1949 won general acclaim at the time because they provided for greater decentralization than had the Weimar Constitution; but, as soon as Germany was free to amend its own constitution, several state functions were reassigned to the national government. In the United States, also, the collapse of the doctrine of "dual federalism," according to which the powers of the national government were restricted by the powers reserved to the states, signalled the end of an era in which the states could claim exclusive jurisdiction over a wide range of functions. Today, forms of cooperative federalism involving joint action by national and state governments are increasingly common. Such cooperative relationships in the United States include programs of public assistance, the interstate highway system, agricultural extension programs, and aid to education. In some areas, such as school desegregation, the national government has used broad powers to compel states to conform to national standards. Efforts made to halt the trend toward centralization and to reinvigorate regional or state governments have met with little success. In the United States a Commission on Intergovernmental Relations established by President Eisenhower in 1953 concluded that it could recommend no major reversion of functions to state governments. Similarly, efforts in France and Italy to decentralize parts of the national administrations have had few practical results. Political regionalism appears to be in steep decline almost everywhere, whether in China or in the American South. The attachments that bind people to localities and allow the growth of genuine subnational political communities have weakened under the impact of technology and the growth of national economies. Only where political regionalism has always been in reality a cloak for movements of national independence--for example, in Scotland, Wales, Northern Ireland, Quebec, and Brittany--are there popular attempts to reverse the trend toward national centralization.
City and local government.
Political scientists since Aristotle have recognized that the nature of political communities changes when their populations grow larger. One of the central problems of contemporary government is the vast increase in urban population and the progression from "polis to metro-polis to mega-polis." The catalog of ills that have resulted from urban growth includes political and administrative problems of extraordinary complexity. Aging infrastructure has become an issue of pressing national importance in the United States, with the major cities obviously suffering in this area. Grave social problems--for example, violent crime (especially that committed by youths in poverty-stricken areas), drug trafficking, unemployment, and homelessness--are concentrated to such a degree that they directly shape the environment in many large urban areas. The majority of cities are ill equipped to handle these problems without significant assistance from the national government. The tax base of U.S. cities has dwindled with the flight of the middle classes to the suburbs and the relocation of industry. Largely as a result of this, political power has begun to follow wealth out of the cities and into adjoining suburbs. These outlying areas have not only increased significantly in population, but, compared with that of many large cities, it is a population more likely to vote and otherwise lobby for its interests. This has served to reduce the national government's activism in the cities at the very time when most cities are suffering from a drastically reduced capacity to act. Aside from such fiscal and political pressures, however, the national government is inevitably concerned with the threats posed by racial conflict, ghetto violence, and other kinds of social chaos in the cities. The metropolis suffers from several acute governmental and administrative failures. Responsibility for the issues that transcend the boundaries of local governments has not been defined, for representative institutions have failed to develop at the metropolitan level. In most cases, there are no effective governmental structures for administering area-wide services or for dealing comprehensively with the common problems of the metropolitan community. The result has been the appearance of a new class of problems created by government itself, including uneven levels of service for metropolitan residents, inequities in financing government services and functions, and variations in the democratic responsiveness of the governments scattered through the metropolitan area. The tangled pattern of local governments, each operating in some independent sphere, does not allow the comprehensive planning necessary to deal with the escalating problems of urban life. Efforts to create new governing structures for metropolitan communities are among the most interesting developments in contemporary government. In the United States these efforts include the creation of special districts to handle specific functions, area-wide planning agencies, interstate compacts, consolidated school and library systems, and various informal intergovernmental arrangements. Although annexation of outlying areas by the central city and city-county consolidations have been attempted in many cases, the reluctance of urban areas to surrender their political independence or to pay for central-city services has been an obstacle. The Los Angeles plan, by which the county has assumed responsibility for many area-wide functions, leaving the local communities with substantial political autonomy, may represent a partial solution to the problem of urban-suburban tensions. In other cases, "metropolitan federation" has been attempted. One of the earliest and most influential examples of a federated system of metropolitan government is the Greater London Area in Britain, which encompasses 32 London boroughs and places effective governing powers in the hands of an elected city council. In Canada the city of Toronto and its suburbs adopted a metropolitan "constitution" in 1953 under which mass transit, highways, planning, and several other functions are controlled by a council composed of elected officials from the central city and surrounding governments. In 1957 Miami and Dade County in Florida chose "metro" government: Miami and 27 suburban cities retained control of local functions, while area-wide functions such as fire and police protection and transportation were allocated to the new federal structure. In 1962 Nashville, Tennessee, combined with Davidson County to form a single metropolitan government; and in 1968 Jacksonville, Florida, joined with Duval County in a similar arrangement. Other examples of various degrees of area-wide consolidation in the United States include Baton Rouge, Louisiana; Seattle, Washington; Portland, Oregon; and Indianapolis, Indiana. Most of the major problems of contemporary politics seem to have found their focus in the metropolis, and there is almost universal agreement that new governing systems must be devised for the metropolitan community if the problems are ever to be resolved.
CONTEMPORARY DIVISIONS OF GOVERNMENT
In his Politics, Aristotle differentiated three categories of state activity--deliberations concerning common affairs, decisions of executive magistrates, and judicial rulings--and indicated that the most significant differences among constitutions concerned the arrangements made for these activities. This threefold classification is not precisely the same as the modern distinction among legislature, executive, and judiciary. Aristotle intended to make only a theoretical distinction among certain state functions and stopped short of recommending that they be assigned as powers to separate organs of government. Indeed, since Aristotle held that all power should be wielded by one man, pre-eminent in virtue, he never considered the concept of separated powers. In the 17th century the English political philosopher John Locke also distinguished the legislative from the executive function but, like Aristotle, failed to assign these to separate organs or institutions. Montesquieu was the first to make the modern division among legislative, executive, and judiciary. Arguing that the purpose of political association is liberty, not virtue, and that the very definition of liberty's great antagonist, tyranny, is the accumulation of all power in the same hands, he urged the division of the three functions of government among three separate institutions. After Montesquieu, the concept of separation of powers became one of the principal doctrines of modern constitutionalism. Nearly all modern constitutions, from the document written at Philadelphia in 1787 through the French Declaration of the Rights of Man and of the Citizen of August 1789 up to the constitutions of the new states of Africa and Asia, provide for the separate establishment of legislative, executive, and judiciary. The functional division among the branches of government is never precise. In the American system, for example, the doctrine of checks and balances justifies several departures from the strict assignment of functions among the branches. Parliamentary forms of government depart even further from the concept of separation and integrate both the personnel and the functions of the legislature and the executive. Indeed, the principle of shared rather than separated powers is the true essence of constitutionalism. In the constitutional state, power is controlled because it is shared or distributed among the divisions of government in such a way that they are each subjected to reciprocal checks and forced to cooperate in the exercise of political power. In the nonconstitutional systems of totalitarianism or autocracy, although there may be separate institutions such as legislatures, executives, and judiciaries, power is not shared but rather concentrated in a single organ. Because this organ is not subjected to the checks of shared power, the exercise of political power is uncontrolled or absolute.
The legislature.
The characteristic function of all legislatures is the making of law. In most systems, however, legislatures also have other tasks, such as selection and criticism of the government, supervision of administration, appropriation of funds, ratification of treaties, impeachment of executive and judicial officials, acceptance or refusal of executive nominations, determination of election procedures, and public hearings on petitions. Legislatures, then, are not simply lawmaking bodies. Neither do they monopolize the function of making law. In most systems the executive has a power of veto over legislation, and, even where this is lacking, the executive may exercise original or delegated powers of legislation. Judges, also, often share in the lawmaking process, through the interpretation and application of statutes or, as in the U.S. system, by means of judicial review of legislation. Similarly, administrative officials exercise quasi-legislative powers in making rules and deciding cases that come before administrative tribunals. Legislatures differ strikingly in their size, the procedures they employ, the role of political parties in legislative action, and their vitality as representative bodies. In size, the British House of Commons is among the largest; the Icelandic lower house, the New Zealand House of Representatives, and the Senate of Nevada are among the smallest. Most legislatures are bicameral, although New Zealand, Denmark, the state of Queensland, in Australia, and Nebraska, in the United States, have all abolished their second chambers. The procedures of the United States House of Representatives, which derive from a manual of procedure written by Thomas Jefferson, are among the most elaborate of parliamentary rules, requiring study and careful observation over a considerable period before members become proficient in their manipulation. Voting procedures range from the formal procession of the division or teller vote in the British House of Commons to the electric voting methods employed in the California legislature and in some other American states. Another point of difference among legislatures concerns their presiding officers. These are sometimes officials who stand above party and, like the speaker of the British House of Commons, exercise a neutral function as parliamentary umpires; sometimes they are the leaders of the majority party and, like the speaker of the United States House of Representatives, major political figures; and sometimes they are officials who, like the vice president of the United States in his role as presiding officer of the Senate, exercise a vote to break ties and otherwise perform mainly ceremonial functions. Legislative parties are of various types and play a number of roles or functions. In the United States House of Representatives, for example, the party is responsible for assigning members to all standing committees; the party leadership fills the major parliamentary offices, and the party membership on committees reflects the proportion of seats held by the party in the House as a whole. The congressional party, however, is not disciplined to the degree found in British and some other European legislative parties, and there are relatively few "party line" votes in which all the members of one party vote against all the members of the other party. In the House of Commons, party-line voting is general; indeed, it is very unusual to find members voting against their party leadership, and, when they do, they must reckon with the possibility of penalties such as the "withdrawal of the whip" or the loss of their official status as party members. It is often said that the 20th century has dealt harshly with legislatures and that this is an age of executive aggrandizement. Certainly, executives in most countries have assumed an increasingly large role in the making of law, through the initiation of the legislation that comes before parliaments, assemblies, and congresses, through the exercise of various rule-making functions, and as a result of the growth of different types of delegated legislation. It is also true that executives have come to predominate in the sphere of foreign affairs and, by such devices as executive agreements, which are frequently used in place of treaties, have freed themselves from dependence upon legislative approval of important foreign-policy initiatives. Moreover, devices such as the executive budget and the rise of specialized budgetary agencies in the executive division have threatened the traditional fiscal controls of legislatures. This decline in legislative power, however, is not universal. The United States Congress, for example, has preserved a substantial measure of its power. Indeed, congressional oversight of the bureaucracy is an area in which it has added to its power and has developed new techniques for controlling the executive. The difficulties of presidents in the late 20th century with legislative programs of foreign aid and the perennial congressional criticism of executive policies in foreign affairs also suggest that Congress continues to play a vital role in the governing process.
The executive.
Political executives are government officials who participate in the determination and direction of government policy. They include heads of state and government leaders-- presidents, prime ministers, premiers, chancellors, and other chief executives--and many secondary figures, such as cabinet members and ministers, councillors, and agency heads. By this definition, there are several thousand political executives in the U.S. national government, including the president, dozens of political appointees in the Cabinet departments, in the agencies, in the commissions, and in the White House staff, and hundreds of senior civil servants. The same is true of most advanced political systems, for the making and implementation of government policy require very large executive and administrative establishments. The crucial element in the organization of a national executive is the role assigned to the chief executive. In presidential systems, such as in the United States, the president is both the political head of the government and also the ceremonial head of state. In parliamentary systems, such as in Great Britain, the prime minister is the national political leader, but another figure, a monarch or elected president, serves as the head of state. In mixed presidential-parliamentary systems, such as that established in France under the constitution of 1958, the president serves as head of state but also wields important political powers, including the appointment of a prime minister and Cabinet to serve as the government. The manner in which the chief executive is elected or selected is often decisive in shaping his role in the political system. Thus, although he receives his seals of office from the monarch, the effective election of a British prime minister usually occurs in a private conclave of the leading members of his party in Parliament. Elected to Parliament from only one of more than 630 constituencies, he is tied to the fortunes of the legislative majority that he leads. By contrast, the American president is elected by a nationwide electorate, and, although he leads his party's ticket, his fortunes are independent of his party. Even when the opposition party controls the Congress, his fixed term and his independent base of power allow him considerable freedom of manoeuvre. These contrasts explain many of the differences in the roles of the two chief executives. The British prime minister invariably has served for many years in Parliament and has developed skills in debate and in political negotiation. His major political tasks are the designation of the other members of the Cabinet, the direction of parliamentary strategy, and the retention of the loyalty of a substantial majority of his legislative party. The presidential chief executive, on the other hand, often lacks prior legislative and even national-governmental experience, and his main concern is with the cultivation of a majority in the electorate through the leadership of public opinion. Of course, since the president must have a legislative program and often cannot depend on the support of a congressional majority, he may also need the skills of a legislative strategist and negotiator. Another important area of contrast between different national executives concerns their role in executing and administering the law. In the U.S. presidential system, the personnel of the executive branch are constitutionally separated from the personnel of Congress: no executive officeholder may seek election to either house of Congress, and no member of Congress may hold executive office. In parliamentary systems the political management of government ministries is placed in the hands of the party leadership in parliament. In the U.S. system the president often appoints to Cabinet positions persons who have had little prior experience in politics, and he may even appoint members of the opposition party. In the British system, Cabinet appointments are made to consolidate the prime minister's personal ascendancy within the parliamentary party or to placate its different factions. These differences extend even further into the character of the two systems of administration and the role played by civil servants. In the U.S. system a change in administration is accompanied by the exodus of a very large number of top government executives--the political appointees who play the vital part in shaping day-to-day policy in all the departments and agencies of the national government. In Britain, when political control of the House of Commons changes, only the ministers, their parliamentary secretaries, and one or two other top political aids are replaced. For all practical purposes, the ministries remain intact and continue under the supervision of permanent civil servants. In nearly all political systems, even in constitutional democracies where executive responsibility is enforced through free elections, the 20th century has seen an alarming increase in the powers of chief executives. The office of the presidency in the United States, like the office of prime minister in Britain, has greatly enlarged the scope of its authority. One of the challenges of representative government is to develop more constitutional restraints on the abuse of executive powers while retaining their advantages for effective rule.
The judiciary.
Like legislators and executives, judges are major participants in the policy-making process; and courts, like legislatures and administrative agencies, promulgate rules of behaviour having the nature of law. The process of judicial decision making, or adjudication, is distinctive, however, for it is concerned with specific cases in which an individual has come into conflict with society by violating its norms or in which individuals have come into conflict with one another, and it employs formal procedures that contrast with those of parliamentary or administrative bodies. Established court systems are found in all advanced political systems. Usually there are two judicial hierarchies, one dealing with civil and the other with criminal cases, each with a large number of local courts, a lesser number at the level of the province or the region, and one or more courts at the national level. This is the pattern of judicial organization in Britain, for example. In some countries--for example, in France--although there is a double hierarchy, the distinction is not between courts dealing with criminal cases and other courts dealing with civil cases but rather between those that handle all civil and criminal cases and those that deal with administrative cases or challenges to the administrative authority of the state. Reflecting the federal organization of its government, the United States has two court systems: one set of national courts and 50 sets of state courts. By contrast, Germany, which is federal in governmental organization, possesses only a single integrated court system. Local courts are found in all systems and are usually of two types. The first type deals with petty offenses and may include a traffic court, a municipal court, a small-claims court, and a court presided over by a justice of the peace or a local magistrate. The second type, sometimes called trial courts, are courts of first instance in which most cases of major importance are begun. These are the state superior courts in the United States, the county courts and quarter sessions in Britain, the tribunal de grande instance in France, and the district courts, or Landgerichte, in Germany. In some systems there is a level above the local court, usually referred to as assize courts, in which exceptionally serious crimes, such as homicide, are tried. Courts of appeal review the procedures and the law in the lower court and, in some instances, return the case for a new trial. In all systems there are national supreme courts that hear appeals and exercise original jurisdiction in cases of the greatest importance, such as those involving conflict between a state and a national government. Outside the regular court systems, there are sometimes found specialized judicial tribunals, such as administrative courts, or courts of claims that deal with special categories of cases.
The functions of government
In all modern states, governmental functions have greatly expanded with the emergence of government as an active force in guiding social and economic development. In Socialist countries, government has a vast range of responsibilities for many types of economic behaviour. Even in the United States, where there remains a much greater attachment than in most societies to the idea that government should be only an umpire adjudicating the rules by which other forces in society compete, such governmental activities as the Tennessee Valley Authority or the use of credit controls to prevent economic fluctuations are now accepted with relatively little question. Government has thus become the major or even the dominant organizing power in all contemporary societies. The historical stages by which governments have come to exercise their contemporary functions make an interesting study in themselves. The scope of government in the ancient polis involved the comprehensive regulation of the ends of human existence. As Aristotle expressed it, what was not commanded by government was forbidden. The extent of the functions of government in the ancient world was challenged by Christianity and its insistence on a division of those things that belong separately to Caesar and to God. When the feudal world succeeded the Roman Empire, however, the enforcement of the sanctions of religion became one of the first objects of political authority. The tendencies that began in the 18th century separated church from state and state from society, and the modern concept of government came into being. The American colonies' Declaration of Independence expresses the classic modern understanding of those ends that governmental functions exist to secure. The first aim of government is to secure the right to life; this comprehends the safety of fellow citizens as regards one another and the self-preservation of the nation as regards foreign powers. Life exists for the exercise of liberty, in terms of both natural and civil rights, and these, along with other specific functions of government, provide those conditions upon which men may pursue happiness, an end that is finally entirely private and beyond the competence of government. With the advent of the Marxist conception of the state, the ends of human existence once again became the objects of comprehensive government regulation. Marxism sees the state as a product of class warfare that will pass out of existence in the future age of perfect freedom. Aristotle believed human perfection to be possible only within political society; Marx believed that the perfection of man would follow upon the abolition of political society. Before the final disposal of the state, however, many Marxists believe that forceful use of governmental power is justified in order to hasten mankind's progress toward the last stage of history.
THE TASKS
Self-preservation.
The first right of men and nations is self-preservation. The task of maintaining the nation, however, is more complex than the individual's duty of self-preservation, for the nation must seek to command the attachment of a community of citizens as well as to preserve itself from external violence. As Thomas Hobbes insisted, civil war constitutes the greatest threat to governments, for it represents the dissolution of the "sovereign power." In modern terms, civil war signifies that the government has lost one of the basic attributes of political authority: its monopoly of force and its control over the use of violence. In a fundamental sense, political authority may be preserved from the threat of civil war only when there exists in the political community an agreement on the basic principles of the regime. Such a consensus is the result, among other things, of a shared " ideology" that gives fellow citizens a sense of communal belonging and recognizes interlocking values, interests, and beliefs. Ideology, in this sense, may be the product of many different forces. Sometimes it is associated with ancient customs, sometimes with religion, sometimes with severe dislocations or the sort of common need that has led to the formation of many nation-states, and sometimes with the fear of a common enemy. The ideological commitment that people call patriotism is typically the product of several of these forces. Governments neglect at their peril the task of strengthening the ideological attachment of their citizens to the regime. In this sense, civic education should be counted among the essential functions of the state, for it is primarily through systems of education that citizens learn their duties. Indeed, as a number of sociological studies have shown, the process of political socialization that transforms people into citizens begins in kindergarten and grade school. Even more than this, education is the instrument by which governments further the cohesion of their societies and build the fundamental kinds of consensus that support their authority. It is not surprising, therefore, that national systems of education are often linked to central elements of the regimes. In France public education was traditionally mixed with the teachings of the Roman Catholic church; in Great Britain a private system of education supported the class divisions of society; and in the United States a primarily secular form of public education traditionally used constitutional documents as the starting point of children's training in patriotism. The preservation of the authority of the state also requires a governmental organization capable of imposing its jurisdiction on every part of the national territory. This involves the maintenance of means of communication, the use of administrative systems, and the employment of police forces capable of controlling domestic violence. The police function, like education, is often a key to the character of a regime. In Nazi Germany, Hitler's Brownshirts took over the operation of local and regional police systems and often supervised the administration of law in the streets. In the Soviet Union the security police acted to check any deviation from the policy of the party or state. In the United States the police powers are left in the hands of the 50 states and the local agencies of government. With the exception of certain offenses created by the McCarran Act and some parallel statutes, political crimes as such are unknown. In addition, there are state militias that act, under the control of the governors of the various states, in moments of local emergency, such as riots or natural catastrophes. The Federal Bureau of Investigation (FBI), the only equivalent of a national police force, is an agency established to carry out specific assignments dealing with a limited but important class of crimes. Since there is no comprehensive federal criminal code, there is not, strictly speaking, a federal police. Governments must preserve themselves against external as well as domestic threats. For this purpose they maintain armed forces and carry on intelligence activities. They also try to prevent the entry of aliens who may be spies or saboteurs, imprison or expel the agents of foreign powers, and embargo the export of materials that may aid a potential enemy. The ultimate means of preserving the state against external threats, of course, is war. In war, governments usually enlarge the scope of their domestic authority; they may raise conscript forces, imprison conscientious objectors, subject aliens to internment, sentence traitors to death, impose extraordinary controls on the economy, censor the press, compel settlement of labour disputes, impose internal-travel limitations, withhold passports, and provide for summary forms of arrest. Many forces generate clashes between nations, including economic rivalry and disputes over trade, the desire to dominate strategic land or sea areas, religious or ideological conflict, and imperialistic ambition. All national governments develop organizations and policies to meet these and other situations. They have foreign ministries for the conduct of diplomatic relations with other states, for representing them in international organizations, and for negotiating treaties. Some governments conduct programs such as foreign aid, cultural exchange, and other activities designed to win goodwill abroad. In the 20th century, relationships among governments have been affected by a developing awareness that world peace and prosperity depend on multinational and international cooperation. The League of Nations and the United Nations, together with their associated agencies, have represented major efforts to establish substitutes for traditional forms of diplomacy. Regional alliances and joint efforts, such as the Organization of American States, the North Atlantic Treaty Organization, the European Economic Community, and the Organization of African Unity, represent another type of cooperation among nations.
Supervision and resolution of conflicts.
The conflict of private interest is the leading characteristic of the political process in constitutional democracies, and the supervision, mediation, arbitration, and adjudication of such conflicts are among the key functions of their governments. Representative institutions are themselves a device for the resolution of conflict. Elections in constitutional democracies provide opportunities for mass participation in a process of open debate and public decision; assemblies, congresses, and other parliamentary institutions provide for public hearings on major issues of policy and require formal deliberative procedures at different stages of the legislative process; and political parties integrate a variety of interests and effect compromises on policy that win acceptance from many different groups. If the interests that compete in the political process are too narrow or restricted, efforts may be made to control or change the rules of competition. Thus, laws have been enacted that seek to prevent discrimination from locking racial and other minorities out of the democratic process; the franchise has been extended to all groups, including minorities such as women, blacks, and 18-year-olds; and government bodies such as courts and administrative agencies enforce legislation against groups considered to be too large or monopolistic. Judicial processes offer a means by which some disputes in society are settled according to rule and legal authority, rather than by political struggle. In all advanced societies, law is elaborated in complex codes governing rights and duties and procedural methods, and court systems are employed that adjudicate disputes in terms of the law. In constitutional systems such as the United States, the judiciary is deeply involved in the process of public decision making; the courts actually produce much of the substantive law that bears on private individuals and economic groups in society.
Regulation of the economy.
Government regulation of economic life is not a new development. The national mercantilist systems of the 18th century provided for regulation of the production, distribution, and export of goods by government ministries; even during the 19th century, governments continued to intervene in the economy. The government of the United States, for example, from its inception in 1789, allotted funds or subsidies for the support of agriculture, maintained a system of tariffs for its own revenue and the support of domestic manufacturers, patronized the arts and sciences, and engaged in various kinds of public works to advance commerce and promote the general welfare. In France even more elaborate governmental schemes of economic regulation were practiced throughout the 19th century, including a variety of Socialist experiments such as the Public Workshops that Louis Blanc established in Paris in 1848. In Britain the various factory acts of the 19th century represented an effort by government to improve slightly the working conditions in industry. After World War II the ability of a government to regulate or control the economy became one of the chief tests of its success, and regulatory agencies multiplied to the point at which they are now often referred to as "the fourth branch of government." The extent of the controls imposed on the economy is one of the principal distinctions among capitalist, Socialist, and Communist systems. In Communist countries it is a matter of doctrine that the means of production should be owned and therefore controlled by the state. In Britain the Labour governments nationalized some major industries, including coal, steel, and the railroads, prompted partly by Socialist doctrine and partly by the failure of British industry to remain competitive in international markets. This process was then reversed when the Conservative Party became ascendent. In the United States the government has involved itself in the economy primarily through its regulatory powers. In France the government has gone further and has engaged in national economic planning in cooperation with private business organizations. The regulation of industrial conditions and of labour-management relations has been a major concern of most Western governments. In the United States the first regulatory efforts in this field were made during the Progressive era at the turn of the 20th century, when the wages, hours, and working conditions of women and children in industry became a matter of public scandal. A little later the conditions, hours, food, and wages of merchant seamen were brought under government regulation; an eight-hour day was set for railway crews; and workmen's compensation laws were instituted. With the Great Depression in the 1930s, minimum wages were introduced for workers in many industries, hours of work were set, and the right to collective bargaining was given legal sanction. Regulation of transportation has been another major activity in most Western political systems, beginning with the railroads. In the United States their monopolistic practices attracted the criticism of agricultural interests and led eventually to the Interstate Commerce Act of 1887, which regulated railroad rates; subsequent legislation covered the hours, conditions, and wages of railroad employees, among other things. Other modes of land and air transportation have since been brought under regulatory controls implemented by government agencies. In most European countries, facilities of communication--the telegraph, telephone, radio, and television--are owned and operated by the government. In the United States, most of these facilities have remained in private ownership, although they are regulated by the Federal Communications Commission. The regulation by government of important instruments of public opinion such as radio, television, and newspapers has important implications for the freedoms of speech and press and other individual rights. In the United States and Great Britain, government censorship of the press and other media has been restricted to matters of national security. This is also generally true of other Western constitutional democracies, although the celebrated Der Spiegel affair in Germany in 1962 and some extraordinary controls imposed on the media in France have been widely criticized. In many of the less-developed nations with authoritarian governments, very extensive controls are imposed on the press, and government-owned newspapers are often the principal sources of political news. Other forms of government regulation of the economy involve the use of taxes and tariffs, the regulation of weights and measures, and the issuance of money.
Protection of political and social rights.
To some extent, all modern governments assume responsibility for protecting the political and social rights of their citizens. The protection of individual rights has taken two principal forms: first, the protection of liberty in the face of governmental oppression; second, the protection of individual rights against hostile majorities and minorities. From the 1960s to the mid-1980s the sphere of public discussion in the Soviet Union was gradually, though erratically, widened. While this widening never extended to the purely political, some of the sociological discussion allowed served to set the intellectual stage for the Gorbachev period of radical reform. Although the Soviet Union suppressed most expression of political opinion until the late 1980s, domination by a central authority protected the basic human rights of some groups from violent rival minorities. On a larger scale, this is also what suppressed many long-standing rivalries in eastern Europe during the Cold War. The degree of repression in the former Communist states varied from country to country and changed with time after the death of Stalin. In the United States the Supreme Court expanded the rights of the criminally accused; and after 1954 the national government acted to bar legal discrimination against ethnic minorities. Indeed, almost all the freedoms detailed in the first 10 amendments to the Constitution have been extended since World War II. Another type of government regulation bearing on the individual concerns the law of immigration and emigration. The great mass migrations of the 19th and early 20th centuries came to an abrupt halt after 1914 with the proliferation of government controls on the freedom of movement across national boundaries. After some later liberalization, immigration to the industrialized states again saw increased restrictions near the end of the 20th century.
Provision of goods and services.
All modern governments participate directly in the economy, purchasing goods, operating industries, providing services, and promoting various economic activities. One of the indispensable functions of government--national defense--has made governments the most important consumers of goods, and they have not hesitated to use their resulting pricing, purchasing, and contracting powers to achieve various economic aims. In efforts to avoid dependence on private sources of strategic goods and defense materials, some governments have taken a further step and established their own military production plants. In wartime, governments have assumed control over entire industries and have subjected the work force to military direction in addition to rationing goods and regulating prices. In nearly all political systems, certain functions are recognized as public, or belonging to the government. In addition to national defense, these include the maintenance of domestic peace, public education, fire protection, traffic control, aid to the indigent, conservation of natural resources, flood control, and postal services. But governments have assumed responsibility for many other commercial operations, even in non-Socialist countries. The sale of electric power, for example, is one of the established enterprising functions of national, state, and local governments in the United States and Canada. Municipally owned power utilities exist in about 2,000 cities in North America; 14 states of the U.S. have public power districts; and the U.S. government markets power through the Tennessee Valley Authority, the Bureau of Reclamation, and several other agencies. Another range of functions is performed by other national agencies, including the Rural Electrification Administration, which loans money to rural cooperatives to finance local power projects; the Export-Import Bank of Washington, which makes loans to finance export and import trade; the Maritime Administration, which holds mortgages on ships; and the Veterans Administration, which makes loans for farm or home purchases to military veterans. The United States government, acting through agencies such as the Social Security Board, the Federal Deposit Insurance Corporation, and the Federal Housing Administration, is also the largest insurer in the nation. Through other agencies, such as the Housing and Home Finance Agency, the Urban Renewal Administration, and the Public Works Administration, the national government has also developed a major role in the construction and rental of residential housing for low-income persons. Other miscellaneous enterprises in which governments are involved include the provision of health care, the operation of public transport facilities, the development of public works, airport and port maintenance, and water-supply systems. In Great Britain the government operates hospitals and provides medical care under the National Health Service. In the United States many state and local governments operate hospitals on a commercial basis, although providing some charity care. At the local level in the United States the Port of New York Authority constructs and operates bridges, terminals, and airports. The states in the Delaware Basin have joined in a compact to establish an agency to control the use of water from the basin, institute programs to prevent pollution, provide recreation facilities, transmit and sell hydroelectric power, and provide watershed management. Cities in the United States and Canada operate more than 70 urban transit systems, 600 municipal gas utilities, and more than 4,000 water-supply systems. Cities are also generally responsible for garbage disposal and sometimes operate commercial slaughterhouses, coal yards, laundries, ice plants, and golf courses. Finally, packaged liquor sales, either wholesale or retail or both, are often made by the state governments.
PUBLIC ADMINISTRATION
While the functional objectives of government administration vary from system to system, all countries that are technologically developed have evolved systems of public administration. A number of common features may be detected in all such systems. The first is the hierarchical, or pyramidal, character of the organization by which a single chief executive oversees a few subordinates, who in turn oversee their chief subordinates, who are in turn responsible for overseeing other subordinates, and so on until a great structure of personnel is integrated and focussed on the components of a particular program. A second common feature is the division of labour or specialization within the organization. Each individual in the hierarchy has specialized responsibilities and tasks. A third feature is the maintenance of detailed official records and the existence of precise paper procedures through which the personnel of the system communicate with each other and with the public. Finally, tenure of office is also characteristic of all public bureaucracies. The various national civil services, despite their similarities, also show important differences, particularly in the way in which individuals are recruited and in the status accorded them in the political system. The British civil service, for example, has traditionally been composed of three classes, or grades--clerical, executive, and administrative. Administrative civil servants, the highest grade, are recruited by examination from among recent university graduates. The top managers of the different government ministries are drawn from this elite group. They remain in office despite changes in government and are accorded immense prestige. The U.S. civil service is organized into 18 grades. Although promotion from the lower grades is the typical means by which positions in the top grades are filled, there is also a flow of individuals into senior positions from private business and the professions. The U.S. equivalent of the administrative civil servant in Britain is usually a political appointee recruited by each new administration from private life or from a position in politics.
Development and change in political systems
The student of political systems grapples with a subject matter that is today in constant flux. He must deal not only with the major processes of growth, decay, and breakdown but also with a ceaseless ferment of adaptation and adjustment. The magnitude and variety of the changes that occurred in the world's political systems between the second and eighth decades of the 20th century suggest the dimensions of the problem. Great empires disintegrated; nation-states emerged, flourished briefly, and then vanished; world wars twice transformed the international system; new ideologies swept the world and shook established groups from power; all but a few nations experienced at least one revolution and many nations two or more; domestic politics in every system were contorted by social strife and economic crisis; and everywhere the nature of political life was changed by novel forms of political activity, new means of mass communication, the enlargement of popular participation in politics, the rise of new political issues, the extension of the scope of governmental activity, the threat of nuclear war, and innumerable other social, economic, and technical developments.
CAUSES OF STABILITY AND INSTABILITY
Although it is possible to identify a number of factors that obviously have a great deal to do with contemporary development and change in the world's political systems--industrialization, population growth, the "revolution of rising expectations" in the less developed countries, and international tensions--there is no agreed theory to explain the causes of political change. Some social scientists have followed Aristotle's view that political instability is generally the result of a situation in which the distribution of wealth fails to correspond with the distribution of political power and have echoed his conclusion that the most stable type of political system is one based on a large middle class. Others have adopted Marxist theories of economic determinism that view all political change as the result of changes in the mode of production. Still others have focussed on governing elites and their composition and have seen in the alienation of the elite from the mass the prime cause of revolutions and other forms of violent political change. In the discussion that follows, a distinction is drawn between unstable and stable political systems, and an attempt is made to suggest ways of understanding the processes of political development and change.
Unstable political systems.
In modern times the great majority of the world's political systems have experienced one form or another of internal warfare leading to violent collapse of the governments in power. Certain crisis situations seem to increase the likelihood of this kind of breakdown. Wars and, more particularly, national military defeats have been decisive in prompting many revolutions. The Paris Commune of 1871, the Russian revolutions of 1905 and 1917, Hitler's overthrow of the Weimar Constitution in Germany, and the revolutions in China all occurred in the aftermath of national military disasters. Many factors in such a situation, including the cheapening of human life, the dislocation of population, the ready availability of arms, the disintegration of authority, the discrediting of the national leadership, material scarcities, and a sense of wounded national pride, contribute to the creation of an atmosphere in which radical political change and violent mass action are acceptable to large numbers of people. Economic crises are another common stimulus to revolutionary outbreaks, for they produce not only the obvious pressures of material scarcity and deprivation but also a threat to the individual's social position, a sense of insecurity and uncertainty as to the future, and an aggravation of the relationships among social classes. A severe national economic crisis works, in much the same way as a military disaster, to discredit the existent leadership and the present regime. Another triggering factor is the outbreak of revolutions in other political systems. Revolutions have a tendency to spread: the Spanish Revolution of 1820 had repercussions in Naples, Portugal, and Piedmont; the French Revolution of July 1830 provoked similar outbreaks in Poland and Belgium; the Russian Revolution of 1917 was followed by a dozen other revolutions; and the colonial liberation movements in Africa, Southeast Asia, and elsewhere after World War II appear to have involved a similar chain reaction. Crisis situations test the stability of political systems in extremely revealing ways, for they place extraordinary demands on the political leadership and the structure and processes of the system. Since the quality of the political leadership is often decisive, those systems that provide methods of selecting able leaders and replacing them possess important advantages. Although leadership ability is not guaranteed by any method of selection, it is more likely to be found where there is free competition for leadership positions. The availability of established methods of replacing leaders is equally, if not more, important, for the result of crises is often to disgrace the leaders in power, and, if they cannot be replaced easily, their continued incumbency may discredit the whole regime. The stamina and resolve of the ruling elite are also important. It is often said that a united elite, firmly believing in the justice of its own cause and determined to employ every measure to maintain its power, will not be overthrown. Most revolutions have gotten under way not when the oppression was greatest but only after the government had lost confidence in its own cause. Other conditions of the survival of political systems relate to the effectiveness of the structures and processes of government in meeting the demands placed on them. Political systems suffer violent breakdown when channels of communication fail to function effectively, when institutional structures and processes fail to resolve conflicts among demands and to implement acceptable policies, and when the system ceases to be viewed as responsive by the individual and groups making demands on it. Usually, a system has failed over a period of some time to satisfy persistent and widespread demands; then, exposed to the additional strains of a crisis situation, it is unable to maintain itself. Revolutions and other forms of violent collapse are thus rarely sudden catastrophes but rather the result of a process of considerable duration that comes to its climax when the system is most vulnerable. Unstable political systems are those that prove vulnerable to crisis pressures and that break down into various forms of internal warfare. The fundamental causes of such failures appear to be the lack of a widespread sense of the legitimacy of state authority and the absence of some general agreement on appropriate forms of political action. Governments suffer their gravest handicap when they must govern without consent or when the legitimacy of the regime is widely questioned. This is often the case in systems that have experienced prolonged civil war, that are torn by tensions among different national or ethnic groups, or in which there are divisions along sharply drawn ideological or class lines. The problem is often most acute where there is a pretender to the throne, a government in exile, a neighbouring state sympathetic to a rebel cause, or some other focus for the loyalty of dissidents. To some degree, also, the problem of legitimacy confronts all newly established regimes. Many of the new states of Africa and Asia, for example, have found it a source of great difficulty. Often they have emulated the form of Western institutions but failed to achieve their spirit: borrowing eclectically from Western political philosophies and systems of law, they have created constitutional frameworks and institutional structures that lack meaning to their citizens and that fail to generate loyalty or a sense that government exercises rightful powers. Closely related to the problem of legitimacy as a cause of the breakdown of political systems is the absence of a fundamental consensus on what is appropriate political behaviour. A regime is fortunate if there are well-established, open channels of political action and settled procedures for resolving grievances. Although the importance of such "rules of the game" is that they allow change to occur in mainly peaceful ways, stable political systems often show surprising tolerance for potentially violent forms of political behaviour, such as strikes, boycotts, and mass demonstrations. Such forms of political behaviour are not permitted in systems where there are no agreed limits to the role of violence and where there is a high risk that violence may escalate to the point of actual warfare. If the government cannot count upon widespread support for peaceful political procedures, it must restrict many kinds of political action. Such restriction, of course, inhibits still more the development of open methods of citizen participation in politics and adds to tension between the government and the people.
Stable political systems.
The simplest definition of a stable political system is one that survives through crises without internal warfare. Several types of political systems have done so, including despotic monarchies, militarist regimes, and other authoritarian and totalitarian systems. After 1868, in the period of the restoration regime under the Meiji emperor, Japan succeeded, without major political breakdowns, in building an industrial state and developing commercial structures that transformed traditional Japanese society. This achievement was based on the development of centralized patterns of political control and the growth of a type of authoritarianism involving the rule of a military elite. Similarly, some of the totalitarian regimes of the contemporary world have demonstrated an impressive capability for survival. The key to their success is their ability to control social development, to manage and prevent change, and to bring under governmental direction all the forces that may result in innovations that are threatening to the system. In some systems, survival does not depend on the detailed management of the society or close governmental control over social processes but is the result of sensitive political response to the forces of change, of flexible adjustment of the structures of the system to meet the pressures of innovation, and of open political processes that allow gradual and orderly development. Much of the Western democratic world has achieved peaceful progress in this way, despite new political philosophies, population increases, industrial and technological innovations, and many other social and economic stresses. Such evolutionary change is possible when representative institutions provide effective channels for the communication of demands and criticisms to governments that rely upon majority support. The election of legislators and executive officials, competition between political parties, constitutional guarantees of freedom of speech and press, the right of petition, and many other structures and procedures perform this function in contemporary constitutional democracies. In such systems, social and economic problems are quickly transformed into issues in the open arenas of politics; governments are obliged to shape policies that reflect a variety of pressures and effect compromises among many conflicting demands. The representative mechanisms that have produced evolutionary change in Western constitutional democracies are themselves subject to a continuous process of adjustment and mutation. Indeed, representative institutions must develop in ways that reflect social and economic developments in the society or they will lose their legitimacy in the minds of the people. In political systems such as the United States, for example, subtle shifts in the function and relative power of different institutions are continuously being made and, over time, produce entirely new structures and very different patterns of institutional behaviour. It is as a result of this process that the presidency has accumulated a range of new powers that have given it primacy among the branches of American government. This process also explains the growth of administrative agencies that perform both legislative and judicial functions. This process of dynamic adjustment is crucial, for institutions that remain static in a changing society are unable to serve as agencies of evolutionary change.
TYPES OF POLITICAL CHANGE
The study of political change is difficult, for change occurs in many different ways and at many different points in the political system. One may distinguish several major types of change.
Radical revolution.
First are changes of the most fundamental type--transformations not only of the structure of government but of the whole polity. Such change is not limited to political life but transforms also the social order, the moral basis, and the values of the whole society. Drastic change of this kind occurred in the four great revolutions of the modern era--the English Revolution of the 17th century, the American Revolution, the French Revolution, and the Russian Revolution. These movements had the most profound effect on social and political life, permanently altering the beliefs by which men live. Their consequences were felt not only in the societies in which they occurred but also in many other political systems, in which, as a result of their example, revolutions of an equally fundamental character occurred. Each of these major revolutions was something of a world revolution, for it resulted in a basic change in the ways in which men in all political systems viewed the nature of politics and the purpose of political life. The independence movements in the colonial empires after World War II, for example, were fuelled by those principles of individual liberty and representative government that were once the slogans of 18th-century American and French revolutionaries. Marxist revolutionary concepts emphasizing economic progress and radical social change have shaped the development of many of the new nations. The continuing impact of such ideas is an example of another way in which fundamental political change occurs. The nature of a political system may be transformed not suddenly or violently in the course of revolution but by the gradual, corrosive influence of ideas and by the accumulating impact of different political philosophies.
Structural revision.
A second type of change involves alterations to the structure of the political system. Such change is not fundamental, in the sense of a basic transformation of the nature of the regime, but it may produce great shifts in policy and other political outcomes. Because the structure of a political system--that is, its formal and informal institutional arrangements--is a major determinant of policy outcomes, it is frequently the target of political action of various kinds. The political activist, the reformer, and the revolutionary share the recognition that the policies of a government may be effectively changed by adjusting the institutional forms through which the government acts. In some systems, structural change has been accomplished by legal means. In the United States, for example, such major institutional reforms as the direct election of the Senate and the limitation on presidential terms were made by constitutional amendment; and in Britain the various reforms of Parliament were accomplished by statute. In other systems, structural changes are often achieved by revolution and other violence.
Change of leaders.
A third type of political change involves the replacement of leaders. Again, the recognition that to change the personnel of a government may be an effective way of changing government policy prompts many kinds of political action, ranging from election contests to political assassination and various forms of coup d'etat. In some systems the existence of established means of changing political leaderships works to prevent violent types of political action. In the United States the quadrennial contests for the presidency afford a constitutional opportunity to throw the whole executive leadership out of office. At the other extreme, the coup d'etat leads to the abrupt, often violent replacement of national executives. Although it is a type of revolution, the coup d'etat usually does not involve prolonged struggle or popular participation; after seizing office, the principal aim of the leaders of the coup is usually the restoration of public order. The coup d'etat occasionally develops into much more than the replacement of one set of governmental leaders by another and may prove to be the initial stage of a truly revolutionary process; e.g., the coups d'etat that initiated Communist rule in Czechoslovakia in 1948 and ended King Farouk I's regime in Egypt in 1952.
Change of policies.
Government policy itself may be an important agency of political change. The social and economic policies of Franklin D. Roosevelt's New Deal and the Socialist programs implemented by the British Labour Party after 1945 are examples. In both cases, government policies resulted in far-reaching modifications to the functioning of the political system: a vast expansion in the role of government in the economy, the use of taxes to redistribute wealth, an increase in the political influence of organized labour, and the implementation of national programs of social welfare. Major policy change of this type, of course, is often a response to widespread pressures and demands that, if not satisfied by the system, may intensify and lead to various forms of violent political action. At other times, however, policy changes are imposed by a government to achieve the political, social, and economic goals of a single class, of an elite, or of the political leadership itself. Many important questions remain as to the reasons for change, the ways in which change occurs, and the effects of change. Political scientists are still not completely certain, for example, why some systems have managed to avoid violent political change for considerable periods, while in other systems change is typically accomplished through coups d'etat, revolutions, and other forms of internal warfare. As suggested above, the explanation may have much to do with the existence in countries such as the United States and Great Britain of well-established political institutions that permit peaceful change, the presence in the population of widely shared attitudes toward the government, and the existence of basic agreement on the legitimacy of state authority. Clearly, however, other factors are also involved. Perhaps one of the chief goals of the study of political systems should be to determine as exactly as possible the conditions and prerequisites of those forms of change that permit the peaceful and evolutionary development of human society.
ELECTORAL PROCESSES
Elections provide a means of making political choices by voting. They are used in the selection of leaders and in the determination of issues. This conception of elections implies that the voters are presented with alternatives, that they can choose among a number of proposals designed to settle an issue of public concern. The presence of alternatives is a necessary condition, for, although electoral forms may be employed to demonstrate popular support for incumbent leaders and their policies, the absence of alternatives disqualifies such devices as genuine elections. The widespread use of elections in the modern world is due in large part to the gradual emergence of representative government from the 17th century on. For proper appraisal, however, it is important to distinguish between the form and substance of elections. Electoral forms may be present but the substance may be missing. The substance is, of course, that the voter has a free and genuine choice between at least two alternatives. In a purely formal sense, the great majority of the more than 150 contemporary nations have what are called "elections," but probably only about a third of these have more or less competitive elections; perhaps a fifth have one-party elections; and in some others the electoral situation may be highly ambiguous. The discovery of the individual as the unit to be counted was, from the 17th century on, the critical factor in the emergence of modern electoral processes. The counting of individuals, in turn, was a by-product of the change from the holistic conception of representation in the Middle Ages to an individualistic conception. The British Parliament, for instance, was seen no longer as representing estates, corporations, and vested interests but rather as standing for actual human beings. The movement abolishing " rotten boroughs"--boroughs of small population controlled by a single person or family--that culminated in the Reform Act of 1832 was a direct consequence of the individualistic conception of representation. Once governments were not only believed to derive their powers from the consent of the governed but were expected to seek consent, the only remaining problem was to decide who was to be included among the governed whose consent was to be sought. The democratic answer was, of course, universal adult suffrage. Although it is common to equate representative government, elections, and democracy and although competitive elections under universal suffrage are in many respects a defining characteristic of political democracy, universal suffrage is not a necessary condition of competitive electoral politics. An electorate may be limited by formal legal requirements--as was the case before universal adult suffrage--or it may be limited by citizens' failure to take advantage of the vote, as is often the case in American municipal and other elections. Although such legal or self-imposed exclusion affects the democratic quality of elections and may ultimately affect the legitimacy of government, it does not impede decision making by election, provided the voter is presented with alternatives among which to choose. Access to the political arena during the 18th century depended largely on membership in some aristocracy, and participation in elections was regulated mainly by local customs and arrangements. With the American and French revolutions, every citizen was declared formally equal to every other citizen, but the vote remained an instrument of political power possessed by very few. Even with the arrival of universal suffrage, the ideal of "one man, one vote" was not achieved. Systems of plural voting were maintained in some countries, giving certain social groups an electoral advantage. In Great Britain, for example, university graduates and owners of businesses in constituencies other than those in which they lived continued to have an extra vote until 1948. Before World War I both Austria and Prussia had three classes of weighted votes that effectively kept electoral power in the hands of the upper social strata. Whereas in the Western nations of the 19th and 20th centuries the increasing use of competitive mass elections in selecting governments had the purpose and the effect of institutionalizing the diversity of modern societies, in the Eastern, one-party, Communist regimes mass elections came to have quite different purposes and consequences. They differed from competitive elections in that each voter usually had only the choice of voting for or against the official candidate. Indeed, they were in the nature of the 19th-century Napoleonic plebiscites, in that they were intended to demonstrate the unity rather than the diversity of the people. Dissent could be registered by crossing out the name of the candidate on the ballot, as several million Soviet citizens did in each election before 1989. As voting was not private, however, this invited reprisals. It may well be that some portion of dissenting votes were cast not so much because of dislike of Communism but because of grievances involving the conduct of minor officials. This may have served to weed out some of the worst officials at the very lowest levels. Even not voting was a form of protest, especially because local Communist Party activists were under extreme pressure to get nearly a 100 percent turnout. Before the revolutions of 1989, not all elections in eastern Europe followed the Soviet model exactly. In Poland, for instance, more names appeared on the ballot than there were offices to fill, and some degree of electoral choice was possible. Many authoritarian regimes throughout the world have attempted to gain some level of legitimacy through the holding of elections. This may be done when it is clear that, because of repression, no substantive opposition is remotely feasible. Often, however, the process is more subtle in order to maximize the regime's gains. Elections may be scheduled when economic factors favour the regime and, more importantly, when election laws have been written to the severe disadvantage of competing parties. The opposition may be given little time to prepare, while the government already has various networks of supporters in place. Challengers also may be forced to campaign in an atmosphere of intimidation that precludes the effective organization of many potential supporters. A regime may cite unrelated reasons for postponing an election if it perceives a significant chance of losing. Also, it is not uncommon for government intervention to occur once balloting has begun, either in the form of voter intimidation (not infrequently actually attacking voters) or manipulating the count of votes freely cast.
Functions of elections.
Fundamental to the use of elections is the contribution that they make to democratic government. Where the members of the body politic cannot themselves govern and must entrust government to representatives, elections serve not only to select leaders acceptable to the voters but also to hold the leaders accountable for their performance in office. Accountability, however, is greatly jeopardized in electoral situations in which elected leaders, for want of ambition, do not care whether or not they are re-elected or in situations in which, for historical or other reasons, one party is so predominant as to preclude effective choice among alternate candidates or policies. Nevertheless, the possibility of controlling leaders by requiring them to submit to regular and periodic elections contributes to solving the problem of succession in leadership and, thereby, to the continuation of democracy. Moreover, where the electoral process is competitive and forces candidates or parties to expose their record of accomplishment and future intentions to popular scrutiny in election campaigns, elections serve as forums for the discussion of public issues, facilitate the expression of public opinion, and, more generally, permit an exchange of influence between governors and governed. Elections also serve to reinforce the stability and legitimacy of the political community in which they take place. Like national holidays commemorating common experiences, elections serve to link the members of a body politic to each other and thereby confirm the viability of the political community. By mobilizing masses of voters in a common act of governance, elections lend authority and legitimacy to the acts of those who wield power in the name of the people. Elections can also confirm the worth and dignity of the individual citizen as a human being. Whatever other needs he may have, participation in an election serves to gratify the voter's sense of self-esteem and self-respect. It gives him an opportunity to have his say, and he can, through expressing partisanship and even through nonvoting, satisfy his sense of belonging to or alienation from the political community. It is for just this reason that the age-long battle for the right to vote and the demand for equality in electoral participation can be seen as the manifestation of a profound human craving for personal fulfillment. In all forms of government, from the most democratic to the most totalitarian alike, elections have a ritualistic aspect. Elections and the campaigns preceding them are dramatic events which, depending on cultural or historical circumstances, may exude the gay atmosphere of a circus or the sombre atmosphere of a funeral. Rallies, banners, posters, buttons, headlines, and television call attention to the importance of participation in the event. Candidates and parties, from right to left, in addition to propagating their policy objectives through rhetoric and slogans, invoke the symbols of nationalism or patriotism, reform or revolution, past glory or future promise. Whatever the peculiar national, regional, or local variations, elections are events that, by arousing emotions and channelling them toward collective symbols, break the monotony of daily life and focus attention on the common fate.
Systems of counting votes.
Individual votes are totalled into collective decisions by a wide variety of rules of counting that voters and leaders have accepted as legitimate prior to the election. These decision rules may call for plurality voting, which requires that, among three or more alternatives, the winner need have only the highest number of votes; simple majority voting, which requires that the winner receive more than 50 percent of the vote; extraordinary majority voting, which requires some higher proportion for the winner, such as a two-thirds vote; or unanimity.
Plurality and majority decision.
The simplest means of deciding an election is the plurality rule. To win, a candidate need only poll more votes than any other single opponent; he need not, as required by the majority formula, poll more votes than the combined opposition. The more candidates contesting a constituency seat, the greater the probability that the winning candidate will receive less than 50 percent of the vote. The plurality formula is used in the national elections of such countries as Great Britain, Canada, and New Zealand. One-half of the former West German Bundestag was elected according to the plurality system, while the other half was elected according to a proportional representation formula (see below). Under the majority rule, the party or candidate winning more than 50 percent of the vote in a constituency is awarded the contested seat. The winning party or candidate must poll more votes than the combined opposition. This system thus ensures that the elected representative has the support of the majority of the voters. The majority formula is employed in Australia and France. It is usually applied only within single-member electoral constituencies. Both the plurality and the majority-decision rules are employed in the election of U.S. presidents. The composition of the electoral college, which actually elects the president, is determined by a plurality vote taken within each state. Voters choose between the names of the presidential candidates, but they are in effect choosing the electors who will elect the president by means of a majority vote in the electoral college. All of a state's electoral votes (which are equal in number to its seats in Congress) are given to the presidential candidate who gains a plurality of the vote in the state election. It is thus possible for a president to be elected on the basis of a minority of the popular vote. A critical difficulty with the majority formula is that, in a multiparty political system, the formula may produce an electoral deadlock if no candidate secures 50 percent of the total vote. In order to break such deadlocks a second round of elections ( second ballot) is required, if no candidate obtains a majority on the first round. In Australia, voters rank the candidates on an alternate preference ballot. If a majority is not achieved on the first round of elections, the weakest candidate is eliminated, and the votes he accrued are distributed to the other candidates according to the second preference on the ballot. This redistributive process is repeated until one candidate collects a majority of the votes. If no candidate secures a majority in the first round of the French National Assembly elections, another round of elections is required. In this second round, the candidate securing a plurality of the popular vote is declared winner. Neither the majority nor the plurality formulas distribute legislative seats in proportion to the share of the popular vote won by the competing parties. Both formulas tend to award the strongest party disproportionately and to handicap the weaker parties. The latter is particularly true if small parties are rooted in ethnic, religious, or social minorities; small parties escape the inequities of the electoral system only if they have a regionally concentrated base. The plurality formula distorts the distribution of seats more than the majority system.
Proportional representation.
Proportional representation requires that the distribution of offices be proportional to the distribution of the popular vote among competing political parties or candidates. It seeks to overcome the distribution imbalances that result from majority and plurality formulas and to create a representative body that reflects the distribution of opinion within the electorate. Because of the use of multimember constituencies in proportional representation, parties with neither a majority nor plurality of the popular vote can still win legislative representation. Proportional representation is an ideal that is sought after, but only approximated: the size of electoral districts is the critical factor; the larger the electoral district in terms of seats, the more proportional the representation will be. The number of seats assigned to a constituency is in fact a greater determinant of the proportionality of the outcome than is the specific type of proportional formula used. The different formulas of proportional representation are basically similar in their effect on the conversion of votes to political representation. Developed in the 19th century in Denmark and in Britain, the single transferable vote formula--or Hare system (after one of its English developers, T. Hare)--employs a ballot that allows the voter to rank the competing candidates in order of preference. When the ballots are counted, any candidate receiving the necessary quota of first preference votes is awarded a seat. In the electoral calculations, votes received by a winning candidate in excess of the quota are transferred to other candidates according to the second preference marked on the ballot. Any candidate who then has the necessary quota is also awarded a seat. This process is repeated, with subsequent surpluses also being transferred, until all the remaining seats have been awarded. Five-member constituencies are considered optimal for the working of the Hare system. The single transferable vote formula, because it involves the aggregation of ranked preferences, necessitates complex electoral computations. This factor, plus the fact that the Hare system limits the influence of political parties, probably accounts for its infrequent use; it has been used in Northern Ireland, Ireland, and Malta in the selection of the Australian and South African senates. The characteristic of the Hare formula that distinguishes it from other proportional representation formulas is its emphasis on candidates, not parties. The party affiliation of the candidates has no bearing on the computations. The basic difference between the transferable vote formula and the list systems is that, in the latter, voters choose among party-compiled lists of candidates rather than among individual candidates. Although voters may have some limited choice among individual candidates, electoral computations are on the basis of party affiliation; seats are awarded in respect to party rather than candidate totals. The seats that a party wins are allocated to its candidates in the order in which they appear on the party list. Several types of electoral formulas are used, although they fall into two main categories: largest average formulas and greatest remainder formulas. All employ some type of electoral quota. In the largest average formula, the number of votes won by each party is divided by the number of seats held by the party, plus one. The first seat is awarded to the party with the highest number of votes, since, no seats yet having been allocated, the initial denominator is one. When a party wins a seat, its formula denominator is increased by one and hence the party's chances of winning the next seat are reduced. The available seats are awarded one at a time to the party with the greatest average. Party totals, not candidate totals, are used in the calculations. No transfer of ballots takes place. Frequently named after its Belgian inventor, Victor d'Hondt, the largest average formula is used in Austria, Belgium, Finland, and Switzerland. The d'Hondt formula has a slight tendency to over-reward large parties and to reduce the chance of small parties gaining legislative representation. The so-called Lague variation of the d' Hondt formula--used in Denmark, Norway, and Sweden--reduces the reward to large parties but increases further the handicap to small parties. By adjusting the denominator of the d'Hondt formula, the Lague formula increases both the cost of the initial seat of a party and that of additional seats. The Lague formula thus aids middle-size political parties and reduces the number of legislatively represented small parties. The greatest remainder method establishes a vote quota for each seat in an electoral district by dividing the total vote in the district by the number of competing parties. The total popular vote won by each party is then divided by the quota, and a seat is awarded as many times as the party total contains the full quota. If all the seats are awarded in this manner, the election is complete. Such an outcome is unlikely, however. Seats that were not won by full quotas are subsequently awarded to the parties with the largest remainder of votes after the quota has been subtracted from each party's total vote for each seat it was awarded. Seats are awarded sequentially to the parties with the largest remainder until all the district's allocated seats have been awarded. Of all the proportional representation formulas, the greatest remainder formula, given large enough constituencies, yields results closest to the proportional ideal. Small parties fare better when the greatest remainder formula is used than when the largest average formula is employed. The greatest remainder formula is used in Israel, Italy, and Luxembourg and in some elections in Denmark. Italy, however, uses a special variety of the formula, called the Imperiali formula, whereby the electoral quota is established by dividing the total popular vote by the number of parties plus two. This modification increases the legislative representation of small parties but leads to a greater distortion of the proportional ideal. The choice of majority and plurality or proportional systems is, of course, not simply a matter of pure theory. Different methods of counting, just as different conceptions of representation, usually reflect cultural, social-structural, and political circumstances in a particular jurisdiction. Majority or plural methods of voting are most likely to be acceptable in relatively stable political cultures. In such cultures, fluctuations in electoral support, given to one party or another from one election to the next, reduce polarization and make for political centrism. Thus the "winner take all" implications of the majority or plurality formulas are not experienced as unduly deprivational or restrictive. Proportional representation, on the other hand, is more likely to be found in societies with traditional ethnic, linguistic, and religious cleavages or in societies experiencing pervasive class and ideological conflicts.
Voting practices.
There is a direct relation between the size of an electorate and the formalization and standardization of its voting practices. In very small voting groups, in which political encounters are face-to-face and the members are bound together by ties of friendship or common experience, voting is mostly informal and may not even require counting, because the "sense of the meeting" emerges from the group's deliberations. The consensus of the Quaker meeting is of this order. An issue is discussed until a solution emerges to which all participants can agree or, at least, from which any one participant will not dissent. By way of contrast, in modern mass electorates, in which millions of individual votes are aggregated into the collective choice, formalization and standardization of voting practices and vote counting are the rule. This is necessary in order to guarantee that the outcome can be considered valid, reliable, and legitimate. Validity means that the collective choice in fact expresses the sense of the electorate. Reliability means that each vote is accurately recorded and effectively counted into the total. Legitimacy means that the criteria of validity and reliability have been met, so that the result of the voting is acceptable and provides authoritative guidelines in subsequent political conduct. The development of routinized and standardized electoral practices in mass electorates is a surprisingly recent phenomenon, not much older than 100 years. It is as much a corollary of the growth of rapid communication through telephone and telegraph as of the growth of the electorate and rational insistence on making electoral processes fair and equitable. Nevertheless, even today electoral practices around the world differ a great deal, depending not just on formal institutional arrangements, but even more on a country's political culture.
Secret voting.
Once suffrage rights had been extended to masses of voters who, in theory, were assumed to be equal but who, in fact, were unequal (in order of birth, in intellectual endowment and educational accomplishment, in social status and the possession of property, and so on), open voting was no longer tolerable precisely because it could and often did involve undue influence, ranging from hidden persuasion and bribery to intimidation, coercion, and punishment. Equality, at least in voting, was not something given but something that had to be engineered; the secrecy of the vote was a first and necessary administrative step toward the one man, one vote principle. Equality in voting was possible only if each vote was formally independent of every other vote, and this suggested the need for strict secrecy. The slow progress made in introducing secret voting, from the French Revolution well into the 20th century, attests to the fact that social engineering, no matter how desirable or lofty in purpose, depends on favourable conditions for success. One need not assume that the obstacles placed in the way of secret voting were the result of some conspiracy on the part of those who recognized, quite accurately, that the mobilization of large numbers of voters fundamentally changed the distribution of political power and who, through opposing the secret vote, hoped to maintain a stranglehold on the newly enfranchised electorates. Rather, the success of secret voting depended on the reduction of illiteracy and, at the cultural level, on the spread of the individualistic norms of privacy and anonymity to certain classes of the population, notably peasants and workers. Traditionally these groups took their cues from those accepted as superior in status, or from their peers. Secret voting required learning to free oneself as a citizen from one's customary associations and from pressures for conformity. The difficulty of introducing and practicing the secret vote in today's politically and economically less developed nations mirrors the tortuous advance of the secret ballot in the Western nations during the 19th and early 20th centuries. Secret voting reduces drastically the possibility of undue influence on the voter. Without it, influence can range from outright purchase of votes to social chastisement or economic sanctions. This is not to say that bribery in voting is automatically eliminated by secret voting. Laws prohibiting and punishing the purchase of votes are on the statute books of many countries and undoubtedly contribute to discouraging the practice. Although informal social pressures on the voter are probably unavoidable and, in some respects, useful in reducing political rootlessness and contributing to political stability, secrecy in voting permits voters to break away from their social moorings and gives them a considerable degree of independence if they wish to take advantage of this electoral freedom. As a result it becomes ever more difficult for interest groups, whether labour unions, farmers' organizations, commercial or industrial associations, ethnic leadership groups, or even criminal syndicates, to "deliver the vote." The extent to which "deviant voting" occurs depends partly on the degree of rigidity in the social structure. In countries where caste or class barriers are high or where traditional social, economic, religious, or regional cleavages remain strong, deviant voting is less likely than in countries where social mobility is possible and where political conflicts cut across traditional social cleavages. In Western nations the increasing difficulties of labour, farm, religious, or ethnic leaders in influencing the voter attests to the success that secret voting seems to have had on freeing the individual from electoral bondage to his traditional or economic affiliations.
Balloting.
The ballot makes secret voting possible. Its initial use seems to have been a means to reduce irregularities and deception in elections. This objective, however, could be achieved only if the ballot was not supplied by the voter himself, as was the case in much early voting by secret ballot, or by political parties, as is still the case in some countries. Ballot procedures differ widely, ranging from marking the names of preferred candidates to crossing out those not preferred or writing in the names of persons who are not formal candidates. Ballots also differ according to the type of voting system employed. Where plurality or majority voting is practiced, most elections employ classified ballots whereby the voter casts his vote for only one candidate or list of candidates. Where proportional methods are used, election is by ballots that enable the voter to rank the candidates according to his preferences. Though evidence is hard to come by, it is commonly believed that the nature of the ballot influences the voter's choice. In jurisdictions where electors are called upon to vote not only for higher offices but also for a multitude of local positions and where, in addition, the election may include propositions in the nature of referenda, the length of the ballot seems to be a factor affecting vote outcomes. Overwhelmed by the length of the ballot, voters may be discouraged from expressing their preferences for candidates of whom they have not heard, or from deciding on propositions that they do not understand. Breaking up of the single ballot into separate short ballots helps overcome this problem but does not eliminate it. Election data show a rapid decline from votes cast for higher offices to those cast for lower offices and referendum-type propositions. Ballot position also seems to have an effect on the votes cast for particular candidates, especially in the absence of cues as to party affiliation or other identifications. The first position on the ballot may be favoured, and in the case of a long ballot both first and last names may benefit, with candidates in the middle of the ballot suffering a slight handicap. Ballot position is likely to have its greatest impact in nonpartisan elections, primaries, and elections for minor offices. Finally, the manner in which candidates are listed--by party column or office bloc--is likely to affect election outcomes. On party-column ballots it is possible to vote a "straight ticket" for all of a party's candidates by entering a single mark, although voting for individual candidates is usually possible. On the other hand, on the office-bloc ballot, voting is for individual candidates grouped by office rather than party. This discourages, though it does not eliminate, voting exclusively for members of one party. This can have important consequences for the structure of government, especially in systems with separated powers and federal territorial organization. If different offices are controlled by different parties, the governmental process may be marked by greater conflict than would otherwise be the case, and governmental decision-making often will be more difficult. The introduction of voting machines has not substantially changed the balloting process, although it has made it faster, more accurate and economical, and virtually tamper-proof. The voting machine is not without some minor problems of its own, in that it may marginally depress the level of voting. In candidate elections the dampening effect is accounted for by improper use of the machine, a problem that is being overcome through improved machines and voter education.
Compulsory voting.
In some nations, notably Australia and Belgium, electoral participation is legally required of all citizens, and nonvoters without legitimate excuses face money fines. The concept of compulsory voting reflects a strain in democratic theory in which voting is considered not merely a right but a duty. Its purpose is to ensure the electoral equality of all social groups. Whether made compulsory in law or through social pressure, it is doubtful that high voter turnout as such is a good indication of an electorate's capability for intelligent social choice. On the other hand, high rates of abstention or differential rates of abstention by different social classes are not necessarily signs of satisfaction with governmental processes and policies and may in fact indicate the contrary.
Electoral abuses.
Corruption of electoral practices is, of course, not limited to bribery or intimidation of the individual voter. The possibilities are endless, ranging from the dissemination of scurrilous rumours about candidates, and deliberately false campaign propaganda, to tampering with the election machinery by stuffing the ballot box with fraudulent returns, dishonest counting or reporting of the vote, and total disregard of electoral outcomes by incumbent officeholders. The existence of these practices depends more on a population's adherence to political civility and the democratic ethos than on the prohibitions and sanctions written into the law. The integrity of the electoral process is maintained by a variety of devices and practices. Permanent and up-to-date registries of voters are maintained to guarantee easy identification of those eligible to participate in elections, and procedures are designed to make the registration process as simple as possible. In most jurisdictions, elections are now held on a single day rather than staggered. Polling hours in all localities are the same, and opening and closing hours are fixed and announced, so that voters have an equal opportunity to participate. Polling stations are manned by presumably disinterested government officials or polling clerks under governmental supervision; and political party agents or party workers are given an opportunity to observe the polling process, enabling them to challenge irregularities and prevent abuses. Efforts are made to maintain order in polling stations, directly through police protection or indirectly through such practices as closing bars and liquor stores. The act of voting itself takes place in voting booths that protect privacy. Votes are counted and often recounted by tellers, watched by party workers to assure an honest count. The transmission of voting results from local polling stations to central election headquarters is safeguarded and checked.
Participation in elections.
The rate at which individuals participate in the electoral process depends on many factors, including the type of electoral system, the social groupings to which voters belong, the voters' personality and beliefs, their place of residence, and a host of other idiosyncratic factors. The level and type of election has a great impact on the rate of electoral participation. Electoral turnout is greater in national than in state or provincial elections, and greater in the latter than in local elections. Because of this, scheduling has an impact on the turnout for local elections. If local elections are held concurrently with provincial or national elections, a higher voter turnout is achieved than for nonconcurrent elections. Whether an election is partisan or nonpartisan also affects voter turnout--lighter participation occurring in the nonpartisan elections. Participation is also greater in candidate elections than in noncandidate elections such as referenda. There is some evidence that elections based on proportional representation, in which in some cases every vote counts, have higher electoral turnouts than majority or plurality elections. Noncompetitive or safe electoral districts tend to depress the level of voter turnout, whereas marginal elections increase the turnout. Technicalities in electoral law involuntarily disenfranchise many potential voters. As a result of moving, people may temporarily lose their vote because of residence requirements for voters in their new electoral district. Complicated voter registration procedures, combined with a high level of geographical mobility, significantly reduce the size of the active electorate in the United States, whereas in Canada and Great Britain the size of the electorate is maximized by government-initiated registration immediately prior to elections. Voter registration in the United States is left to the initiative of individuals and political parties. Relatively low levels of electoral participation are associated with rural residence, and also with low levels of education, occupational status, and income. The groups in society that have been most recently enfranchised also tend to vote less. Hence women vote less than men, American blacks less than whites, and working class people less than those of the middle class. Young people who have just turned of age, and have therefore just been enfranchised, are less likely to vote than people who are middle-aged. It is important to note that the nonparticipation of certain groups in elections has important implications; if everyone were to vote, the balance of electoral power would shift toward the recently enfranchised and less privileged members of the society. Some people are conscientious nonvoters, although such people are rare. Others, perceiving the vote more as an instrument of censure than of support, may not vote because they are satisfied with the present government. This group of voluntary nonvoters is also small, however. In fact, nonvoters have been shown to be generally less satisfied with the political status quo than are voters. The vote is a rather blunt and ineffectual instrument for expressing dissatisfaction, and nonvoting is more likely to be symptomatic of alienation from, than of satisfaction with, the political system. Supporters of political parties vote more often than nonsupporters; to party supporters the vote becomes a pledge of party loyalty as well as a political instrument. Those who feel that government policies have some direct relevance to their lives are more likely to vote than those who are disinterested or who sense the government as being more remote. Finally, a great number of random factors may determine individual participation in specific elections. Election campaigns vary in their intensity. A crisis atmosphere may induce an unusually large number of people to vote on one occasion, whereas on another the chance to vote for an extremist candidate may increase the participation of the normally disinterested. Even the weather has a substantial impact on election turnout.
Influences on the direction of voting.
The electoral choice of voters is largely influenced by their membership in social groups or by the social groups with which they identify, and, to a much lesser extent, by campaign issues and party promises. The determinants of party membership or party identification are the most crucial factors behind the voting decision. Membership in social and occupational classes, regional, religious, or ethnic groupings, and so on, are thus important influences on the direction of the vote. Because the electoral choice appears to be largely determined by long-standing group and party identifications, the voting decision may appear to be irrational, in that it is not based on a careful calculation of the immediate benefits expected to accrue to the voter from each electoral outcome. Group-determined voting does not preclude rationality, however, for individual self-interest may well be tied to the destiny of the social groups to which the voter belongs. The independent voter, contrary to much common belief, is likely to be poorly informed politically and relatively uninterested and uninvolved in politics. Paradoxically, however, by switching their support, independent voters represent an important factor in democratic politics. In most countries the relatively permanent party alignments are based on social and cultural cleavages. But if elections are to be competitive, and if control of the government is to alternate between parties or coalitions of parties, then some voters must switch party support from election to election. New voters and independent voters, therefore, provide a vital source of change in democratic politics.
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