CHAPTER 2:

INSTITUTIONS:
ECONOMIC, POLITICAL AND
LEGAL SYSTEMS

For use with International Business

by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
Learning Objectives

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Opening Case:
Managing risks in the new South Africa

How do legal changes in South Africa since 1994 affect opportunities for business people
of all ethnic groups?

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Institution-based view
• The institutional framework governing a particular
context is made up of formal and informal institutions
governing individual and firm behaviour.
• Transaction costs
– Costs associated with economic transactions or,
the costs of doing business
• Opportunism
– Act of seeking self-interest with guile
• What are some transaction costs involved in
starting a home-based business?

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Dimensions of Institutions
Formal institutions are normally the government, and informal institutions
concern behaviours are morally right and wrong, and what is important and not within
a society.

The financial crises of 2008 revealed that banks made major mistakes in
their risk management practices. Probing deeper, it emerged that a
combination of cognitive and normative pressures may be at fault.

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Understanding Institutions
• Institutions
– “rules of the game”
• Institutional transitions
– Fundamental and comprehensive changes introduced to formal and informal
rules of the game that affect firms as players
• Institution-based view
– success and failure of firms are enabled and constrained by institutions
• Institutional framework
– Formal and informal institutions governing individual and firm behavior
• Formal institutions
– Laws, regulations, and rules - may be imposed by home countries and host
countries
• Norms
– Values, beliefs, and actions

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 What do Institutions do?
• The key role of Institutions is to reduce uncertainty.
– Uncertainty increases transaction costs, which are
defined as the costs associated with economic
transactions.
– Institutional frameworks can reduce the potential for
opportunistic behaviour by explicitly establishing
rules.
• Institutions are not static; they evolve over time.
Institutional transition, defined as ‘fundamental and
comprehensive change introduced to the formal and
informal rules of the game that affect organizations as
players’, are common, especially in emerging economies

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Core Propositions

This chapter focuses on formal institutions (informal institutions will be

covered in Chapter 3). Chief among formal institutions are those of the (1)
political systems, (2) economic systems and (3) legal systems.

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Political systems
• A political system refers to the rules of the game on how a country is
governed politically.
– Political risk is the risk associated with political changes that may
negatively impact domestic and foreign firms.

Types of Political System

• Democracy
– System in which citizens elect representatives to govern the
country on their behalf

• Totalitarianism (dictatorship)
– System in which one person or party exercises absolute
political control over the population

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
Why are political elections – even in other countries – important for
business?

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Economic Systems
• Economic Systems
– The rules of the game on how a country is governed
economically.
• Market economy
– Characterised by the “invisible hand” of market forces;
government takes a hands-off, or laissez faire, approach
• Command economy
– Government taking the “commanding height” in the economy; all
factors of production are government- or state owned and
controlled, and all supply, demand, and pricing are planned by
the government
• Mixed economy
– Elements of both market economy and command economies

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
Varieties of Capitalism

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Legal Systems
Legal Systems
• Rules of the game on how a country’s laws are enacted and
enforced

Civil law
• A legal tradition that uses comprehensive statutes and codes as a
primary means to form legal judgments.

Common law
• A legal tradition that is shaped by precedents and traditions from
previous judicial decisions.

Case law
• Rules of law that have been created by precedents of cases in court.

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
Legal Traditions

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Intellectual Property Rights
• Patents
– legal rights awarded by government authorities to
Property
inventors of new technological ideas, who are given traditionally refers
exclusive (monopoly) rights to derive income from to tangible pieces
such inventions through activities such as of property
(such as land).
manufacturing,licensing or selling.
• Copyrights Intellectual
property
– the exclusive legal rights of authors and publishers to specifically refers
publish and disseminate their work (such as this book, to intangible
a photo or a piece of software). property

• Trademarks
– exclusive legal rights of firms to use specific names,
brands and designs to differentiate their products from
others.

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Arguments:
Institutions & Economic Development
• Institutions ensure that firms are able to make gains from trade.
Specifically, they enable firms to enter contracts, and be reasonably
sure that partners will honour their contractual obligations, or that they
can use the court system to enforce the contract.
• A lack of strong, formal, market-supporting institutions forces individuals
to trade on an informal basis with a small neighbouring group and
forces firms to remain small, thus foregoing the gains from a sharper
division of labour by trading on a large scale with distant partners.
• Emergence of formal, market-supporting institutions encourage
individuals to specialize and firms to grow in size to capture the gains
from complicated long-distance trade (such as transactions with distant,
foreign countries).
• When formal, market-supporting institutions protect property rights, they
will fuel more innovation, entrepreneurship and thus economic growth.

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Implications for Practice
This chapter has sketched the contours of an institution-based view of
international business, which is one of the two core perspectives
presented throughout this book.

Most developed economies are supported by strong, effective

and market-supporting formal institutions, while most underdeveloped
economies are held back by weak, ineffective and market-depressing
formal institutions.

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Closing Case: The Russia Puzzle
If you were a board
member at one of the
Western multinational
retailers (such as
Carrefour, IKEA, Metro or
Wal-Mart), would you vote
yes or no for a new project
to set up your firm’s first
major store in Russia?

If you were to advise the Russian government on property rights reforms,

what would be your advice?
If you were managing the funds of a Russia oligarch, where would you
invest?

For use with International Business

by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Chapter Summary
1. Explain the concept of institutions and their key role in reducing
uncertainty:
• Institutions are defined as ‘the rules of the game’.
• Institutions have formal and informal components, with different
supportive pillars.
• Their key functions are to reduce uncertainty, curtail transaction
costs and constrain opportunism.
• Managers and firms rationally pursue their interests and make
choices within formal and informal institutional constraints in a
given institutional framework.
• When formal constraints are unclear or fail, informal
• constraints will play a larger role.
2. Explain the basic differences among political systems:
• Totalitarianism is a political system in which one person or
political party exercises absolute political control.
• In democracies, citizens elect representatives to govern the
country, yet the institutions governing this selection vary widely.

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Chapter Summary continued:
3. Explain the systemic differences among economies:
• A pure market economy is characterized by laissez faire and total
control by market forces.
• In liberal market economies (LMEs), companies are predominantly
financed through the stock market, while labour markets are highly
flexible.
• In coordinated market economies (CMEs), businesses, governments,
trade unions, industry association and other economic actors coordinate
their actions not only through markets.
4. Explain the basic differences between legal systems:
• Civil law uses comprehensive statutes and codes as a primary means to
form legal judgments.
• Common law is shaped by precedents and traditions from previous
judicial decisions.
• Property rights are legal rights to use an economic resource and to
derive income and benefits from it.
• Corporate governance systems specify how managers are controlled by
other interested parties of the firm.

For use with International Business

by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
 Chapter Summary
5. Participate in two debates on institutions and international business:
These are:
(1) What drives economic development?
(2) How to best measure political risk?
6. Draw implications for action:
• Managers considering working abroad should have a
thorough understanding of the formal institutions before
entering a country.
• In situations where formal constraints are unclear,
managers can reduce uncertainty by relying on informal
constraints, such as relationship norms.

For use with International Business

by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
Critical Discussion Questions

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by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning
Recommended Readings

For use with International Business

by Mike Peng and Klaus Meyer
1408019566 © 2011 Cengage Learning