In thinking about competition we tend to be retrospectively oriented. We often have past or previous models of competition and competitive situations

What do such changes mean for the firm? They imply a need to create differential advantage on other than a price basis. 3 They support the creation of preferences through aggressive, integrated marketing programs; by adjusting the goods and service mix, the communications mix, and the distribution mix of the firm to bring them into line with consumer wants and needs and so assure a market niche and satisfactory profit position. They stress the pivotal role of innovation in the management of corporate resources.These changes also indicate that in reality management's attempt to create advantage does not stem from a drive to develop a monopoly, as critics have suggested. Rather, it is rooted in the desire to compete successfully. In using marketing strategies to create differential advantage, management is concerned with competitors and their activities and not the establishment of a monopoly. For each innovation they expect counter-innovations. Management expects that differential advantage will eventually be eroded by counter-moves of competitors.Gaining consumer acceptance of new products or services, especially radically new ones, is a difficult challenge confronting marketing managers in creating differential advantage. It requires: 1. that consumers be so motivated that they will acquire new patterns of thought, new habits, even new skills, that are necessary for the acceptance and use of the new product in a favorable manner.
2. that the assistance in developing the attitudes and skills will be furnished by the members of the marketing system including manufacturers, wholesalers, retailers, and advertising and other facilitating agencies.
3. that in some cases attempts be made to alter cues in the consumers' environment which elicit the types of consumer behavior that are unfavorable to the product.
4. that consumers' reward systems must be understood so that changes are encouraged by rewarding the consumer for adopting new patterns.

Companies today are competing for much different types of markets than they have in the past. They are no longer competing to provide ample food, shelter, and clothing. Ours is an economy of plenty which has, in great measure, met the demands of basic physical needs. As a result, competition, market expansion, and the creation of differential advantage, to a large extent, become vertical in nature rather than horizontal. New markets must be found in terms of types of food, types of clothing, types of shelter, and types of recreation. An opportunity exists, therefore, for upgrading the tastes, the desires, and acts of consumers. Marketing through programmed innovation on a vertical plane can become a significant cultural, and civilizing force.

It has been suggested that the next competitive frontier facing business is an inner one. It is the market of the mind and the personal development of consumers. Competition and innovation may be geared to filling the needs of this inner frontier. One of the roles of marketing in the future may be that of encouraging increasing expenditures, of both dollars and time, to develop consumers intellectually, socially, and morally. Hence, during a period of increasing leisure, and abundance, competition, through marketing, may well become a significant cultural stimulus. It may provide the impetus for the improvement of consumer tastes. It may afford an increase in consumer cognizance and appreciation of aesthetic values. Competition, then, may be pursued on a cultural plane. If this occurs, marketing, innovation, and competition may become driving forces for the cultural development of society.

Dimensions of competition

Competition has many dimensions. There are legal considerations, political aspects, ethical perspectives, psychological and social dimensions. Essentially competition can be defined only in terms of the culture and nature of the people that surround it. Competition has its fullest meaning in the marketing environment of a consumeristic economy rather than in the cartelized, planned, or cooperative environments existing in many countries.

From a marketing perspective what does competition connote? It emphasizes changing profit opportunities that are available for perceptive firms because of the existence of a dynamic marketing environment. It stresses the necessity of striving for the creation of differential advantage in the market place. It underscores the primacy of planning and programming innovation on a continuing basis to adjust company offerings to a changing competitive scene.

Competition, in marketing terms, refers to the effective management of innovation to meet changing marketing opportunities. Innovation is an instrument by means of which companies compete vigorously in the market place. Programmed innovation is the corporate method of achieving continuous market adjustment; competition is its stimulus. Keenly competitive situations manifest themselves in new products, new processes, new services, new ideas, and new techniques as well as in price adjustments. We should be aware, however, not only of the degree of competition suggested by quantitative measures of newness, and number of competitors, but also the kind of competition suggested by qualitative considerations.

In thinking about competition we tend to be retrospectively oriented. We often have past or previous models of competition and competitive situations in mind. We often conceptualize competition in terms of an emerging industrial society rather than a maturing industrial society, in terms of price competition rather than convenience and service competition, in terms of an economy of scarcity with relatively low consumer purchasing power rather than an abundant economy with widespread discretionary purchasing power, in terms of manufacturers and sellers completely controlling and dominating the market place rather than an economy governed to a considerable extent by consumer sovereignty, and in terms of intra-industry competition rather than interindustry competition. Sometimes we even conceive of competition in terms of an agrarian economy where only imperfectly competitive situations exist.

In particular the emphasis on price, that stems from past economic situations, is today often misplaced. This does not mean that price competition is no longer important. It does mean, however, that ours is often a competitive situation in which price obscurity and not price clarity is the rule. The general situation where consumers face competitive price offerings in the market place, and must exercise rational economic judgment by becoming human calculators is not the norm. In its stead we find the use of fictitious list prices, trade-ins, coupons, allowances, special discount prices, service variations, packaging differences and a multitude of brands. They tend to obliterate price information, to reduce the emphasis on rational price behavior, and to alter our concepts of competition.

Competitors must be viewed as both instigators and receptors of competition. As instigators, they must perceive of their environments accurately, assemble marketing intelligence, and draw inferences about competitive reality. As receptors, they must be prepared to launch counter strategies.

The normal competitive cycle becomes one of programmed innovation and counter-innovation. The stimulus for innovation at any time, however, may be curtailed because of two types of resistance: external and internal. Internal resistance may stem from inertia, lack of capital, fear of counter-competitive consequences, or a host of real or imagined obstacles on the part of a company. External resistance, which raises the most substantial barriers, includes consumers' resistance in the market place.

To an extent, a company may have some effect in altering consumer resistance by communicating with markets, developing products so they better meet consumers wants and needs, and by helping consumers overcome resistance to change. Limits exist, however, beyond which corporate action will have relatively little impact. Quite often, for example, when a product is totally new, consumer resistance will be great and extensive marketing effort is required to overcome resistance to change.

Other external factors which place a limit on competition and innovation include various types of governmental regulation, accepted industry practices and agreements, and the social and cultural environment. As factors limit or restrict innovative opportunity, they affect competition directly.

Marketing as an intervening variable

Marketing managers are always concerned with the changing relationships between a business and its external environment. Marketing must have its primary focus in company adjustments to meet the wants, needs, and opportunities of the market place in a better manner. Marketing, therefore, is an intervening variable between two environments.

The first is an enabling environment, or a larger system, within which a business operates and which is affected by sociological, psychological, technological and economic forces. The second is a precipitating environment, an internal system, which helps precipitate innovation, the creation of differential advantage, and the implementation of aggressive competition on the part of the individual firm. It is the latter environment which stimulates corporations to program innovation.

Marketing as an intervening variable links the enabling environment with the precipitating environment. It becomes a means of fulfillment for a business enterprise. In this role marketing becomes directly concerned with change and innovation. Most immediately, innovation is perceived as a means of providing for the growth and survival of business. In reality, however, it is more than a tool for corporate prosperity. Innovation is among the significant stimuli of social change. As a result it creates problems -- problems that stem from social change. It has an impact on value systems, on cultures, and on economic and social orders.

Competition and innovation

A competitive system assumes the willingness of management to accept risks and to adopt new perspectives and methods of business operations. Hence, it is inextricably intertwined with innovation. Competition is manifested through company innovations. Innovations which stem from change in turn result in further change. Since change begets change at an ever increasing rate, a major management responsibility becomes that of recognizing and adapting to a more dynamic business scene.

To date technological changes have had the greatest effect on management thinking. Change, however, is not limited to technology and the physical sciences. Changing methods of marketing are having tremendous impact on competition and our way of life. Consider the competitive implications of the supermarket, self service, discount houses, shopping centers, automatic vending machines, and credit plans. Such process and service innovations will have an even greater impact in the future.

The challenge of innovation in marketing is the unused productive capacity of the firm and the economy. Unused capabilities are among our greatest social and economic wastes. Producing innovations which will result in greater utilization of the capacity is an urgent corporate and national need. It is worthy of the attention of thoughtful executives.

Two aspects of innovation should be distinguished. They are the perception, and the implementation. Innovation refers essentially to a qualitatively different thought perception. The focus of innovistic attention may be a process, a product, or even another idea. Competition, however, is affected largely by the implementation of innovations.

The corporate environment has a great influence on competition and the implementation of innovation. For instance, when there is a corporate climate in which change is anticipated, then competition flourishes and innovations tend to occur freely. In our society there is a rich tradition of expecting change [2]. This anticipation of change results from a conscious belief that changes are useful, helpful, good, and that they will occur. Such an attitude is one of the foundations of aggressive marketing. It is one of the reasons why the American economy has produced the marketing technology which today is being emulated in other parts of the world.

In the United States, then, we have an expectation of competition, in terms of price, products, brands, packages, services, and qualities. Each year we anticipate changes in automobiles, refrigerators, clothing, housing, recreation. We know that there is keen cross-competition among unlike products for consumer dollars. By contrast, however, there are other cultures which are restrictive in their anticipations. They do not expect, hope for, or plan for any changes in any part of their environment. They strive to maintain the status quo. In these cultures, which are resolute against the suggestion of new ideas, new products, and new processes, marketing plays but a minor role. Economic competition becomes devoid of meaning.

Competition and management action

Competition in our economy takes place within a dynamic framework largely beyond the control of any individual management. Among the changing elements that will provide a backdrop for future competitive situations are: (1) continued economic growth, and accelerating rates of scientific and technological development, (2) an increasing availability of leisure time and greater mobility on a very broad base, (3) a great increase in discretionary buying power and hence postponable purchases, (4) a population explosion which is resulting not only in more consumers but greater proportions of the population at both ends of the age spectrum, (5) a revolution in information and information handling, including an explosion of knowledge that is useful in business administration, marketing, and related fields, (6) increasingly vigorous domestic and foreign competition brought about by the creation of such markets as the European Common Market.

Such factors stimulate the appearance of new marketing forms, the break down of traditional product lines, and the revision of institutional and organizational classifications. They encourage an accelerated rate of product development. They foster changing concepts of transportation, warehousing, communications, and commercial intelligence, all of which result in more aggressive competition and planned innovation. They will have a great impact upon the business system of the future.

The society that we live in is most accurately described by its changing parameters. However, businessmen who are confronted with these dynamic elements, for many reasons often resist change. In fact one approach to change in the past was the philosophy that whatever was good enough for previous consumers is good enough for present and future consumers. Change was viewed with suspicion. As a result, competition was not as dynamic, as keen, as aggressive, and as vigorous as it is now. Likewise, market opportunities which result from change remained unrecognized and unsatisfied.

Today, however, management cannot ignore change and the accompanying opportunities. They cannot plot inflexible courses of action for long periods of time. Management must be fluid and viable. It must be prepared to deal with new problems and processes. It must continuously chart new directions.

In such a dynamic atmosphere, managers must recognize that change is the constant in planning, organizing, and controlling activities. Management's responsibility becomes that of anticipation, of adaptation, and of innovation
under conditions of accelerating rates of change. In fact the emphasis, in many enterprises in the near future, is not likely to be on operations. "It is going to be on change -- change to give business new roles, new clientele, new products and new processes. Indeed, in many ways we are entering a future in which the management of business is going to change and become very much like the management of a total research process -- a carefully planned learning effort in which knowledge itself is the scarcest resource being allocated." Marketing knowledge will govern the future competitive effectiveness of a firm. A greater emphasis on research, knowledge, and innovation, will also result in more intelligent approaches to competition.

Competition, innovation and marketing management

A consideration of competition, innovation and marketing management is both crucial and timely. It has implications for the development of effective systems of business action, for each of the functional areas of business administration, and for our position in world affairs. For those interested in marketing it has special significance and meaning. Competition and innovation are at the core of marketing activity.

Management today is forced to assess activities continuously in an economic environment characterized by keen competition, an explosive development of usable knowledge, and rapid and wide-spread change. In particular, students and practitioners concerned with the marketing aspects of business are confronted with the major responsibility of understanding and managing change. Marketing is the dynamic area of business which is perhaps most directly confronted with change. It is the area most immediately concerned with competition and competitive strategies. It is the area which reflects the vitality of business organizations as they attempt to deal with shifting external market parameters.

Our economy has been termed a capitalistic, a free enterprise, and a mixed economy. An economy in which the consumer is the focal point of economic effort, and in which marketing is the essential motive power. In such an economy, companies compete for customer and consumer favor and the resulting market stature. Consumers occupy a pivotal position. As a result, even non-marketing executives are becoming more concerned with the market-related activities of their own functions. Similarly, various social and political observers are investigating competition and competitive practices, and they are questioning the moral, social, legal, psychological, and ethical bases of marketing actions.

In a competitive society, marketing becomes more than a functional field of business. It is a philosophy of business operation -- a way of business life. Decisions made concerning marketing activities extend well beyond the functional boundaries of marketing in any organization. They establish parameters for the total operations of the business system. They have an impact on research and development, on production, on finance, on purchasing, and on personnel. In fact, it is marketing which distinguishes business organizations from other forms of organization and that in essence there are only two top management functions: innovation and marketing.

Nature of Futures Trading

Contracts calling for the future delivery of products are common in all lines of business. The term futures trading is, however, ordinarily applied only to a special type of contract, bought and sold according to the rules of organized commodity exchanges.

A futures contract is an agreement between two parties—one who agrees to sell and deliver and one who agrees to buy and receive (1) a certain kind and quantity of a commodity, (2) at some specified future time, (3) at a specified price, and (4) according to the conditions of trading prescribed by an organized commodity exchange or conditions generally understood in the trade. Payment and delivery are postponed to a future time, for the goods may not even be in existence at the time of the contract, as is the case of many grain contracts made before the commodity has actually been harvested.

A futures contract is an agreement to buy or to sell and not a consummated purchase or sale. Such contracts, regardless of the specific commodity involved, generally have certain prescribed characteristics that have been established for the purpose of simplifying the trading activity. First, all contracts involve a standard quantity unit of the commodity or some multiple thereof. Thus, in wheat futures, trading is in terms of "round lots" of 5,000 bushels. Similarly defined standard units are recognized for other commodities. Second, trading is ordinarily confined to a single so-called contract grade or to a few such grades specified for this purpose. The assumption is that prices of grades other than those recognized for trading purposes will fluctuate in the same manner as contract grades. It is, accordingly, not necessary to establish machinery for trading in all recognized grades of a commodity. Third, delivery of the commodity must be made during a specified month. Futures trading does not involve specific delivery dates; rather, the seller has the option as to the day of the specified month that he will make delivery. Fourth, the seller has the option of delivering certain stipulated grades higher or lower than the contract grade, at a specified premium on or discount from the contract grade as the case may be. Fifth, the commodity to be delivered on the contract must be weighed and graded by licensed inspectors. Finally, delivery must be made from approved warehouses. These characteristics constitute elements of standardization in exchange, which are well understood by those engaged in futures trading. Because of their existence and widespread acceptance, such contracts may be effected speedily and without delay in accordance with rigidly maintained, equitable principles of trade.

Even though considerable attention is devoted to the terms of delivery in the foregoing discussion, such contracts seldom involve actual physical delivery of the commodity from seller to buyer.

Shifting Risks of Market Conditions

Risks of changes in market conditions are not insurable because losses cannot be anticipated with accuracy; and, even if this could be done, the cost of such insurance would be prohibitive. Consequently, various methods indicated in the following discussion are used to shift all or parts of such risks to others.

Shifting Individual Risks to Society

A high degree of protection has been enjoyed by many companies when the government, under conditions of war or national emergency, has guaranteed minimum prices for certain products. Over a long period of war and nonwar years, prices of certain basic agricultural products have been controlled or supported at given levels as a matter of public policy. This does not eliminate price risks, but does involve the shifting of a large part of the risk of individuals to the government and, consequently, to the whole of society.

Cooperative Activity

Risks incident to fluctuations in prices have frequently been reduced through the activity of trade associations. Although price fixing through such associations is contrary to law, it is probable that there still remain informal understandings among members of some associations with regard to prices that should prevail at a given time. Another example of risk-shifting activity is afforded by cooperative marketing organizations. When a large group of agricultural producers pool their commodities, the place and time risks arising out of sale in unfavorable markets are greatly diversified and minimized for each participant.

Manufacture to Order

Market risks are reduced when goods are sold in advance of manufacturing. This is not the usual situation in industry but is common for some types of products, such as major industrial installations, special purpose industrial equipment, and certain classes of fashion apparel. Most men's suits, for example, are sold to retailers from a sample line shown many months prior to delivery, and manufacturing is largely devoted to merchandise that has been sold in advance. Some farm products, as sweet corn, tomatoes, and pumpkins, are sold to canners even in advance of cultivation, and in some instances canners furnish the seeds or plants for this purpose.

Price Guaranties

Some vendors offer their customers guaranties against price declines. This involves shifting risks that may normally be carried by the buyer to the seller. The practice offers protection to purchasers who are hesitant in placing orders because of fear of a falling market, an unfavorable change in consumer preferences, or a modification of styles or model numbers.

Subcontracting

An illustration of shifting risks by contracts is afforded by the building industry. General contractors in the building trades submit bids for the construction of a building on the basis of their knowledge of the business and of other factors including the cost of materials, labor conditions, and so on. The successful contractor, if he is so inclined, may then proceed immediately to let subcontracts for necessary materials and for the construction of all or most of the different parts of the building. In this manner, the general and original contractor shifts most of his risk to those who are presumably experts in their fields, unless his estimates have been incorrect or some subcontractors fail to perform their function.

Insurable Risks

While all classes of risks can be reduced substantially through good management, even the best managed companies are still confronted with hazards that they are reluctant or unwilling to assume. Most firms are quite willing to bear normal risks when they can afford to absorb possible losses without endangering their financial structure. On the other hand, they are not willing to assume risks when possible losses involve catastrophic consequences. Attempts are usually made to shift such risks to others if there is an opportunity to do so at reasonable cost. Some kinds of risks may be covered by insurance, which is a social or institutional device whereby the uncertain risks confronting individuals are combined in a group and thus made more certain. Then, the certainty of a relatively small, fixed insurance premium is substituted for the uncertain probability of a large loss.

Among the risks of physical destruction or deterioration, insurance protection is available and commonly carried for protection against fire, windstorm, hail, and damage to merchandise inventories, buildings, and equipment. Losses from theft by outsiders can be covered by insurance, and defalcation of employees may be insured against by having such persons bonded by surety companies. Personal risks involving key individuals are often minimized by insurance policies on their lives. Insurance is even available for certain types of protection against credit losses; it is, however, quite costly and provides only partial coverage, with the result that its use is relatively restricted.

Minimizing Risk through Management Practices

There are two general methods of minimizing market risks. One is to lessen the chance of their occurrence, through good management practices. The other involves shifting risks to others who are better able or more willing to assume the hazard.

All classes of market risk can be reduced, frequently to a very considerable extent, through various management practices. To an increasing extent, large business firms regard the task of risk management as an important function which requires for proper performance specialized personnel who analyze risks, ascertain potential losses, institute corrective or risk-reducing measures, as well as handle decisions about insurable risks.

Preventive measures are employed to minimize possible losses from physical destruction or deterioration. Fire hazards are decreased by fireproof buildings and safeguards such as sprinkler systems, night watchmen, or fire inspections. Provision of proper storage conditions may forestall losses due to vermin, dirt, or extreme temperature changes.

Risks of theft can be minimized by the use of burglar alarm systems, night watchmen, safes for the protection of money or high-value merchandise, and other similar practices. Losses from shoplifting can be kept at a minimum by appropriate methods of displaying merchandise most likely to be pilfered; by training store employees to be observant in "policing" the selling area; and, in large institutions, by the use of store detectives.

Some personal risks, including accidents and, to a certain extent, sickness of employees, may be prevented by the adoption of safety devices, proper ventilation, and healthy working conditions. To guard against losses that may arise in the case of death or illness of key employees, competent substitutes can be trained for responsible positions.

For most firms, the only effective way to minimize credit risks is through efficient management in the granting of credit and the collection of accounts. This does not mean that all losses from bad debts will be eliminated. The most successful credit manager is not the one who has practically no losses but one who reduces losses from uncollectible accounts to a minimum, without sacrificing sales volume. Some losses must be expected in all businesses, and creditors should stand ready to bear their proportionate share. To keep this share of losses down to a minimum, sound control of credit operations is essential.

Both time and place risks of changes in market conditions can be controlled to a considerable extent through good management. Since most risks of market conditions result from changes in, or uncertainties regarding, supply and demand conditions, well-managed firms find it advisable to make careful qualitative and quantitative analyses of markets, and to gather and intelligently interpret market news from various sources. Only a study and analysis of information gathered from various sources enable one to ascertain the current status of the market and to forecast its future trend.

Proper and adequate control of inventories is a significant earmark of successful management. Only in this way can a buyer determine the quantity and quality of goods to be bought from time to time in order to prevent overstocks on the one hand and "outs" on the other. Careful planning of financial, merchandise, manufacturing, and selling requirements and a proper coordination of these factors contribute much toward the reduction in risks of vendor or purchaser.

Market Risk, Speculation, and Hedging

The assumption of risk is an important function that must be performed by all types of middlemen, manufacturers, and original producers in the agricultural and extractive industries. In addition, there are numerous specialists in risk bearing, known as speculators. A number of types of risk which are of especial interest to those engaged in marketing are considered in this chapter. Major emphasis is placed upon the risks which arise out of changing market conditions and the methods whereby such risks may be minimized or shifted to others.

Classification of Market Risks

Market risks may be classified according to their cause or character into five groups, as follows:

1. Physical destruction or deterioration of commodities or other properties which may result from natural causes such as windstorms, floods, earthquakes, drought, or unseasonably cold or hot weather, or from controllable causes such as inadequate safeguards against fire, vermin, or freezing

2. Theft, including fraud or pilferage by employees, burglary, or shoplifting

3. Personal contingencies relating to accident or sickness of employees, death of key executives, or, especially in small companies, of key salesmen who account for a large proportion of a firm's sales volume

4. Credit extensions which involve the risk that debtors may be unwilling or unable to meet their obligations at maturity or ultimately

5. Market conditions which involve risks arising out of uncertainty about the exchange value of commodities

Of these classes, the most significant risks are those which arise out of market conditions. They may be divided principally into time risks and place risks. Practically all marketing transactions involve a certain degree of hazard due to changes wrought by the passage of time. Merchants buy goods with the hope of reselling them at a profit; manufacturers attempt to make products that will sell at remunerative prices; farmers raise what they think will be in demand. But markets for certain commodities may be glutted; the wants of consumers may change; or seasonal changes may be too slow or otherwise unfavorable. Any of these changes may affect the demand for and supply of any commodity one way or another, with a resulting increase or decrease in risk. Place risks are great when a commodity is offered for sale, or a purchase must be made, in an unfavorable market. Special losses may result from misjudging markets. This is often true of perishable fruits and vegetables when, because of a lack of adequate information on the part of shippers, they are forwarded to a glutted market where they must be sold without delay to prevent physical deterioration.

Relation of Finance to Distribution Channels

The financial strength of a vendor has a decided influence upon his channels of distribution. Some canners of fruit and vegetables dispose of their entire output through selling agents to whom they are financially obligated. A similar reason is often advanced for the employment of selling agents in the textile trades although another marketing specialist, the factor, is often used for purely financial assistance.

Whether or not a firm shall embark upon a method of distribution involving the elimination of the wholesaler or even the retailer may hinge largely or entirely upon the extent of its financial resources. Few manufacturers, indeed, can muster the capital required for establishing their own retail stores. Many of them cannot even afford to establish a sales organization to sell directly to retailers, or to maintain the warehouses necessary to furnish prompt delivery. This is one of the important reasons for the utilization of the wholesaler in the channel of distribution. One reason for the employment of manufacturers' agents is the inability of sellers to finance their own sales force.

This problem may be viewed, with results not dissimilar, from the standpoint of the buyer. Relatively few retailers can afford to purchase their merchandise requirements directly from manufacturers. Most independent druggists and hardware merchants use wholesalers not only as a source of supply for merchandise but also as a source of capital for financing inventories through trade credit.

Selection of Kinds of Goods

Freedom in determining the kinds of goods to be purchased varies from one type of business to another. In many lines of manufacturing the materials to be bought are fixed automatically by the nature of the product manufactured. The manufacturer of cotton textiles must buy cotton yarn or raw cotton, and the butter manufacturer must have cream. Installations and industrial equipment are determined largely by the nature of the manufacturing process, with the result that there is sometimes rather limited freedom in their purchase.

For most merchants, on the other hand, the determination of kinds of goods to be purchased is a real problem, since the firm may not constantly handle exactly the same merchandise. While within certain limits most wholesalers and retailers find their choice of merchandise circumscribed by their clientele and competition, nevertheless it is a rare mercantile business which does not have some latitude.

This problem has been aggravated considerably by a pronounced tendency for many types of stores to expand or diversify their merchandise lines. Self-service grocery stores, for example, have sought to handle any type of merchandise that is suitable for sale by self-service methods. In seeking new items to purchase, they have been attracted by the higher margins obtainable on numerous items normally handled by drug-, department, or hardware stores. As a result, numerous advertised brands of proprietary remedies, toilet preparations, cosmetics, housewares, magazines, and alcoholic beverages have been successfully added to the lines carried by many supermarkets. Drugstores, hardware stores, and other kinds of business, feeling the pressure of this competition, have also sought to expand their offerings by invading fields hitherto foreign to them. Similarly, most variety chains have abandoned their limited-price position, and some have become in essence junior department stores. Department stores, in turn, have expanded their sales volume by the addition of departments for sporting goods, cameras and photographic equipment, and other kinds of merchandise that have been sold traditionally in specialized types of establishments.

Many marketing establishments have made costly mistakes in experimental attempts to diversify their merchandise offerings. For most small establishments, experience has indicated that new items cannot ordinarily be added successfully unless (1) they are in keeping with the general character of the business as reflected by firm name, atmosphere, location, and advertising and promotion policies; (2) they can be sold according to the present method of sale and by present employees; and (3) sufficient space and capital investment can be devoted to the new merchandise to offer customers a reasonable range of choice within the classification to which it belongs. Obviously, these rules have not been important limiting factors for very large wholesale or retail firms where it is more feasible to add specialized personnel or facilities to handle the merchandising of items not closely related to those previously sold.

Specialization in Buying

Unless buying of raw materials, semimanufactures, and the many items of equipment and supplies needed for the production process is effectively accomplished, manufacturers handicap themselves in their ability to compete with those who may be more skillful in the performance of this function. Ability to select from many offerings just what will sell best and to determine the most economic quantities to be bought at a given time is one of the prime tests of the efficiency of both wholesaler and retailer.

Moreover, buying is closely related to other marketing functions. Its practices and policies are often determined, in part at least, by the financial position of the purchaser, the availability of adequate and economical transportation and storage facilities, and the degree to which standardization has been accomplished. Risk is often reduced by the adoption of proper buying policies. Skillful buyers make use of reliable and pertinent market information from a variety of sources. Goods purchased for resale must be selected primarily with reference to what the market will absorb. In short, this marketing function is closely related to the functioning of almost every part of our marketing system.

Specialization in Buying

That buying is a very active and quantitatively significant function cannot be questioned when it is considered that manufacturing companies and middlemen ordinarily employ specialists to perform this activity. In manufacturing establishments a key employee, generally known as the purchasing agent, sometimes bearing the title of Vice President in Charge of Procurement, is responsible for the function. All wholesale merchants have buyers who generally occupy the position of executives, the number depending upon the size of the business and the number of different merchandise departments involved. Larger retail stores employ buyers who are also usually the managers of merchandise departments. Quite a number of large department stores have more than 100 buyers each. In the chain store field the buying function is either centralized or divided between the central office and the individual retail store unit. Among smaller independent stores, the buying function is usually the responsibility of the proprietor or one of the partners, but it is almost invariably one of the most important of their activities.

In every transaction someone engages in buying

In every transaction someone engages in buying. Goods or services may be purchased for industrial or commercial use, for resale, or for ultimate consumption. The buyer may be one who specializes in performing this function, one who does buying along with many other business activities, or an ultimate consumer satisfying a personal want. In any event, there is no better indication of the importance and pervasive nature of the buying function than the fact that someone buys every time a sale is made. Buying is significant not only as a differentiated specific function but also as an economic activity, the understanding of which is basic to modern concepts of customer-oriented marketing management.

Buying—An Active Marketing Function

While buying is a basic marketing function, it is often improperly relegated to an unimportant position. It is sometimes erroneously assumed that it is of a passive character—merely the opposite of selling. Quite to the contrary, buying does not take care of itself, but is indeed an active function.

The skill used in buying has an important influence in determining the relative value of what is purchased by the consumer. The constant increase in the variety of products offered to him, the growing tendency to procure more goods and services in the market rather than to produce them in the home, the multiplicity of brands, the frequency of relatively small quality differentials, and the widely differing services offered by stores, all combine to add to the difficulty of the consumer's choice and to stress the importance of his being able to buy with intelligence.

The active character of buying is especially conspicuous in the case of the consumer. Traditionally, he has taken the initiative in the exchange process. When wants are recognized and the consumer is ready to act upon them, it is customary for him to seek out a seller or sellers. When a salesperson comes into contact with the consumer-buyer, the process of exchange is often nearly completed. This is dramatically emphasized by the small proportion of retail business which is accounted for by house-to-house canvassers or other sellers who take the initiative in seeking out prospective consumer-buyers, and, by way of contrast, by the predominant proportion which is accounted for by regular retail establishments that are visited by a purchasing-minded public. Developments in simplified selling or self-service merchandising accentuate the importance of consumer buying activity. The more the retail selling and service functions are curtailed, the greater becomes the task and responsibility of the consumer as a buyer. While there is a substantial amount of pre-buying stimulation in the form of aggressive retailer and manufacturer advertising and sales promotion activity, the number of items competing for consumer attention is so vast and diverse that the ordinary person must play an extremely active role in making the purchases that satisfy his wants. Because of the detailed treatment of consumer demand and motivation in the early part of this book, the discussion in this chapter is devoted substantially to buying by business firms. It may be observed, however, that buying is often as active when examined from the standpoint of the firm as it is in the case of the ultimate consumer.

Commercial Letter of Credit

A substantial volume of foreign trade is transacted on "draft basis," in which the parties to the exchange instrument are the exporter and the importer. A standard and simple transaction on draft basis has been described; the following two chapters will supply the variations. The reader should have observed that when foreign trade is handled in this manner banks may act in either of two capacities, as collectors or as negotiators. There are many occasions in which the strength of a bank's name is used to assist foreign trade. Importing and exporting in this instance is on "bank credit basis" and involves the use of the commercial letter of credit, which may be described as an instrument by which "a banker, for account of a buyer, gives formal evidence to a seller of its willingness to permit him to draw on certain terms and stipulates in legal form that all such bills will be honored" on presentation.

From the viewpoint of a single country, commercial letters of credit may be divided into two groups. If an American importer provides the foreign exporter or shipper with a credit, we would consider it an import letter of credit, since it is being used to finance our imports. To the foreigner it will be an export letter of credit. If an American exporter is provided with a credit by the foreign importer or buyer, we would call it an export letter of credit, since it is being used to finance our exports. To the foreigner it will be an import letter of credit. In the case of either import or export letters, the credit may be in dollars or in foreign currency and may provide either for sight drafts or for time drafts.

Commercial or Trade Drafts

Some small imports are paid for by money orders, and when importers pay for goods in advance they usually use the bank draft or cable or mail transfer just described. The draft, cable transfer, and mail transfer are, furthermore, the principal forms of remittance by which an importer will cover a maturing obligation incurred a month or so earlier when he bought goods on an open account or consignment basis. But traditionally and generally the dominant type of exchange instrument in the commodity trade between nations is the draft drawn by the exporter either in United States dollars or in foreign currency. If the exporter is satisfied with the credit rating of the importer and the exchange risk, he may draw an ordinary draft on the importer. If the credit rating of the buyer is not acceptable to the seller, or if custom requires, he may draw on a bank under a commercial letter of credit, assuming that a letter of credit is opened by the buyer through his bank. In either case the drafts may be in the exporter's currency or in the importer's currency.

Let us suppose that for one reason or another an American exporter decides to sell goods to an English importer on a sterling draft basis. He will prepare the goods for shipment, make up a commercial invoice, obtain an insurance certificate or policy, and deliver the goods to a carrier to obtain a bill of lading. He will also obtain whatever authorization is required by the British Consul. These papers--the commercial invoice, consular invoice, insurance certificate or policy, and bill of lading-are the principal "documents" used in export-import trade.

The exporter will then draw a draft on the importer either to his own order or, to the order of a bank. The terms of the sale will have been agreed upon in advance. If the Englishman is to pay on sight or on arrival of the goods, the draft will be drawn payable "at sight" or "on arrival"; otherwise it will be payable a specified number of days "after sight" or "after date" as the case may be. The importer will not be able to obtain the goods until he has paid the sight or arrival draft and obtains the shipping documents. In general postponing the details-the documents on a time draft will be turned over to him either on payment (i.e., "documents on payment" or D/P) or on acceptance of the draft (i.e., "documents on acceptance" or D/A). In this case say the agreed terms are: a sterling draft 60 days date, documents on acceptance, goods invoiced, and draft drawn for £3,000. If, as is probable, the exporter is charging the importer interest for the 60 days' credit, we may assume it is included in the cost of the merchandise, since interest on drafts is customarily implicit rather than explicit.

The exporter attaches to the draft the documents previously mentioned and if the credit standing of the importer warrants he may send the documents direct to the importer. More probably, however, he will employ an intermediary as collecting agent--a bank, for example. The bank will forward the draft and documents to its correspondent nearest the English importer. The importer will inspect the documents and if he finds everything in order he will write his "acceptance" across the face of the bill, hand it back to the correspondent, and retain the documents. Following instructions, the correspondent will now hold the acceptance till maturity, when it will be presented to the acceptor for payment.

Ultimate payment will be in pounds sterling, and if the exporter, who is in this case carrying the draft till. maturity, fears that sterling may decline during the 60 days the acceptance is outstanding, he may enter a contract with his bank to sell £3,000 for future delivery at an agreed rate. He might, however, have sold the draft to his bank, avoiding the exchange risk and obtaining the dollar equivalent of £3,000 at the current rate on 60-day sterling bills. If, by chance, acceptance should be refused by the importer-drawee in England, the loss will rest on the exporter-drawer in the United States and not on his bank which bought the draft in good faith. Whether the bank will have its correspondent in England hold the acceptance until maturity or discount it in the London market depends on whether it wants to add to its sterling deposits at once or prefers to earn the interest on the bill.

Foreign Exchange Instruments

The principal foreign exchange instruments may be classified as follows, roughly in order of importance: Bank drafts, not drawn under letter of credit.

Mail transfers.

Commercial or trade drafts and drafts drawn under letters of credit.

Traveler's checks and letters of credit.

Postal money orders.

Express orders and bank post remittances.

Bank Drafts

For whatever the reason--to pay for goods, for securities, and so on--Americans frequently need to remit to foreigners under conditions which make money orders generally undesirable. The amount may be large, or the remitter may wish to send the remittance in his own mail. In all these cases the ordinary bank draft is a most convenient form of remittance.

In this country, in purely domestic trade, we have become so accustomed to making payments by personal check that we may forget that in general the personal check is not used in foreign trade. It is true that in trade with Canada, Cuba, and Mexico, payments are sometimes made by dollar checks drawn by the buyer (i.e., debtor) on his own bank account, just as in domestic trade. Usually, however, the importer, or anyone else, wishing to remit to a foreigner by check obtains from his bank a "bank draft" drawn by it on one of its correspondents or branches abroad.

Here, again, it should be noticed that an American bank cannot sell a foreign-currency draft to its customer unless: (1) it has a correspondent bank or branch in that foreign country; and (2) it makes arrangement to reimburse the correspondent for the drawing. It may, of course, have an adequate deposit in that bank already; but if it does not, it must purchase exchange in order to avoid an "open" or "uncovered" position in the foreign currency involved. The bank check reproduced is a "demand" draft.

That is, it is payable "at sight" (i.e., on presentation) in London, and it will be sold to the buyer (or remitter) at the current market rate.

Instruments of Foreign Exchange

We have used many terms in this chapter relating to foreign bills or "instruments" of exchange which we have not paused to define or describe: drafts, acceptances, letters of credit, demand or spot exchange, futures, and so on.

Foreign bills of exchange--drafts, traveler's checks, money orders--are negotiable instruments and in general have in this country the same legal definition and position possessed by purely domestic bills. They are made payable to bearer or to a named party and can be moved by endorsement from hand to hand just as freely as the endorsement of the first or "order" endorser permits. The general terminology with which we are familiar in the field of domestic negotiable instruments carries over into foreign bills. The exporter or other maker of a draft is the drawer and the drawee is the importer or any other party on whom the draft is drawn. The drawee usually becomes the payer and the drawer, on receiving payment, becomes the payee.

The Liabilities Arising Out of Foreign Bills of Exchange

So far as our laws are concerned, the liabilities are those typical of all drafts. But there are always two laws to be taken into account in the case of foreign bills of exchange, our own and those of the foreign country involved.

If an exporter sells and delivers goods to a foreign buyer or importer, he has a legal claim on the importer for the payment of the agreed price on the agreed date. The sale may be made on a draft basis. If so, the exporter will draw a sight or time draft on the importer "ordering" him to pay the agreed amount, but he cannot force the importer to "accept" the draft. Consequently, the drawer of a draft is primarily liable under it to anyone who buys it in good faith, until the drawee becomes primarily liable by accepting the draft. Even then the drawer continues secondarily liable, should the drawee default. The only exception to this rule is in those cases where (as, for example, under some authorities to purchase a bank will discount a draft "without recourse" to the drawer should the drawee default on maturity.If an importer who is drawee under a draft either refuses to accept it or refuses to pay it, the exporter has two legal routes open to him. He may, under the laws of most countries, protest the nonacceptance or nonpayment of the draft; or he may sue on the basis of the underlying sales contract. Some exporters believe that protest for nonacceptance is valueless, since even after a draft is protested for nonacceptance the drawer can sue only on the basis of the sales contract. Where an accepted draft is protested for nonpayment, however, the drawer may institute legal proceedings against the acceptor on the basis of the dishonored obligation. There are thus some advantages in protesting for nonpayment, and many exporters instruct the collecting bank to protest all drafts for nonpayment. The majority do not do so, and this for two chief reasons:

(1) they do not believe legal action in foreign countries is advisable;

(2) they believe that more often than not foreign buyers are provoked by protest proceedings and may be more successfully persuaded to pay by other means.

Interbank Relations

Important in the smooth functioning of banking operations in both domestic and foreign fields are the cooperative relationships between our own banks. It is not too much to say that orderly and expeditious foreign exchange operations are almost entirely the result of this bank-correspondent relationship. This relationship links the smaller banks with the great metropolitan foreign exchange bankers and through the latter gives the smaller banks indirect contacts with the major banks of every important city of the world.

At almost every point in the average foreign exchange transaction the bank correspondent is indispensable. If an American bank purchases a sterling draft from an American exporter it will, unless it immediately resells the draft to another bank, need an English correspondent bank to present the draft to the drawee for acceptance and subsequent payment and in which to deposit the proceeds. If an American exporter requests his bank to transmit to the drawee for collection a dollar or foreign-currency draft with accompanying shipping documents, the bank can safely do so only if it has a dependable correspondent somewhere near the drawee. Even the sale of drafts by an American bank against its foreign balances presupposes a correspondent relationship with a foreign bank. Nor could a bank arrange a letter of credit for either a traveler or a merchant, unless it had previously arranged with foreign banks to recognize the letter of credit.

The domestic correspondents of a large American bank having foreign relationships are scarcely less important. They serve the function of enabling the larger bank to fulfill certain obligations for its own foreign correspondents. To illustrate, suppose an English exporter draws a draft on an importer in Bethlehem, Pa., and that the exporter's bank in London has no Bethlehem correspondent. Let us suppose further that the Guaranty Trust Company of New York is the New York correspondent of the London bank. In that case, the draft, with shipping documents, might be sent to the Guaranty Trust Company for collection. The Guaranty Trust Company would forward the draft and documents to its own correspondent bank in Bethlehem which would, following instructions, make the collection and deliver the shipping documents to the importer. Whether the draft would be payable at sight or after a lapse of time, whether it would be in dollars or in sterling, are questions to be discussed later on. All that need be noted here is that the chain of correspondent banks made it possible for an English exporter to safeguard a collection on an inland American importer. It might also be observed, in passing, that if the draft was in dollars, the net effect after the collection was made would be an increase in the dollar balances owned by the London bank in the United States and, in England, either an outpayment of sterling to the exporter or an increase in the exporter's bank account (in sterling, of course) in the London bank.

Now look at the correspondent system from the standpoint of the bank in Bethlehem. By agreeing to render such services as that above to the Guaranty Trust Company of New York, the Bethlehem bank can depend on the Guaranty Trust Company for services in return, some of which may be purely domestic. We are concerned, however, with the international aspects of a correspondent relationship between a small bank and a large metropolitan foreign exchange banker.

It is probable that a bank in Bethlehem will not have sufficient demand from its customers for foreign exchange to justify the maintenance of deposits in banks in various foreign cities against which foreign-currency drafts could be sold.

Nor is this the only foreign service made available to the bank in Bethlehem by its correspondent relationship with the Guaranty Trust Company. If the former bank has customers who are actively exporting, their dollar drafts on foreign buyers may be forwarded through it to the Guaranty for collection. In the event the drafts are drawn in foreign currency they could be sent through the Bethlehem bank to the Guaranty Trust Company for sale. In addition, letter of credit and other facilities, later explained, are provided.

But it should not be imagined that the New York City foreign exchange bankers are the sole intermediaries between the other banks of the United States and the banks in foreign countries. Many American banks maintain relationships with banks in the important foreign cities. Consequently, few large cities in this country are without a bank engaging in wholesale exchange operations, although in many cases their foreign correspondents may not be so numerous as those of the great New York City banks; nor will they, with few exceptions, have their own foreign branches. Thus a bank in Chicago, Cleveland, or Pittsburgh will draw drafts on and collect drafts through its own foreign correspondents wherever possible; but if a client--say an exporter --should present a draft for collection on a merchant in some part of the world where one of these inland banks has no correspondent, then it will probably make use of the larger foreign facilities of its New York correspondent. It might forward the draft to that New York bank for collection, or, if the New York bank happens to have a foreign branch near the drawee, the inland bank may forward the draft directly to that branch.

Let us suppose again that no bank in Bethlehem, Pa., has its own foreign correspondent system. In that case there are a number of channels through which an exporter in that city may collect or borrow against his drafts.

(1) He may maintain relations with a New York City bank directly or through his New York export office.

(2) He may depend on the nearest bank with its own foreign correspondents--possibly one in Philadelphia.

(3) He may turn the business over to his local bank, which would probably forward the draft to its New York correspondent.

(4) If he is shipping his goods through a freight forwarder with New York or other metropolitan facilities, he may request the forwarder to arrange for the collection of the draft through its bank.

(5) If the manufacturer's export business is not substantial he may make use of the services of a combination export manager, who will represent, as a general rule, a number of inland manufacturers doing an export business. In some cases where manufacturers do not wish to assume the credit or exchange risk in selling abroad, they make an arrangement with an export house to undertake sales in foreign countries on its own responsibility. The export house for an arranged commission will in addition pay the manufacturer cash at the point of export and take care of any necessary financing under its own name. It will be observed that all these channels are ultimately dependent on foreign banking correspondents and that several of them require domestic correspondent relations as well.

Each foreign collection problem presents its own variations, and no standard agreement between correspondent banks could cover every contingency, so that, attached to foreign drafts based on export transactions, there will be an instruction sheet advising the collecting bank what to do and whom to consult in an emergency. Many of the activities arising out of collections, however, can be reduced to the terms of standard fees and procedures.

Hence it is customary for correspondent banks to give their principals in the United States a tariff schedule, setting forth the charges mutually agreed upon.

Foreign exchange market

Foreign exchange is bought and sold by a diversity of persons and institutions in a nation-wide "open" or "over-the-counter" market. If governments leave foreign exchange trading in private hands the transactions ordinarily converge upon the principal financial centers and will be carried on chiefly by the large international banks. When foreign exchange is a government monopoly the market immediately becomes highly centralized, although as a result of the restrictions bootleg or illegal trading frequently develops. In the United States foreign exchange trading is not materially regulated by the government. Consequently the market is "free" in that supply and demand are virtually unrestricted in the determination of exchange rates.

The rate-making forces are the subject of the next chapter. It is necessary here to call attention to the rather obvious fact that in the United States there is at all times both a demand for foreign exchange and a supply of foreign exchange. Exchange is created chiefly by those persons and companies that have sold goods and services to foreigners or that have foreign-currency balances derived either from borrowing or from foreign ventures. Some of these "creators" of exchange can use it themselves. For example, an exporter of tin plate might find it convenient to use some of the exchange received in payment to pay for imported raw materials. On the whole, however, the exporter of goods, services, or securities will sell the resulting foreign exchange for its dollar equivalent. On the other hand the Americans and the American companies who have incurred debts abroad--by importing, for example--must buy foreign exchange to make settlement. It is the function of the dealers and brokers in the foreign exchange market to serve as intermediaries between these two groups.

In the United States, New York City is the principal center of foreign exchange operations. New York banks have the most elaborate foreign departments; and in this city is the greatest concentration of import and export offices. The great New York banks stand ready to buy or sell, at some price, almost any international currency for which, to their knowledge, there is a ready market. At certain periods of the year the larger travel organizations, such as the American Express Company, are also largescale wholesale dealers in foreign exchange. Banks in certain other large cities in the United States are independent of New York institutions for foreign exchange facilities, as they too in many instances are wholesale buyers and sellers of exchange on their own account.

In recent years banks have been overwhelmingly the most important factor in the foreign exchange market both as buyers and sellers and as intermediaries in the collection of dollar and foreign-currency drafts. With the motivating factor of profit as the principal incentive, the banks buy foreign exchange in order to be in a position to sell foreign exchange. They purchase foreign bills in order to build up foreign-currency balances abroad against which they may sell their own drafts. For this service they expect to earn the spread between the buying and selling rates. An importer or anyone else who needs exchange to pay an obligation in foreign currency most probably will purchase a sight draft or cable or mail transfer in the appropriate foreign currency, from an exchange banker.

In passing, reference might be made to the foreign exchange broker, whose principal function at present is almost entirely confined to operating as liaison in interbank exchange transactions. The broker acts as an agent, not as a principal, and depends on commissions for his income.

The Hedging Function, Exchange risk

This aspect of the foreign exchange market is less easily understood. In domestic trade the seller faces the paramount risk that the buyer will wholly or partially fail to make payment. The foreign trader faces the same risk. This credit risk is probably no greater and may even be less in foreign trade than in domestic. If the transaction is arranged in a foreign currency there is, however, a peculiar risk undertaken by the exporter or importer, the risk of exchange fluctuation. To cover this exchange risk the foreign exchange dealers offer the machinery of the "forward market"--although unfortunately not in all currencies.

"Exchange risk" arises from both the transfer and the credit elements in foreign exchange. Let us assume that this risk is to be borne by the importer and leave for later chapters the question of whether it is usual for importers to assume it. An American importer, then, buys goods invoiced at £1,000 from an English exporter. At the time that the deal is closed the dollar-sterling demand rate is $1.90. If the importer pays cash in advance he may ignore any fluctuation in the exchange rate, but if a considerable period (say, 15 to 90 days) is to elapse before payment is made in sterling, a very material exchange risk may arise.

Suppose the English exporter allows the American importer 60 days in which to pay and draws a 60-day £1,000 draft on the American firm. The American firm is obligated, on accepting the draft, to remit £1,000 to the English exporter 60 days later. If, when that time has come, the dollar-sterling demand rate is $1.90, the importer will have sustained neither gain nor loss in exchange, but if, say, sterling should strengthen to $1.92, he will have to pay $20 more for the £1,000 draft than he had anticipated. He might lose much more if sterling rose still further; or, conversely, he might gain materially if dollars, instead of sterling, strengthened. In any case, here is an undeniable risk which the importer or exporter faces and which is not encountered in purely domestic trade.

Whether or not the foreign trader will voluntarily take his chances on this speculation in fluctuating exchanges is not the question just now. The question is: Can the risk be avoided, or must one or the other of the two parties to the trade (exporter or importer) assume it? Sometimes it can be avoided and sometimes not, depending on the existence of a forward market in the foreign currency involved. In the case just imagined, let us suppose the American importer wishes to "hedge" against any shift in the dollar-sterling rate to his disadvantage in the 60 days during which he has assumed an obligation to pay £1,000. He will do so by obtaining from his bank a contract obligating the bank to deliver £1,000 to him 60 days hence at a stated rate. We shall not stop now to inquire how that "future" rate will be determined and whether or not it will vary from the present or "spot" rate. The point to be noted here is that if the importer does contract to obtain the "future" sterling he needs at a fixed rate he is fully protected from any losses due to an increase in the dollar-sterling rate during the 60 days, although at the same time he foregoes any gains should the rate decrease.

Unfortunately, forward markets are not available in all currencies--although we shall postpone to a later chapter any query about the conditions prerequisite to a dependable forward market. To the extent that the foreign exchange market offers forward facilities in a given currency, the hedging function of foreign exchange may be fulfilled.

The Functions of Foreign Exchange

Although there is no formal international clearinghouse through which sellers and buyers in foreign trade may settle their accounts, some sort of system or mechanism must exist if there is to be any important commerce between nations. It needs no elaborate proof, certainly, to demonstrate that if an American sells raw cotton to an English buyer, payment can be made only if the buyer has facilities for obtaining dollar exchange for remittance to the shipper or if the American shipper can obtain dollars for his sterling draft on the English buyer. To make this process possible merchants and bankers have developed a number of "instruments" or bills of exchange, and there exist at all times various sorts of markets--public or private, regulated or unregulated, legal or illegal--in which exchange may be bought and sold.

The Transfer Function

Theoretically, pairs of exporters and importers in each country could get together and arrange to circumvent the foreign exchange problem. This has actually been attempted in the barter schemes of Germany, Italy, and other countries. As a matter of practicability, however, even these modern private barter deals have required some sort of intermediary to bring the four parties into association. Under more normal circumstances the basis of a foreign exchange market is a group of professional intermediaries or middlemen who provide the dependable purchase and sale facilities essential to any continuous market.

What should be observed is that the two exporters are paid in their own currencies, the New Yorker in dollars and the Londoner in ster- ling, and that this result was possible because the two banks (here taken to be correspondents) stood ready to buy foreign exchange from the exporters.

There is a danger in drawing too many conclusions from a simple diagram, because in reality foreign exchange is not simple either in theory or in practice. It will, however, be useful to the reader later on if he will notice in this example that the two banks purchased foreign currency drafts from the exporters. They did so because they anticipated a demand for foreign exchange from importers and others who are in debt to foreigners. Or, following the diagram, if the money values are equal, the

London bank can swap its dollars for the New York bank's sterling. This illustrates in its most elementary form the financial link between the imports and the exports of a country, which is so seldom really understood. This link is the substance of the concept of reciprocity.

The principal function of foreign exchange, then, is to convert the money of one country into that of another--to enable exporters and other creditors to receive payment in their own currency. This we may call the transfer function of foreign exchange, as distinguished from its less important, but nonetheless useful, credit and hedging functions.

The Credit Function

Anyone at all familiar with the role of credit and credit instruments in domestic trade will perceive that similar facilities must be made available in foreign commerce and that there is nothing peculiar about the credit function of foreign exchange. If importers are unable to pay cash in advance or on delivery, there are several ways by which the burden of credit may be shifted to other shoulders.

In foreign trade, as in domestic, goods may be sold on open account. Under such terms--most attractive to the importer-the exporter "carries" his customer for a stated period, after which he receives a remittance, usually in his own currency. This latter will be the only instrument of exchange involved, since the exporter will not have drawn a draft. As we shall see later, a good deal of foreign trade, especially in manufactured goods, is carried on in this manner, particularly when conditions are favorable.

More usually the exporter will extend credit to the importer by drawing a time draft directly on the importer or the importer may arrange to open a letter of credit through his bank under which the exporter will draw drafts. This relieves the importer of the necessity of paying before the expiration of 30, 60, 90, or 120 days, as the case may be. If the draft has been drawn on a prime bank under a letter of credit, it provides the exporter with a prime credit instrument which he may easily discount at a favorable rate if he needs immediate cash. So through the use of time drafts the importer obtains credit and the exporter has the choice of holding the drafts till maturity or of discounting or otherwise borrowing against them. If he holds them, he is himself extending credit; if he discounts or borrows, he is transferring the credit burden to the general money market.

At all times there is in existence a vast number of bills of exchange which have arisen out of foreign trade. They reflect the short-term credit through which the trade is financed. Some of them will be sight or demand bills, payable on presentation to the drawee. In the case of these bills the credit or "time" element is limited to the collection time--for example, sight bills on London may be in collection up to 25 days. Generally sight drafts will have been drawn by exporters who need or wish to obtain prompt payment from the foreign buyer or payment before releasing the goods to him; or they will be drawn in foreign currencies by banks against their balances with foreign correspondents and sold to importers or other debtors who have to make payments in foreign currencies. In contrast are the bills of exchange drawn so as to be payable only after a specified number of days. These time bills are evidence that creditors in one country have agreed to extend "terms" or "credit" to debtors in another country.

The importance of the credit function of foreign exchange scarcely needs emphasis. Whenever an increase in the risk and uncertainty of international trade impels exporters to require cash in advance or on delivery of documents from their foreign customers, world commerce labors under a heavy handicap.

The Functions and Markets of Foreign Exchange

Even the most casual examination serves to reveal the diversity and complexity of foreign trade. Almost countless thousands of separate import and export transactions occur every year, each one creating a distinct debtor-creditor relationship. In its broader sense foreign commerce includes much more than the exchange of goods. Myriads of other acts between human beings separated by an international frontier require payments from one to the other. Travel, insurance, investment, transportation, communication, education, philanthropy--all these can occur on an international scale only if there is some means by which international payments or settlements can be made.

Any sort of "exchange" raises monetary problems which increase in complexity in direct proportion with the difficulties of communication. Before the development of interregional banking systems, widely separated persons even in the same country found it necessary to engage in much laborious crisscross shipping of currency and specie in order to carry on trade. Most of these hindrances to domestic trade have been wiped out by modern central banking, which has provided such national clearing systems as that in the United States, but each of the nations in the world is still using its own type of currency or "money" and, despite all the proposals for an international clearing bank, there is no formal system or institution by which multitudinous currencies are converted one into the other.

World economy a collection of national economies

What we too glibly call "world economy" is really only a collection of national economies, each with a money that cannot normally be freely spent outside its frontier. Consequently, in order that peoples of these various countries may do business with each other on something other than a barter basis, they have gradually devised foreign exchange instruments and foreign exchange markets in which they may exchange with each other the money claims arising out of international trade. This elaborate foreign exchange system cannot create foreign exchange instruments to a greater value than the sum of all international transactions (including borrowings and specie movements) within a given period. Hence it follows that the people of one country can convert the claims they have on the rest of the world into their own currency only to the value of the claims the rest of the world has on them.

Under specie-standard (say, gold-standard) conditions, lack of equivalence in the money value of the claims of the people of one country on the rest of the world and of the rest of the world on them will result in offsetting movements of specie or shortterm funds which will lead to corrective changes in the balance of payments. Under paper-standard conditions lack of equivalence between the international debits and credits of a country will result in one or another of other forms of corrective, the commonest being fluctuations in exchange rates with consequent changes in "visible" and "invisible" trade.

The balance of international payments

Although on logical and empirical grounds we can conclude that the balance of international payments must and does balance, it must not be thought that we have reached the end of balance of payments analysis. The compelling question is, to repeat, how does it balance--what is the mechanism which sees to it that debits and credits will be equal in value? It must again be emphasized that the myriads of international transactions which, in the course of a year, require payments into and out of dollar exchange are generally separate, distinct, and unrelated unless by some underlying and pervasive link not readily apparent on the surface. Nor is it any more readily apparent that all American "visible" and "invisible exports somehow are causally interrelated with all American "visible" and "invisible" imports so that the dollar value of the two streams of international business will be approximately equal. Yet link and mechanism there must be.

Very early in modern times economists began to search for some explanation of the tendency toward equilibrium in balances of international payments. If the exports (visible and invisible) of a country failed to equal imports, specie flowed out, temporarily balancing the international accounts. This loss of specie caused a shrinkage in money, a reduction in gold reserves, an increase in rates of interest or discount, and consequently a decline in the volume of credit and in business activity and prices. The end result would be a decrease in imports (because of low prices and declining purchasing power in the home market) and an increase in exports (because prices and purchasing power were rising abroad) and ultimately a restoration of equilibrium in the balance of payments.

This is a vastly oversimplified account of the specie-flow mechanism of an international metallic standard. With its details we are not primarily concerned.

By its proponents, an international gold standard involving equilibrating gold flows of this type was regarded as essentially automatic or self-regulating. It is probable that it did, in "normal" times, involve considerably less "management" by the monetary authorities (say, the central bank) than do the modern systems of balance of payments control which revolve around exchange stabilization funds and various sorts of exchange restrictions.

Under simon-pure gold, silver, or bimetallic standard conditions, with unrestricted specie export and import, the specie-flow mechanism was--and is--the dominant explanation of the tendency toward balance in a country's international debits and credits. When international metallic standards are abandoned and some form of inconvertible currency prevails, other solutions have to be found to the ever-absorbing, as well as practically important, problem of the maintenance of equilibrium in balances of international payments. They all directly or indirectly owe much to clues first tracked down by specie-standard theorists. They all recognize that the data relevant to the problem are disequilibrium in balances of payments, changes in prices and costs, changes in exchange rates, changes in the volume of money and credit in circulation, and changes in money rates. They do not agree on the causal relationships between these data.

Use of the term balance of payments

All this does very little to justify the use of the term "balance" of payments. Why not simply a statement of international payments, some being debits and some credits? In double-entry accounting the idea of balance, as visibly expressed in the familiar balance sheet, arises logically out of the fact that for every transaction completed by the enterprise two ledger entries are made, one offsetting the other. Hence it follows that the debits must equal the credits and the books must balance. When, however, we examine the totality of international payments of a country in a given period, what reason is there for anticipating that the credits will equal the debits, that is, that the exports, visible and invisible, will equal the imports, visible and invisible, including specie?

Certainly it is obvious that the analogy of double-entry accounting is of no assistance. Traders, railroads, steamship companies, tourists, immigrants, missionary societies, investors, governments, all engaged in activities which necessitated payments by foreigners to Americans and by Americans to foreigners. It is impossible that the persons and institutions in the United States who were responsible for the credit or "export" activities should have acted in concert with the persons and institutions who were responsible for the debit or "import" activities with the purpose of seeing to it that the value (in, say, dollars) of the two aggregates of payments were identical. The fact is that they acted separately and individually--although of course they were influenced by common sets of economic forces.

Yet on both logical and empirical grounds we are forced to the conclusion that somehow the total credits of a country on international account do balance or equal the total debits over any reasonable period of time. Every country in the world has its own currency. This means that the people of one country have only three ways of making payments to the people of another country, since neither will accept the other's currency as a final means of payment. The first way is to sell goods and services; the second way is to borrow or to sell shares or titles to property; the third way is to export some commodity granted peculiar acceptability by long custom, such as gold or silver.

Now what if, in that year, no Americans bought any goods or services from foreigners or otherwise became indebted to foreigners and that no American was willing to lend money to foreigners? The creditor Americans, of course, want payment in dollars. They might temporarily accept foreign currency if it could readily be converted into dollars at a satisfactory price or rate; but since we have assumed that no American had payments or loans to make to foreigners during the year there would be no demand for foreign currency (i.e., foreign exchange). Thus the first two means of payment would be denied to the foreign debtors; only by shipping gold (or silver, if it was acceptable) could they settle their debts to Americans.

Such a one-sided situation manifestly could not long continue. Logically there must be a balance between the inpayments and outpayments of a country on international account. To the extent that the aggregate credit transactions do not balance the aggregate debit transactions, there will be uncollectible accounts on one side or the other. For example, the United States might in one year engage in a considerably larger volume of credit than of debit transactions. The net credit balance would probably in part be settled by gold imports. Most countries, however, are no longer on an international gold standard and are reluctant to release much gold for export. They are more likely to "block" or "freeze" the "excess" American claims in domestic currency deposits. So far as the United States balance of payments is concerned, this situation may be reflected in either of two ways. The American funds blocked abroad may be regarded as an involuntary, indeterminate-term loan to the foreigners and hence as a debit to offset the (temporarily) uncollectible credit; or these latter may be deducted from the aggregate volume of credit transactions, leaving as a remainder only those which actually resulted in dollar payments to the United States. In either case the result would be the same, the international debit and credit payments (including specie) balance.

On empirical grounds there is added reason to conclude that the debits and credits in the international accounts of a country tend to equality. Every competent attempt to ascertain the volume of international payments of a country for a given period has revealed an approximate balance in the exports and imports (visible and invisible and specie). To be sure, some investigators have been rather casual in deriving unknown items by reference to known items; for example, taking from official statistics the value of commodity and gold imports and exports and estimating other services, they have assumed that capital movements comprise the remaining debit or credit needed to "balance" the balance of payments. This is not to deny that judicious and expert estimating is essential in balance of payments research; but it is clear that, if the initial assumption on which the estimating proceeds is that aggregate debits and credits must balance, the chances are that before the work is completed they will balance. Obviously, however useful and true such a balance of payments may prove to be, it would not be, to the unconvinced, very conclusive empirical evidence of the tendency toward equality in debits and credits. Where, in a given balance of payments, the area of estimation is known to be relatively small and the number of items based on official statistics, questionnaires, and the like, relatively large, a finding of approximate balance in aggregate debits and credits is significant evidence.

Paper Currency

Before we turn to an examination of specie movements as balance of payments transactions, a brief analysis of the rather puzzling paper-currency item is probably needed. Normally, paper currency does not circulate outside, or even cross, the boundary of the issuing country to any large extent, but travelers may carry some home currency with them if they have any reason to believe it may easily be exchanged for local currency abroad. In the immediate postwar years to the people of inflation-ridden central Europe the United States dollar was a symbol of stability. Hence American tourists found that paper dollar currency was readily accepted in those areas for hoarding. Fairly large amounts of United States currency cross into Canada and Cuba and of Canadian currency cross into the United States.

Ultimately most such migrant paper currency comes home again. The point for discussion here is its status on the balance of payments both as it leaves the country and as it returns. When the United States "exports" its own currency (i.e., when Americans take it abroad) it is properly a balance of international payments transaction only when and if it is sold (or exchanged) for foreign currency. At that time it should appear as a credit on the balance of payments. When, at some later time, the foreign holders of that dollar currency exchange it for their own currency and it is sent, through banking channels, to the United States, the imported currency appears as a debit on our balance of payments. Or, reversing the example, when the foreign departments of our banks buy the Canadian (or other foreign) currency which is offered to them, the transaction is just as surely a debit on our international accounts as if we had imported (and paid for) Canadian wheat. Later, when such foreign currency is sent abroad for exchange, it constitutes a credit on our balance of payments.

Interest and Dividends and Capital

The other transactions are sometimes more confusing. Interest and dividends, to be sure, should cause no difficulty. The "export" or "import" might be considered to be the bond coupons or--stretching the idea of export and import still further--the legal claims on declared dividends. The capital transactions require more careful examination. The general rule is: An inflow of capital (i.e., a capital import) creates a credit, while an outflow of capital (i.e., a capital export) creates a debit.

Now at first glance this seems to contradict the previous discussion, in which credits were defined, broadly, as exports and debits as imports, since here we have said that an import of capital creates a credit and an export of capital a debit; but the contradiction is only seeming. In the case of a capital inflow the "export" consists of the securities or the titles to property evidencing the investment. Hence by this test the capital import is a credit. A few examples will illustrate the point. Suppose an American buys, on the Toronto Stock Exchange, $1,000 worth of Canadian mining shares. By two tests this export of American capital is a debit on our balance of payments.

First, the share certificates are imported, and like all imports must be paid for. Second, the American will have a "bill" to settle with his broker in Toronto; i.e., a Canadian has a claim on an American, thus a debit on our balance of payments and, of course, a credit on that of Canada. Or suppose the American Soup Company invests $250,000 in a factory in Australia. We may imagine that $100,000 will consist of machinery shipped from the United States and thus ought to be excluded altogether from the balance of payments since no international payment resulted. The remainder--$150,000--the company needs in Australian currency in order to pay the local contractor for the erection of the building. So the company (or its bankers) will buy $150,000 worth of Australian pounds. This will give to some Australian bank (we shall suppose) a deposit in (i.e., a claim on) an American bank. The export of capital therefore turns out to be a debit on the balance of payments of the exporting or investing country, in the year in which the capital outflow occurs. Of course, in subsequent years the income from and any repayment of principal of such foreign investments will appear as credits on the balance of payments of the creditor country and debits on the balance of payments of the debtor country.

Banking and other short-term capital, as balance of payments items should cause no trouble for the reader who has understood the discussion of long-term capital.

The Nature of Debits and Credits

To the casual observer it might at first appear that the term "balance of trade" should refer to the difference between exports and imports, and that the "balance of payments," similarly, should refer to the difference between all "credit" and all "debit" transactions in a country's international accounts. Actually, however, the student of international finance has taken his cue from the accountant who, in speaking of the "balance sheet," means not simply the difference between or "balance" of assets and liabilities but the entire statement from which that difference may readily be computed.

Superficially the balance, with its opposing columns of "debits" and "credits," is reminiscent of double-entry accounting. Conceptually there is no kinship between a balance sheet and a balance of payments and only in the most restricted sense is there resemblance between an income statement and a balance of payments. These distinctions will become clear as the chapter proceeds. Let us begin with the meaning of the terms "debit" and "credit" in balance of payments terminology.

From the standpoint of a given country, say the United States, all international transactions which give rise to a money claim on some person, institution, or government abroad are credits (or, strictly speaking, credit transactions). Conversely, all international transactions which give rise to a money claim on someone (or some institution or the government) in the country by someone (or some institution or government) abroad, are debits. The most obvious credits are commodity or merchandise exports. Hence it is helpful to think of a country's international credits as having been created by the export of goods, services, securities, etc. Similarly, merchandise or commodity imports are the most easily imagined debits, and it is accurate to consider the international debits of a country as arising from the import of goods, services, securities, etc.

International Transactions vs. International Payments

The balance of international payments of the United States (or of any country) consists of all the payments transferred into and out of its currency in a given period--usually a year, although sometimes shorter periods are used. It should immediately and forcefully be cautioned that the balance of payments does not list all the international transactions which take place between one country and others; it lists--or should list--only those transactions which resulted in payments within the period. Not only does the balance of payments properly include solely those international transactions which result in payments during the period in question, but the payments must be international payments-i.e., they must in some manner involve the exchange of one currency for another. An example or two may illustrate how an international transaction may sometimes not result in an international payment. It is, of course, clear that where the payment for goods or services exported to foreign countries is delayed beyond the balance of payments year--or even defaulted permanently--such exports should, in strict accuracy, be eliminated from any balance of international payments. Or suppose an American manufacturing company decides to put up a branch plant in Canada at a cost of $200,000, of which $50,000 will represent the cost of machinery to be purchased in the United States and paid for by the company with American dollars. Now so far as our official foreign trade statistics are concerned, this equipment will appear as an export of machinery to Canada valued at $50,000. Obviously, for balance of payments purposes a $50,000 deduction should be made from merchandise exports, since no international payment was made: One American company simply bought machinery from another American company and shipped it to Canada for installation. In practice, the balance of international payments of the United States would include the machinery as a credit (export) of $50,000 and would add $50,000 to new direct investments abroad, or debit. The two items thus offset each other, but neither item involves an international payment within the year and hence neither item should be included in the balance of payments. Of course, the new branch plant may in later years earn a profit which the parent company may convert into American dollars, but that contingency has nothing to do with the immediate balance of payments. Consider another example: An American owning Canadian mining shares listed only on the Toronto stock exchange may leave them in the custody of his broker. If, then, he orders his broker to sell shares worth $5,000 (Canadian currency) and hold the proceeds on deposit in Canada, there is no international payment, although the transaction is by some tests international. It should not appear on the balance of payments in any form.

All this is almost self-evident. Yet in the collection of balance of payments data it is almost impossible to be sure that all transactions are eliminated for which either no international payment at all is going to be made or in which the payment will be deferred beyond the balance of payments year. The Department of Commerce, for instance, is obliged to accept as balance of international payments items the commodity import and export statistics as recorded by the Customs Service, without attempting the corrections suggested above.

Theoretically, it should be possible to draw up a statement of the balance of international payments of a country which would really include all the payments made during the year on international account. Actually, however, the task is immensely difficult, even when attempted by a government department with unsurpassed fact-finding resources at its disposal. Some items-gold, silver, paper currency, bankers' balances, government transactions--are regularly recorded with reasonable accuracy, although anyone who has compared, for example, United States exports to Canada as recorded in official United States statistics with Canadian imports from the United States as recorded in official Canadian statistics, will have mental reservations concerning the accuracy even of the merchandise item on the balance of payments. The problem of ascertaining the volume of most of the "invisibles"--notably immigrant remittances, interest and dividends, and capital movements--is a tremendously difficult one. Consequently the student must be prepared to distrust any balance of payments statement which balances out neatly to the last dollar --although in theory it should do just that.

The idea of a balance of international payments

The preceding section has purposed to show that wherever two regions engage in reciprocal economic and financial relations the volume of the payments in the two directions tend to balance and that this tendency is present even where no currency frontier intervenes between the trading areas. It is the central problem of international finance. We turn now to a very hasty glance at the historical development of the idea of a balance of international payments.

For a period of about two hundred years prior to the publication of Adam Smith Wealth of Nations in 1776, "the most pervasive and the most emphasized doctrine is the importance of having an excess of exports over imports. To this doctrine and the trade regulations which it inspired, Adam Smith . . . gave the name of the 'commercial' or 'mercantile' system, which later became . . . the now familiar 'mercantilism.'" Probably best known and most easily accessible of these polemical writings is Thomas Mun England's Treasure by Forraign Trade, written about 1630 but not published until 1664.

Very early-- ProfessorViner discovered references as far back as 1381--it was observed that if a country's exports and imports were not exactly equal, there would be a balance payable or receivable in gold or silver. Soon after 1600 the term "balance of trade" came into common usage to denote this excess. Attaching, for a number of reasons, a very great importance to a net inflow of specie or "treasure," the mercantilist urged that every effort be made to encourage exports and to discourage imports, in order that there might be a net export surplus or, as it ultimately came to be called, a "favorable" balance of trade.

Fully to explain why a continuous inflow of precious metals was desired by the mercantilists would require more space than can be spared. Briefly, the case for a favorable balance of trade was based on the indispensability of precious metals as an emergency fund for the state, as a means of storing or saving "wealth," as a source of "capital," and to stimulate trade by its service as a circulating medium.

If England had happened to be a large-scale producer of gold and silver, it is possible that the mercantilist doctrine of the balance of trade would not have been developed with such vigor. But she was not, and the mercantilist was correct in insisting that an excess of exports over imports was the only certain way of provoking an inflow of precious metals from other countries. In conceding that much it is not intended to defend the mercantilist system, its concepts of wealth and capital, and the self-interested protectionism that it provoked.

The mercantilist, then, perceived the nature of the international balance of a country. Moreover, the ablest of the writers --for example, Thomas Mun--distinguished clearly between commodity exports and imports, and the other typical international transactions such as freight earnings, insurance payments, tourist expenditures, and so on. The terminology of the mercantilist, however, was confusingly simple. By the phrase "balance of trade" he meant the whole statement of a country's international transactions--commodity or merchandise as well as noncommodity. Not until very late in the period of mercantilist writing was the term "balance of payments" devised to refer to the entire balance of international transactions, reserving the term "balance of trade," as in present-day usage, to the commodity export-import accounts of a country.