CHAPTER 3

POLITICAL, ECONOMIC AND LEGAL SYSTEMS

Outlines of the chapter:

3.1 Types of political systems

3.2 Types of economic systems

3.3 Types of legal systems
3.4 Treaties
3.5 Resolution of international business disputes
3.6 Risk and other impacts of political, economic,
and legal systems on business
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 3.1 Types of political systems
•In doing business internationally managers evaluate,
monitor, and forecast political environments
•A country’s political system refers to the structural
dimensions and power dynamics of its government that
specify institutions, organizations, and interest groups,
and define the norms that govern political activities
• A political ideology stipulates how society ought to
function and outlines the methods by which it will do so.
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 3.1 Types of political systems cont’
•Most modern societies are pluralistic different groups
champion competing political ideologies:
•Democrats vs. Republicans in the USA

•Democratic Party vs. Liberal Party in Japan

• A political spectrum outlines the various forms of

political ideology

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3.1 Types of political systems cont’

Political spectrum

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 3.1 Types of political systems CONT’
A. Democracy
In a democracy all citizens are politically and legally
equal all are equally entitled to freedom of thought,
opinion, belief, speech, and association all equally
command sovereign power over public officials
 Prominent types of democracy include:
•Radical
•Liberal
•Conservative
•Reactionary
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 3.1 Types of political systems CONT’

B. Totalitarian System
•A totalitarian system subordinates the individual to the interests
of the collective dissent is eliminated through indoctrination,
persecution, surveillance, propaganda, censorship, and violence
• Prominent types of totalitarianism include

 Authoritarianism

 Fascism

 Communisms

 Dictatorship
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 3.2 Types of economic systems
•An economic system refers to the mechanism that
deals with the production, distribution, and
consumption of goods and services

Types:
•Market economy

•Command economy

•Mixed economy

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3.2 Types of economic systems

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 3.2 Types of economic systems

a) Market economy systems

• A market economy describes the system where individuals, rather
than government, make the majority of economic decisions:
• Capitalism or free market: are built upon the private
ownership and control of the factors of production.
• Private ownership of capital

• Laissez-faire: Credited to Adam Smith, i.e., nonintervention by

government in a country’s economic activity, states that
producers are driven by the profit motive, while consumers
determine the relationship between price and quantity demanded.
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 3.2 Types of economic systems cont’
b) Command economy
• Also known as centrally-planned economies
• Command economies are built upon the government
ownership and control of the factors of production.
•Central planning authorities determine what products will be
produced in what quantities and the prices at which they will be
sold.
•In a command economy the visible hand of the state
supersedes the invisible hand of individuals
•Government :
•Owns and controls resources
•Determines prices
•Communism
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 3.2 Types of economic systems
c) Mixed economy
•Most economies are mixed economies
•Fall between market and command economies
•While economic decisions are largely market-driven and
ownership is largely private, government nonetheless
intervenes in many economic decisions.
•The extent and nature of such intervention may take the
form of government ownership of certain factors of
production, the granting of subsidies, the taxation of
certain economic activities, and/or the redistribution of
income and wealth. 11
Features of an economy
The following are features of economy :
a) Inflation
b) Unemployment
c) Debt
d) Income distribution
e) Poverty
f) Balance of payments

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 Features of economy cont’
a) Inflation
•A measure of the increase in the cost of living
• When aggregate demand grows faster than aggregate
supply, i.e., when prices rise faster than incomes, the
effects can be dramatic
• Among other things, high inflation results in governments’
setting higher interest rates, installing wage and price
controls, and imposing protectionist trade policies and
currency controls
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a) Inflation cont’
• Consumer Price Index (CPI): measures the average change in
consumer prices over time in a fixed market basket of goods and
services.
•Deflation: When prices for products go down not up

•Reflation: Increase the money supply and reduce taxes to accelerate

economic activity
b) Unemployment rate: Share of unemployed workers seeking
employment for pay relative to the total civilian labor force.
•Misery index: The sum of a country’s inflation and unemployment
rates 14
 Features of economy cont’
c) Debt: the total of a government’s financial obligations
•Its measures the state’s borrowing from its population, from foreign
organizations, from foreign governments, and from international
institutions. It can be:
•Internal debt: is the portion of the government debt that is
denominated in the country’s own currency and is held by domestic
residents.
• Internal debt results when a government spends more than it
collects in revenues; the subsequent pressure to revise government
policies often leads to economic uncertainty.
•External debt: is the portion of the government debt that is
denominated in foreign currencies and is owed to foreign creditors.
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•External debt results when a government borrows money from
foreign lenders.
•Growing public debt signals:
Tax increases
Reduced growth
Rising inflation
Increasing austerity
d) Income distribution
• Estimates the proportion of the population that earns various
levels of income
•Income distribution describes what share of a country’s incomes
goes to various segments of the population.
• It is a problem for countries rich and poor.
•Gini coefficient: Measures the extent to which the distribution of
resources deviates from a perfectly equal distribution.
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 Features of economy cont’

e) Poverty: the state of having little or no money and few or no

material possessions, and little or no resources with which to enjoy
a reasonable standard of living.
•Extreme poverty: Less than $1.25 per day
•Moderate poverty: Less than $2.00 per day
•Today the world population is 80% poor, 10% middle income,
and 10% rich

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 Features of economy cont’
f) Balance of payments (BOP)
•Reports a country’s trade and financial transactions with
the rest of the world
•Current account: which tracks all trade activity in
merchandise and services,
•Tracks merchandise trade
•Capital account: which records transactions in real and/or
financial assets between residents of a given country and the rest
of the world.
•Track loans given to foreigners and loans received by
citizens

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Current Account Balances: The Top and Bottom Five

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3.3 Types of legal systems……Next Class
•The legal system is the mechanism for creating,
interpreting, and enforcing the laws in a specified
jurisdiction:

Types of legal system:

A. Common law

B. Civil law

C. Theocratic law
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3.3 Types of legal systems……cont’
A. Common Law
 The United States and the United Kingdom are
examples of countries with a common law system.
 Common law is based on tradition, precedent, and
custom and usage/practice.
 The courts fulfill an important role by interpreting
the law according to these characteristics.
 Because common law in the modern setting
originated in the United Kingdom, its former colony
such as Hong Kong, also have common law systems.
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3.3 Types of legal systems……cont’
B. Civil Law
•A civil law system, also called a codified legal system, is
based on a detailed set of laws organized into a legal code.
•Rules for conducting business transactions are a part of
the code.
•Over 70 countries, including Germany, France, and Japan
operate on a civil law basis.
•One important difference between common law and civil
law systems is apparent in the roles of judges and lawyers:-
In a common law system the judge serves as a neutral
referee, ruling on various motions by the opposing parties’
lawyers.
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B. Civil Law cont’
•In a civil law system, the judge takes on many of the tasks
of the lawyers, determining, the scope of evidence to be
collected and presented to the court.
•Common law is based on the court’s interpretation of
events, whereas civil law is based on how the law is applied
to facts.
•Legal systems implication in international business:
Example: In a common law country, contacts tend to be
detailed, with all contingencies spelled out.
•In a civil law country, contracts tend to be shorter and less
specific b/c many of the issues that a common law contract
would cover are already included in the civil code.
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B. Civil Law cont’
•Thus, when entering into contracts abroad, it is
important for the manager to understand which type of
legal system will establish the contract.
C. Theocratic Law
•This law is based on the officially established rules
governing the faith and practice of a particular religion.
• A country that applies religious law to civil and criminal
conduct is called a theocracy.
EXAMPLE: In Iran a group of mullahs, or holy men,
determine the legality or illegality through their
interpretation of the Koran, the holy book of Islam.
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C. Theocratic Law CONT’
•Religious laws can create interesting problems for firms.

Example: Consider the teaching of the Muslim holy

book, the Koran, which denounces charging interest on
loans as an unfair exploitation of the poor.
•Muslim firms and financial institutions have had to
develop alternative financing arrangements to acquire
and finance capital.

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Trends in Legal Systems
What is the basis of rule in a country?
The rule of man:
•Legal rights derive from the individual who
commands the power to impose them associated with
a totalitarian system
The rule of law:

•Systematic and objective laws applied by public

officials who are held accountable for their
administration associated with a democratic system

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3.4 TREATIES

•Signatories to trade agreements typically confer/award

some authority on an independent agent in the belief
that a neutral or internationalized body is more
effective in governing trading relations than the
signatories themselves.
•Multilateral institutions can also foster peaceful
relations among countries, thereby creating the general
conditions for profitable exchange through trade.
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3.4 TREATIES cont’
•Trade blocs are a significant influence on the strategies
of MNEs because they define the size of regional
markets and the rules by which companies must operate.
•The World Trade Organization has become the primary
multilateral forum through which governments conclude
trade agreements and settle associated disputes.
•Let us see some of the international and regional
treaties/agreements as follows:
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3.4 TREATIES cont’
A. GATT (General Agreement on Tariffs and Trade )
• GATT was established in 1947 by twenty-three signatory nations
as a multilateral agreement whose objective was to liberalize
world trade.

B. The WTO (World Trade Organization)

• WTO was founded in 1995 as a permanent world trade body for
the purposes of:
a) Facilitating the development of a free and open international
trading system according to the GATT and
b) The adjudication of trade disputes between or among member
nations. 29
•Currently the 140+ member countries of the WTO
collectively account for more than 90 percent of the
value of world trade.

C. The rise of bilateral agreements

•Bilateral agreements, also known as Preferential
Trade Agreements (PTAs) or Free Trade Agreements
(FTAs) are some-times negotiated by partner nations as a
way to avoid the multilateral trading system and meet
their mutual trading objectives.

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D) Regional Trade Agreements
• Involve multiple countries engaged in the process of
economic integration.
• The two basic types of regional economic integration
that address barriers to trade are:
a. Free Trade Agreements, in which all barriers to
trade, i.e., tariff and nontariff barriers, are abolished
among member nations, but each member determines
its own external trade barriers beyond the bloc
b. Customs Unions, in which all barriers to trade, i.e.,
tariff and nontariff barriers, are abolished among
member nations, and common external barriers are
levied against non-member countries. 31
D) Regional Trade Agreements cont’
• EXAMPLE: THE EUROPEAN UNION
• The European Union represents the most advanced
regional trade and investment bloc in the world today.
• It evolved from the European Economic Community
(EEC) to the European Community (EC) to the
European Union (EU).
• The European Free Trade Association (EFTA) consists
of Iceland, Liechtenstein, Norway, and Switzerland; all
but Switzerland are linked to the EU via a customs
union known as the European Economic Area (EEA).
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D) Regional Trade Agreements
• Example: NORTH AMERICAN
• Effective as of January 1, 1994, the North American
Free Trade Agreement (NAFTA) incorporates Canada,
Mexico, and the United States into a regional trade bloc of
countries of quite different sizes and sources of national
wealth.
• The Caribbean Community and Common Market
(CARICOM) and the Central American Common Market
(CACM) are both found in Central America.
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D) Regional Trade Agreements cont’
•REGIONAL ECONOMIC INTEGRATION IN ASIA
•The Association of Southeast Asian Nations (ASEAN) (1967).

•Asian Free Trade Area (AFTA) (2008).

• The Asia Pacific Economic Cooperation (APEC) (1989)
•REGIONAL ECONOMIC INTEGRATION IN AFRICA

•Southern Africa Development Community (SADC),

• The Common Market for Eastern and Southern Africa (COMESA),
• the Economic and Monetary Community of Central Africa, and the
West African Economic and Monetary Union (WAEMU).

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3.5 Resolution of international business disputes
•The presence of an agreement to oversee trade does not mean
that there will be no conflict between countries.
•There is considerable trade and legal disagreement
among countries.
•Resolving any disputes across borders is very complex
b/c:
A trade conflict might be treated differently by
international and domestic laws
Example: The United States, for example, has been castigated
by some other countries for trying to restrict exports to nations
in conflict with the United States, like Cuba or Iraq.
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3.5 Resolution of international business disputes cnt’
•Those other countries claim that US action is in violation of
WTO regulations, whereas the US officials point to domestic
laws and constraints that force their hand.
•An important question in situations like this is where should the
issue be resolved?
Source of Jurisdiction
•An instance where the issue of the source of jurisdiction came to
the fore happened in 1984 when one of the most deadly industrial
accidents in history unfolded near Bhopal, India.
•Union Carbide India, Limited (UCIL), an Indian corporation,
operated a chemical plant near Bhopal.
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Source of Jurisdiction
•Immediately after the accident, American lawyers traveled to India
and signed up many Indian clients.
• (All of those affected, including all the plant employees, were
Indian.) Within four days of the accident, the first of over 100 legal
actions was filed in the US District Court.
•To justify the filing of these suits in US courts, the argument was
made that the US parent corporation (UCC) controlled the subsidiary
(UCIL).

•They claimed, therefore, that Indian courts were the correct

forum to hear the case. 37
Source of Jurisdiction cnt’

•Although this situation raises questions about whether

parent companies are responsible for the activity of their
foreign subsidiaries, the point here is that it is difficult to
decide which country’s courts and laws apply in any one
situation.
•Often this confusion may be the result of political issues
•surrounding the legal ones.

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3.6 Risk and other impacts of political, economic, and legal
systems on business
A. Political risk
• Refers to the risk that political decisions or events in a country
negatively affect the profitability or sustainability of an investment

• Political risks are the actions by groups of people or

governments that have the potential to affect the immediate
and/or long-term viability of a firm.
• Many of the factors involved in determining political risk are
difficult to predict or anticipate, even for an expert in
international politics.
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A. Political risk cont’
•For example, many experts believed that Iraq would not invade
Kuwait in 1990 and therefore did not consider the potential negative
effects on business operations in the country.
•Although the Middle East is generally viewed by many as
relatively risky, there are some forms of risk inherent in most areas
and countries.
For example, the EU severely restricts Japanese auto imports, and
the United States has a history of tight control over foreign
investments in the banking and airline industries.
•Many of these restrictions appear to be politically motivated. 40
A. Political risk cont’
Nevertheless, because of the potentially catastrophic effects of
political events, management needs to do at least two things:
(1) Investigate political risk before entering a new market, and
(2) Continually monitor political events that may affect ongoing
operations
Types of political risks

Let us take a look at the two basic general types of risk:

a) Systemic risk
b) Unsystematic risk
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1) Systematic Risk:

A risk that influences a large number of assets.

• An example is political events. It is virtually
impossible to protect yourself against this type of risk.
2) Unsystematic Risk:

Sometimes referred to as “specific risk.”

• It is risk that affects a very small number of assets.
• An example is news that affects a specific stock such
as a sudden strike by employees.
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3.6 Risk and other impacts of political …cont’
B. Risk and impact of Economics:
We can see from two perspectives (domestic and external condition):
i. Domestic Economic Conditions
•Domestic conditions in the host country, such as the ability of a country
to purchase a company’s products and the presence of infrastructure, can
add to or reduce the amount of risk a company faces in a foreign location.

• Usually, good infrastructure support reduces risk and thereby

facilitates entry and expansion of business.
•The passing of legal regulations regarding environmental
pollution.
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i. Domestic Economic Conditions cont’
• The enforcement of such laws could restrict how an MNC may
operate in a foreign country.
• For example, in Germany, as in the United States, and other
industrialized countries, there are many very restrictive environmental
laws that affect the production and disposal of industrial wastes.
•In many developing countries, such as Bangladesh, Nepal, and
Ethiopia, environmental laws are almost nonexistent.
•Consequently, these countries may become places for industrialized
countries to dump their unwanted waste.
•To deal with this issue, over 50 countries signed the so-called
agreement of the Basel Convention, which refers to the international
transport of hazardous wastes.
•This agreement states that there must be a written consent for
the movement of toxic waste and permission should be
received from all countries through which it passes.
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i. Domestic Economic Conditions cont’
Remarkable environmental risks:
• The toxic release at Bhopal, India,
• The meltdown of the Chernobyl nuclear plant in the
Ukraine, and
• The Exxon-Valdez oil spill off Alaska,
ii. External Economic Relations as Risk Factors
•There are also a large number of factors that deal with how a
country relates economically to another country.
• Furthermore, although some of the earlier factors that we
considered are quite rare (civil war), virtually every country
restricts its external economic relations in several ways.
For example, many countries have restrictions on imports,
usually in the form of tariffs.
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ii. External Economic Relations as Risk Factors c
•A tariff would increase the price of a foreign product or service
relative to the domestic counterpart.
•So through the use of import taxes a country can partially restrict
imports and provide protection for domestic industry.
•This presents a risk for the foreign MNC.

For example: The United States, restricts the number of

automobiles that Japan may import in order to pressurize Japan into
purchasing more US-made components.
•The EU also limits the import of Japanese autos to a very low
percentage of the total autos sold in the EU. 46
C) The Legal Environment risk
• A domestic firm must follow the laws and customs of
its home country
• An international business faces a more complex task: It
must obey the laws not only of its home country but
also of all the host countries in which it operates.
• The laws of both the home and the host countries can
affect directly and indirectly the international
companies and the way they conduct their business.
• These laws determine the markets the firms serve, the
cost of goods and/or services they offer, the price they
charge, and costs for labor, raw materials, and
technology.
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C) The Legal Environment cont’
•Different laws and practices are found among countries of
the world.
•In most Western cultures the law functions within the
framework of society whereas in theocratic cultures the law
is a function of both societal and spiritual guidance.
Example Hebrew and Islamic laws are the result of what
God dictates
•International law plays an important role in the conduct of
international business
•Although there is no body to enforce international law,
certain treaties and agreements are respected by a number
of countries and influence international business operations
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