Chapter 3
THE POLITICAL AND LEGAL ENVIRONMENTS
FACING BUSINESS
OBJECTIVES
3-1 Explain how politics and laws influence business
3-2 Appraise the principles and practices of the political environment
3-3 Discuss the contemporary state of political freedom
3-4 Interpret political risk
3-5 Appraise the principles and practices of the legal environment
3-6 Describe key legal issues facing international companies
3-7 Relate the ideas of politics, law, and the business environment
CHAPTER OVERVIEW
When firms source, produce, and/or market products in foreign countries, they encounter
dynamic and challenging political and legal environments. Chapter Three provides a conceptual
foundation for the examination of the political and legal dimensions of international business
operations. It compares major political regimes, discusses their potential influence upon the
development of effective business strategies, and considers the relevance of political risk. The
chapter also examines the major types of legal systems that exist today, as well as the strategic
and operational concerns they pose. It concludes with a discussion of intellectual property rights
and the associated challenges confronted in an age of globalization.
CHAPTER OUTLINE
OPENING CASE: CHINA: COMPLICATED RISKS, BIG OPPORTUNITIES
During its thirty years of communist rule, China prohibited foreign investment and restricted
foreign trade. Then, China enacted the Law on Joint Ventures using Chinese and Foreign
Investment in 1978. China’s subsequent transformation has been fueled by a landslide of foreign
investments made in response to the country’s market potential, market performance, improved
infrastructure, enormous resources, and strategic position. Frustrating this process, however,
have been the politics of China’s elaborate bureaucracy, as well as its ill-defined legal system and
pervasive corruption. Historically China has relied upon “the rule of man” and the belief that
legal rights are derived from the power of the individual. Upon joining the WTO, China agreed
to continue to reform its business environment and to move toward transparent, rules-based,
enforcement-oriented standards. But the business reality is far from the WTO obligations
specifically in the continued controversy over the protection of intellectual property. Coming
full circle, today’s fully-owned Chinese enterprises are themselves becoming global investors,
both by acquiring foreign firms and investing in foreign lands.
I. POLITICS, LAWS, AND OPERATING INTERNATIONALLY
Politics and laws are always and everywhere dynamic. At different times, different parties
champion different ideologies that endorse different political systems. Consequently,
investing and operating internationally exposes MNEs to risks that arise from change in a
country’s political system. For a multinational enterprise to succeed in countries with
different political and legal environments, its management must carefully analyze the fit
between its corporate policies and the political and legal conditions of each particular nation
in which it operates. [see Fig. 3.1.] [see Map 3.1.]
II. THE POLITICAL ENVIRONMENT
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A political system is a complete set of institutions, political organizations, and interest
groups, the relationships among those institutions, and the political norms and rules that
govern their activities. Thus, it integrates the various parts of a society into a viable,
functioning entity. It also influences the extent to which government intervenes in business
and the way in which business is conducted both domestically and internationally. The
ultimate test of any political system is its ability to hold a society together.
A. Individualism versus Collectivism
It is useful to profile the similarities and differences among political systems according
to the general orientation within a society about the primacy of the rights and role of the
individual versus that of the larger community. Under an individualistic paradigm
(e.g., the United States), political officials and agencies play a limited role in society.
The relationship between government and business tends to be adversarial; government
may intervene in the economy to deal with market defects, but generally it promotes
marketplace competition. This concept that the government should not interfere in
business affairs is captured in the idea of laissez-faire. Under a collectivist paradigm,
the government defines economic needs and priorities, and it partners with business in
major ways. The government is highly connected to and interdependent with business;
the relationship is cooperative.
B. Political Ideology
Applying the implications of individualism and collectivism to a political system brings
us to the discussion of political ideology. A political ideology is the body of goals,
theories, and aims that constitute a sociopolitical program. Pluralism indicates the
coexistence of a variety of ideologies within a particular society. Although shared
ideologies create bonds within and between countries, differing ideologies tend to split
societies apart. The two extremes on the political spectrum are democracy and
totalitarianism. [see Fig. 3.2.] Understanding the impact of political ideologies on
business environments allows managers to adjust company practices and
decision-making.
C. Democracy.
A democracy represents a political system in which citizens participate in the
decision-making and governance process, either directly or through elected
representatives. Contemporary democracies share the following characteristics:
freedom of opinion, expression, press, religion, association and access to
information; freedom to organize; free elections; an independent and fair court
system; a nonpolitical bureaucracy and defense infrastructure; and citizen access to
the decision-making process. [see Table 3.1.] In decentralized democracies, e.g.,
Canada and the United States, companies may face different and sometimes even
conflicting laws from one state or province to another. The defining characteristic
of democracy is freedom. Measures of political rights and civil liberties have been
developed to assess levels of freedom; a country may be rated as free, partly free,
or not free.
D. Totalitarianism.
Totalitarianism represents a political system in which citizens seldom, if ever,
participate in the decision-making and governance process; power is monopolized
by a single agent and opposition is neither recognized nor tolerated. Through the
control of media, education, and police, the state suppresses dissent. In theocratic
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totalitarianism, religious leaders are also the political leaders. In secular
totalitarianism, the government maintains power through the authority of the state.
Other variants of totalitarianism include authoritarianism and fascism.
III. THE STATE OF POLITICAL FREEDOM
A. The Prevalence of Political Freedom
Since 1972 Freedom House has annually assessed the state of political freedom around
the world. Freedom House identifies three types of political systems: (1) Free, (2) Partly
free and (3) Not free. In 2015, 86 countries were free, 59 partly free, and 50 not free.
[see Map 3.2.] The second half of the twentieth century saw the steady diffusion of
democracy worldwide. This shift signified the so-called Third Wave of
Democratization, a global movement that expanded individual freedoms and civil
liberties. This megatrend had huge consequences for IB. Democratic governance
stabilized business environments, both at home and abroad. Growing stability
encouraged MNEs to expand their investment horizon to include markets, such as
China, Russia, and Eastern Europe, that had previously been off-limits given extreme
political risks. Troubling data, however, question the momentum of democracy in the
twenty-first century.
B. The Struggles of Political Freedom
The Economist Intelligence Unit identifies four types of political systems: (1) Full
democracy, (2) Flawed democracy, (3) Hybrid regime, and (4) Authoritarian regime.
[see Table 3.3.] [see Map 3.3.]
C. The Allure of Authoritarianism
Countries, skeptical of the virtues of a multiparty democracy, have translated
authoritarian ideologies into single-party political systems. Analogous to the engines
that powered the Third Wave of Democratization, several contemporary developments
promote authoritarianism. Powering the resurgence of totalitarianism is strong states
support strong performance, gaps in the principles and practices of democracy,
economic insecurity following slowing growth, and escalating debate over the meaning
of democracy.
LOOKING TO THE FUTURE: Political Ideologies and the MNEs’ Actions
There is a clear link between political and economic freedom and economic growth. However,
democracy does not necessarily mean stability; in fact, in a transition economy, political risk is
often quite high. The emergent democracies of the 1990s, especially those of the former Soviet
bloc, still wrestle with domestic unrest and security threats. Although challenges to democracy
are many, terrorism stands out above all others. Some people argue that if a country is to flourish
as a democracy, certain preconditions such as economic development must be present. However,
others argue that democracy is the result of having political leaders who exhibit both the
determination and the skills required to assure that democratization occurs. Still, others feel that
indirect support may flow from Asia’s alternative conception of democracy, where economic
freedom is progressing more rapidly than political freedom. China is a case in point. With a
totalitarian democratic system, China has focused on economic growth in the belief that growth
solves most problems. China’s success with “freedom stagnation” throws into question Western
ideals of democracy. If democracy proves resilient and resourceful, then managers will face the
task of adjusting their operations during periods of economic crisis, but if democracy falters, then
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managers will face the task of rethinking their operations in a world of increasing state control
and repression.
IV. POLITICAL RISK
Political risk is the possibility that political decisions, events, or conditions will affect
a country’s business environment in ways that will cost investors some or all of the
value of their investment or force them to accept lower than projected rates of return.
Leading sources of political risk are: expropriation or nationalization, international war
or civil strife, unilateral breach of contract, destructive government actions, harmful
actions against people, and restrictions on the repatriation of profits, differing points of
view, and discriminatory taxation policies. The global economic crisis has only served
to increase political risk.
A. Classifying Political Risk
The following types of political risk range from the least to the most destructive. [see
Figure 3.4.]
1. Systemic Political Risk. Systemic political risk creates risks that affect all firms
because of a change in public policy. However, such changes do not necessarily
reduce potential profits.
2. Procedural Political Risk. Procedural political risk reflects the costs of getting
things done because of such problems as government corruption, labor disputes,
and/or a partisan judicial system.
3. Distributive Political Risk. Distributive political risk reflects revisions in such
items as tax codes, regulatory structure, and monetary policy imposed by
governments in order to capture greater benefits from the activities of foreign
firms.
4. Catastrophic Political Risk. Catastrophic political risk includes those random
political developments that adversely affect the operations of all firms in a country.
POINT—COUNTERPOINT: Proactive Political Risk Management: The Superior
Approach
POINT—PROACTIVE POLITICAL RISK MANAGEMENT: Active political risk management
reasons that if one measures the right set of discrete events, one should be able to calculate the
degree of political risk in a country and estimate the likelihood that politically risky disruptions,
(e.g., civil strife, terrorism, regime change, ethnic tensions, contract repudiation, financial
controls) will occur. Hence, rigorous quantitative analysis and modeling should detect, measure,
and predict future instances of political upheaval. Others opt to assess such risk with qualitative
measures by polling a panel of country experts who possess an expert sense of the situation.
Then, likely scenarios are developed and probabilities assigned for a finite period of time.
COUNTERPOINT—PASSIVE POLITICAL RISK MANAGEMENT: Many firms choose to
treat political risk as an unpredictable hazard of international business. Given that, the
strategically responsible thing to do is to find a cost-effective way to hedge the firm’s exposure.
Typically, these companies shield themselves from political risk by purchasing insurance that
protects their operations from various sources of risk, including government expropriation,
involuntary abandonment, or damage to assets due to political violence. Organizations that offer
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such insurance include the Overseas Private Investment Corporation (OPIC), multilateral
development banks (MDBs) such as the World Bank (IBRD) and its regional counterparts, as
well as private insurance firms.
V. THE LEGAL ENVIRONMENT
A legal system is the mechanism for creating, interpreting, and enforcing the laws in a
specified jurisdiction. The three components of modern legal systems are constitutional law,
criminal law, and civil and commercial laws.
Legal Systems. A legal system is the means and methods a country uses to regulate business
practices, define how companies conduct business transactions, specify the rights and
obligations of those engaged in business transactions, and spell out the methods of legal
redress for those who believe they have been wronged. Modern legal systems have
three components: 1. Constitutional law; 2. Criminal law; and 3. Civil and Commercial
law.
A. Types of Legal Systems. Generally, legal systems fall into one of the following
categories: [see Map 3.3.]
1. Common law. Common law is based upon tradition, judge-made precedent,
custom, and usage; therefore, courts play an important role in interpreting the law.
Common-law nations include Australia, Canada, New Zealand, and the United
States.
2. Civil law. Civil law is based upon a detailed set of laws that comprise a code that
includes rules for conducting business; therefore, courts play an important role in
applying the law. Civil law nations include France, Germany, and Japan.
3. Theocratic law. Theocratic law is based upon religious precepts; ultimate legal
authority is conferred upon religious leaders who govern society. The best example
is Islamic law, or Sharī ahʿ, which is based on the Koran, the Sunnah, the writings of
Islamic scholars, and the consensus of Muslim countries’ legal communities.
4. Customary law. Customary law anchors itself in the wisdom of daily experience
or great spiritual or philosophical traditions. Customary law may play a significant
role in matters of personal conduct in countries with mixed legal systems.
5. Mixed System. A mixed legal system emerges when two or more legal systems
are used within a single country. Although the majority of such countries are found
in Africa and Asia, the United States’ legal system combines both common and civil
law.
B. The Foundation of Legality
Presently, democracy’s retreat, by signaling the rise of single-party governments
advocating state-sponsored collectivism, pushes managers to pinpoint likely changes in
legal systems. Bluntly put, justice is not blind, but arbitrary, oppressive, and
state-serving. Another major development is the rise of emerging markets. Once
relegated to the periphery of the global economy, emerging markets steadily command
center stage. These developments require managers to ask, “What is the basis of rule in
a given country?” This question inevitably directs attention to the rule of man versus
the rule of law. The rule of man places ultimate power in the hands of one person and is
the cornerstone of totalitarian governments. The rule of law is the hallmark of
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democratic governments and holds that authority comes from written and transparent
laws. [see Map 3.5.]
D. Implications for Managers – Rule of law flourishes in well-to-do industrialized
countries such as the United States, Japan, and most of Europe. When managers from
these countries conduct business in emerging markets, they may expect to find
perplexing and inconsistent legal systems.
VI. LEGAL ISSUES FACING INTERNATIONAL COMPANIES
Two major areas of concern to international business concerning legal issues are operational
concerns and strategic matters.
A. Operational Concerns
Efforts to start a business, to enter and enforce contracts, to hire and fire employees, and
to close a business are all affected by national laws and regulations. While there
appears to be an inverse relationship between a country’s per capita income and its
tendency to regulate business, the legal systems of the more highly developed countries
tend to regulate the major operational features of business activity more consistently
than do the less developed nations. Further, those countries that make it easy to start a
business also tend to impose fewer and simpler regulations to hire and fire workers and
impose less regulation in their courts and bankruptcy systems. [see Tables 3.3 and 3.4.]
A key change since the last World Bank study shows Hong Kong, China surpassing the
United States in the ease of doing business ranking.
B. Strategic Concerns
Many legal issues affect the process of value creation. The following legal
contingencies often shape an international competitor’s strategic plans.
1. Product Regulation. Host governments set laws that regulate access based on the
product’s country of origin—the country where it was grown, produced, or
manufactured. Some countries apply this policy to product labels, under the title
COOL (country-of-origin labeling), to inform consumers and support local
producers. National security concerns also shape country-of-origin regulations. In
addition, most host governments push MNEs to add value locally by enforcing local
content regulations.
2. Marketplace Behavior. National laws determine permissible practices in pricing,
distribution, advertising, and the promotion of products, and they vary widely from
one country to another.
3. Product Safety and Liability Regulation. Often products must be customized in
order to comply with local standards, which may be higher than those found in a
firm’s home market. While product liability laws are very stringent in markets such
as the United States, they are spotty, absent, and at times even arbitrary in many less
developed countries.
4. Legal Jurisdiction. Every country specifies which law should apply and where
litigation should occur when agents are involved—whether they are legal residents
of the same or different countries.
5. Intellectual Property Rights. Intellectual property rights consist of ownership
rights to intangible assets, i.e., the right to control and derive the benefits from
writing and other creative art forms (copyright), inventions (patents), and identifiers
(trademarks). Problems arise because intellectual property, whether in the form of
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literature, music, design, software, scientific patents, or brand names, is difficult to
create but easy to duplicate. Cross-national and cross-cultural legal differences
complicate specifying, regulating, and enforcing intellectual property rights. The
costs of piracy, whether in terms of lost sales and royalties or future creativity, are
very high for registered owners. International Property Rights. constitute a
legally enforceable but limited monopoly granted by a country to an innovator.
Enforcement of IPRs is difficult due to the fact that there is no way to globally
register a patent, trademark, or copyright. The pervasiveness of piracy and matters
of jurisdiction further challenge the protection of IPRs.
VII.POLITICS, LAW, AND THE BUSINESS ENVIRONMENT
Table 3.5 identifies the top-ranked and bottom-ranked countries whose political and legal
policies enact, respectively, the most or least supportive business environments. The
rankings highlight a key relationship: most of the top-ranked countries have a democratic
political system and a common or civil law legal system anchored in the rule of law. In
contrast, most bottom-ranked countries exhibit authoritarian politics and a mixed legal
system anchored in the rule of man. Table 3.5, along with Table 3.4, highlights an inverse
relationship between nation’s general income levels and its scope of regulation—generally,
richer countries regulate less and poorer countries regulate more. [see Table 3.4.] [see Table
3.5.]
CLOSING CASE: It’s a Knockoff World
Software technology is plagued by the problem of digital piracy—the illegal copying and/or
distribution of software for personal or business use. An explosive issue, it increasingly cuts to
the perception, protection, and enforcement of intellectual property rights. Presently software
piracy ranges from a single individual’s making an unauthorized copy of a software product for
use, sale, or free distribution to a company’s mismanagement of its software license. Principal
types of piracy include: end-user piracy, pre-installed software, Internet piracy, counterfeiting,
and online auction piracy. Countries where piracy rates were the highest in 2008 include
Georgia, Bangladesh, Armenia, and Zimbabwe. Countries where piracy rates were the lowest in
2008 include the United States (20%), Japan (21%), Luxembourg (21%) and New Zealand
(22%). The pervasiveness and tenacity of software piracy in the face of an ever-expanding set of
intellectual property rights laws, policies, and treaties raises profound questions for the software
industry in particular and intellectual property rights in general. The case ends with a legitimate
question questioning the inevitability of piracy.
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