Understanding Institutions

Building on the “rules of the game” metaphor, Douglass North, a Nobel laureate in economics,
more formally defines institutions as “the humanly devised constraints that structure human
interaction.” An institutional framework is made up of formal and informal institutions
governing individual and firm behavior. These institutions are supported by three “pillars”
identified by Richard Scott, a leading sociologist. They are (1) regulatory, (2) normative, and (3)
cognitive pillars. Shown in Table 2.1, formal institutions include laws, regulations, and rules.
Their primary supportive pillar, the regulatory pillar, is the coercive power of governments. For
example, while many individuals and companies may pay taxes out of their patriotic duty, a
larger number of them do so in fear of the coercive power of the government if they are caught
not paying.

Political Systems
A political system refers to the rules of the game on how a country is governed politically. At the
broadest level, there are two primary political systems: (1) democracy and (2) totalitarianism.

Legal Systems
A legal system refers to the formal rules of the game on how a country’s laws are enacted and
enforced. By specifying the do’s and don’ts, a legal system reduces transaction costs by
minimizing uncertainty and combating opportunism. This section first introduces the three legal
traditions and then discusses crucial issues
associated with property rights and intellectual property.
Economic Systems
An economic system refers to the rules of the game on how a country is governed economically.
At the two ends of a spectrum, we can find (1) a market economy and (2) a command economy.
In between, there is a mixed economy.

What Do Institutions Do?

While institutions do many things, their key role, in two words, is to reduce uncertainty. By
signaling which conduct is legitimate and which is not, institutions constrain the range of
acceptable actions. In short, institutions reduce uncertainty, which can be potentially devastating.
Political uncertainty, such as terrorist attacks and ethnic have made the US government “less
stable, less effective, and less predictable,” which led Standard & Poor’s to downgrade its triple
A credit rating to AA+.

An Institution-Based View of Global Business

Shown in Figure 2.1, an institution-based view focuses on the dynamic interaction between
institutions and firms, and considers firm behaviors as the outcome of such an interaction.
Specifically, firm behaviors are often a reflection of the formal and informal constraints of a
particular institutional framework. In short, institutions matter.
 Chapter Summary
2-1 Explain the concept of institutions and their key role in reducing uncertainty.
 Institutions are commonly defined as the rules of the game.
 Institutions have formal and informal components, each with different supportive
pillars.
 Their key function is to reduce uncertainty, curtail transaction costs, and combat
opportunism.
2-2 Articulate the two core propositions underpinning an institution-based view of global
business.
 Proposition 1: Managers and firms rationally pursue their interests and make
choices within formal and informal institutional constraints in a given institutional
framework.
 Proposition 2: When formal constraints are unclear or fail, informal constraints
will play a larger role.
2-3 Identify the basic differences between democracy and totalitarianism.
 Democracy is a political system in which citizens elect representatives to govern
the country.
 Totalitarianism is a political system in which one person or party exercises
absolute political control.
2-4 Outline the differences among civil law, common law, and theocratic law.
 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.
 Theocratic law is a legal system based on religious teachings.
 2-5 Understand the importance of property rights and intellectual property rights.
 Property rights are legal rights to use an economic resource and to derive
income and other benefits from it.
 Intellectual property refers to intangible property that is the result of intellectual
activity.
2-6 Appreciate the differences among market economy, command economy, and mixed
economy.
 A pure market economy is characterized by laissez faire and total control by
market forces.
 A pure command economy is defined by government ownership and control of all
means of production
 Most countries operate mixed economies, with a different emphasis on market
versus command forces.
2-7 Participate in two leading debates concerning politics, laws, and economies.
 (1) What drivers economic development: Culture, geography, or institutions?
 (2) Private ownership versus state ownership.
2-8 Draw managerial implications for action
 Have a thorough understanding of the formal institutions before entering a
country.
 Insisting on formalizing the contract in initial negotiations may backfire in some
countries.