Globe 5f333k

Differences and the CAGE Distance Framework1 Pankaj Ghemawat After analyzing the cases in section 1, the reality of semiglobalization and the importance of cross-country differences should be clear. This section introduces the CAGE distance framework, which is used to identify and prioritize the differences between countries that companies must address when developing cross-border strategies.2 Begin by considering the example summarized in exhibit 2-1, which plots Walmart’s operating margin by country in 2004 against the distance between each country’s capital and Walmart’s headquarters in Bentonville, Arkansas. The impact of geographic distance is obvious, but what other types of difference or distance can you identify that separated the markets that were profitable for Walmart from those that weren’t? Exhibit 2-1 Walmart International’s Operating Margin by Country (2004 estimates) Figure 2-1: Wal-Mart International’s Operating Margin by Country, 2004 (Estimated)

1

The CAGE distance framework disaggregates distance or difference into four major categories: Cultural, istrative, Geographic, and Economic. Differences along these dimensions generally have a negative effect on many cross-border interactions, although in some cases, differences along a limited subset of CAGE dimensions can actually encourage rather than discourage such interactions.3 Each of these broad types of difference or distance is illustrated by the Walmart example. 

Cultural distance: Culture can be defined as the collection of beliefs, values, and social norms—the unwritten, unspoken rules of the game—that shape the behavior of individuals and organizations. Cultural distance encomes differences in religious beliefs, race/ethnicity, language, and social norms and values. Societies even differ in their social attitudes toward market power and globalization in ways that have important effects, both formally via regulation and informally, on how businesses operate. 4 Interestingly, Walmart’s four profitable markets share linguistic, religious and ethnic similarities or, at least, ties through large diaspora.



istrative distance: Historical and political associations between countries—colonial links, free trade agreements, the tenor of current relationships—profoundly affect economic exchange between them—which is the same as saying that differences along these dimensions matter a great deal. So, of course, do istrative attributes specific to a particular country such as autarchic policies or weak institutions and high levels of corruption. In the Walmart example, note that two of the profitable countries, Canada and Mexico, partner with the United States in a regional free trade agreement, the North American Free Trade Agreement (NAFTA). And a third profitable ―country‖ as classified by Walmart, Puerto Rico, is officially an unincorporated territory of the United States.



Geographic distance: The geographic dimension of distance involves more than just how far two countries are from each other: other attributes to be considered include contiguity, a country’s physical size, within-country distances to borders,

2

access to the ocean, topography, and even time zones. Exhibit 21 makes it clear that the capital city of each of Walmart’s four profitable ―countries‖ is geographically closer to Walmart’s headquarters than the capitals of any of the unprofitable ones; in addition, Canada and Mexico share a common land border with the United States. 

Economic distance: Consumer wealth and income and the cost of labor are the most obvious (and related) determinants of economic distance between countries. Others include differences in availability (or lack) of resources, inputs, infrastructure and complements, and organizational capabilities. It seems a bit harder for Walmart to do well in poorer countries—although the number of data points is very limited. Note, however, that economic distance has not been entirely or even primarily a liability for Walmart. The company saves more money by procuring merchandise from China—exploiting economic distance, particularly in of labor costs—than it makes from its entire international store network. We will return to such strategies in section 5, which discusses arbitrage.

What the Numbers Tell Us International economists have adapted Newton’s law of universal gravitation to describe trade and other international economic interactions. Thus, the simplest gravity model of international trade between two countries predicts that trade will be directly related to their economic sizes (a unilateral attribute of each country) and inversely related to the physical distance between them (a bilateral or country-pair attribute). Augmented gravity models add measures of other types of differences as well as unilateral attributes. Exhibit 2-2 shows the results of one such analysis that evaluated cultural, istrative, geographic, and economic effects on trade.

3

Exhibit 2-2 Effects of Similarities Versus Differences on Bilateral Trade Dimensions of Distance/Proximity

Determinant

Change in Trade

Cultural

Common language

+42%

istrative

Common regional trading bloc Colony/colonizer links Common currency Differences in corruption

+47% +188% +114% –11%

Geographic

Physical distance: 1% increase Physical size: 1% increase Landlockedness Common land border

–1.1% –0.2% –48% +125%

Economic

Economic size: GDP (1% increase) Income level: GDP per capita (1% increase)

+0.8% +0.7%

Source: Pankaj Ghemawat and Rajiv Mallick, “The Industry-Level Structure of International Trade Networks: A Gravity-Based Approach,” working paper, Harvard Business School Boston, February 2003. The estimates correct for unobserved thresholds for participation in trade and are all significant at the 1% level but are, in a number of cases, smaller than those reported in many other studies, apparently due to the correction

The signs on most of the estimates in the table probably accord with your intuitions (although they cannot be reconciled with a fully globalized ―flat‖ world). What are probably more surprising are the magnitudes of some of the effects—for example, that countries with colonial ties are apt to trade almost three times as much as countries without them, or even more if one also s for the role of colonial ties in generating cultural similarities! The persistence of such large effects decades and, in some instances, more than a century after the original colonial relationships were dissolved reinforce the conclusion that complete globalization—as in the disappearance of the effects of such considerations—is extremely unlikely anytime soon. Similarities versus differences along many of the same dimensions also help explain foreign direct investment or companies’ foreign presence. Thus, for U.S. companies that operate in just one foreign country, that

4

country is Canada 60 percent of the time (and 10 percent of the time it is the United Kingdom).5 Gravity models have also been adapted to explain cross-border interactions as diverse as equity trading, e-commerce transactions, patent citations, immigrant flows, air traffic, phone calls, and even the incidence of wars! The basic conclusion from this literature is that differences between countries—and differences in differences— matter in significant, predictable ways. Identifying and Prioritizing Differences Having highlighted the persistent impact of cross-country differences or distances, the rest of this section focuses on using the CAGE distance framework to identify and prioritize the differences that must be ed for in developing global strategies. Exhibit 2-3 helps in this regard by identifying bilateral and unilateral factors to consider for each of the CAGE categories. Exhibit 2-3 The CAGE Framework at the Country Level

Cultural Distance Country pairs (bilateral)

Countries (unilateral)

 Different languages  Different ethnicities; lack of connective ethnic or social networks  Different religions  Lack of trust  Different values, norms, and dispositions  Insularity  Traditionalism

istrative Geographic Distance Distance

Economic Distance

 Lack of colonial ties  Lack of shared regional trading bloc  Lack of common currency  Political hostility

 Physical distance  Lack of land border  Differences in time zones  Differences in climates / disease environments

 Rich/poor differences  Other differences in cost or quality of natural resources, financial resources, human resources, infrastructure, and information or knowledge

 Nonmarket/closed economy (home bias vs. foreign bias)  Lack of hip in international organizations

 Landlockedness  Economic size  Lack of internal  Low per capita navigability income  Geographic size  Geographic remoteness  Weak transportation

5

 Weak institutions, corruption

or communication links

The most distinctive feature of the CAGE framework is that it encomes the bilateral attributes of country pairs as well as the unilateral attributes of individual countries. Most of the other frameworks that have been proposed for thinking about the differences across countries (or locations) focus on just unilateral attributes; that is, they assume that countries can be assessed one by one against a common set of yardsticks. Note that this characterization applies not only to cardinal indices such as the World Economic Forum’s Global Competitiveness Index or Transparency International’s Corruption Perceptions Index but also to ordinal ranking schemes such as Michael Porter’s ―diamond‖ framework for diagnosing the (relative) international competitiveness of different countries as home bases in specific industries. But indexicality of this sort is restrictive since it can’t deal with ideas such as ―The U.S. is closer to Canada than it is to Indonesia.‖ More generally, indexicality is incapable of capturing bilateral differences of the sort necessary to envision countries as existing in (and even occupying) space in relation to each other, that is, as nodes in a network instead of as an array along a common yardstick.6 Having drawn that distinction between unilateral and bilateral influences, it is useful to add that they can be fitted together into the same overall structure. Specifically, unilateral measures of isolation (or integration) capturing country-specific attributes that generally decrease (or increase) a country’s involvement in cross-border economic activities can be treated as a common component of that country’s distances along various dimensions from all other countries. For example, really isolated countries (characterized by unique, ingrown cultures, closed istrative policies, physical remoteness, or extremely high or low incomes) can be thought of as being relatively distant from everywhere else. That said, one needs to add bilateral indicators to such unilateral conceptions to capture the idea that a company’s home base affects which countries are close and which ones are farther away. The other point worthy of even more emphasis is that different types of distance matter to different extents in different industries. For instance,

6

since geographic distance affects the costs of transportation, it is of particular importance to companies dealing in heavy or bulky products. Cultural distance, on the other hand, shapes consumers’ product preferences and should be a crucial consideration for a consumer goods or media company—but is much less important for a cement or steel business. Exhibit 2-4 provides a summary of the characteristics that are likely to make an industry particularly sensitive to a particular kind of distance. Exhibit 2-4 The CAGE Framework at the Industry Level

Cultural Distance Cultural differences matter the most when:  Products have high linguistic content (TV programs)  Products matter to cultural or national identity (foods)  Product features vary in of size (cars) or standards (electrical equipment)  Products carry country-specific quality associations (wines)

istrative Distance Government involvement is high in industries that are:  Producers of staple goods (electricity)  Producers of other ―entitlements‖ (drugs)  Large employers (farming)  Large suppliers to government (mass transportation)  National champions (aerospace)  Vital to national security (telecommunications)  Exploiters of natural resources (oil, mining)  Subject to high sunk costs (infrastructure)

Geographic Distance Geography plays a more important role when:  Products have a low value-to-weight or bulk ratio (cement)  Products are fragile or perishable (glass, fruit)  Local supervision and operational requirements are high (services)

Economic Distance Economic differences make the biggest impact when:  Nature of demand varies with income (cars)  Economics of standardization or scale are limited (cement)  Labor and other factor cost differences are salient (garments)  Distribution or business systems are different (insurance)  Companies need to be responsive and agile (home appliances)

Applications of the CAGE Distance Framework The CAGE framework, once it is taken down to the industry level, lends itself to a very broad array of applications. Let’s focus here on four of the most important ones.

7

Making Differences Visible One application of the CAGE distance framework is to make key differences visible. While this application may seem too obvious to be worth belaboring, most notable international business debacles can be traced back to a failure to appreciate a key type of cross-country difference or distance. Furthermore, in a very diverse world, managers cannot simply fall back on personal experience to ensure adequate sensitivity to differences. Checklists of the sort embedded in exhibits 2-3 and 2-4 can help even experienced people avoid errors due to forgetfulness and cognitive overload in a complex environment. Understanding the Liability of Foreignness A second application of the CAGE framework is to pinpoint the differences across countries that might handicap multinational companies relative to local competitors—the so-called liability of foreignness—or more generally affect their relative positions. This can be a useful exercise for both multinationals and their local competitors. When there are substantial liabilities of foreignness, multinationals often look to acquire or set up t ventures with local firms to overcome these barriers. Assessing Natural Owners and Comparing Foreign Competitors Even if multinationals can be confident that they are going to prevail over local competitors in a particular market, the CAGE framework can be used at a finer level of resolution to shed light on the relative position of multinationals from different countries. For example, CAGE analysis can help explain why Spanish firms do well in many industries across Latin America, but also why success in Mexico has proved comparatively easier for U.S. firms. 7 Again, such analysis is most valuable when conducted at the industry level and is indicative rather than decisive. Thus, particularly good or bad global strategies can matter more than ―natural ownership‖ advantages.

8

Comparing Markets and Discounting by Distance The CAGE framework can also be used to compare markets from the perspective of a particular company. One method to conduct quantitative analysis of this type is to discount (specifically, divide) raw measures of market size or potential with measures of distance, broadly defined. While such discounting involves numerous approximations, making some adjustments of market potential for distance is a better idea, given how much distance matters, than refraining from making any adjustments at all. Some companies do formally use methods of this sort in deciding to enter or exit markets (as described in the first case in this section, on Grolsch). Conclusion The CAGE framework helps identify the most important cross-country differences and their implications for strategy. However, understanding differences is not a sufficient basis for setting global strategy. Think back to the ADDING value scorecard from the previous section and ask yourself how each type of difference or distance affects the six levers for value addition and subtraction. Is it a challenge that must be ed for and addressed? Or does it offer an opportunity to improve economic profitability? The next three sections help address these questions by introducing three types of strategies for creating and claiming value in the presence of cross-border differences: adaptation, aggregation, and arbitrage.

1

Pankaj Ghem aw at And Jord an I. Siegel, ―Cases on Redefining Global Strategy‖ , (H arvard Bu siness Review Press, 2011):59-69 2

For a more extended treatment of this material, see Pankaj Ghemawat, ―Distance Still Matters: The Hard Reality of Global Expansion,‖ Harvard Business Review, September 2001. This topic is also addressed at substantially greater length in chapter 2 of Pankaj Ghemawat, Redefining Global Strategy (Harvard Business School Press, 2007), and chapter 3 of Pankaj Ghemawat, World 3.0: Global Prosperity and How to Achieve It (Harvard Business Review Press, 2011). For a collection of maps that highlight distance effects, see www.ghemawat.com.

9

3

For further discussion of the ways in which CAGE differences can encourage rather than discourage cross-border activity, see the discussion of arbitrage in section 5 and the references cited therein. 4

For an original discussion of cultural distance and how it affects foreign direct investment, see Jordan Siegel, Amir Licht, and Shalom Schwartz, ―Egalitarianism, Cultural Distance, and FDI: A New Approach,‖ working paper, Harvard Business School, Boston, October 2008. 5

Su san E. Feinberg, ―The Exp ansion and Location Patterns of U.S. Mu ltinationals,‖ u np u blished w orking p ap er, Ru tgers University, 2005. 6

For a more extended discussion of indexicality in a broader social science context, see Andrew Abbott, Chaos of Disciplines (Chicago: University of Chicago Press, 2001). 7

Subramanian Rangan and Aldemir Drummond, ―Explaining Outcomes in Competition among Foreign Multinationals in a Focal Host Market,‖ Strategic Management Journal 25, no. 3: 285–293.

10