978-1305500891 Chapter 2 Lecture Note

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CHAPTER 2

UNDERSTANDING FORMAL INSTITUTIONS:

POLITICS, LAWS, AND ECONOMICS

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1. explain the concept of institutions and their key role in reducing uncertainty.

2. articulate the two core propositions underpinning an institution-based view of global

business.

3. identify the basic differences between democracy and totalitarianism.

4. outline the differences among civil law, common law, and theocratic law.

5. understand the importance of property rights and intellectual property rights.

6. appreciate the differences among market economy, command economy, and mixed

economy.

7. participate in two leading debates concerning politics, laws, and economics.

8. draw implications for action.

GENERAL TEACHING SUGGESTIONS

Politics, laws, and economics are fertile ground for heated debate. The Debates and Extensions

section in this chapter may give you some ideas for the development of debate teams. If you

regularly read the Wall Street Journal, you will likely find a current article that might be used as

an effective tool to bring out some aspects of this chapter.

OPENING CASE DISCUSSION GUIDE

Emerging Markets: The Peril and Promise of Russia. This case can yield many questions for

class discussion. It covers the economic growth and development since the Soviet Union

dissolved and Russia became separate from the other Soviet republics. Although it mentions

corruption and loss of individual freedom in covering the extent to which Russians are better off,

much (not all) of the discussion focuses on economics. Ask your students whether they feel that

too much focus is placed on economic betterment or not enough. Ask them if they would be

willing to lose some personal freedoms if the country where they live could enable them to enjoy

a better life financially.

CHAPTER OUTLINE: KEY CONCEPTS AND TERMS

Sections I through VIII of Chapter 2

I. UNDERSTANDING INSTITUTIONS

1. Key Concept

Institutions are commonly defined as “the rules of the game.” Institutions have formal

and informal components, each with different supportive pillars.

2. Key Terms

Cognitive pillar is the internalized (or taken-for-granted) values and beliefs that

guide individual and firm behavior.

Formal institutions are institutions represented by laws, regulations, and rules.

Informal institutions are institutions represented by cultures, ethics, and norms.

Institutional framework is formal and informal institutions that govern individual

and firm behavior.

Institutional transitions are fundamental and comprehensive changes introduced to

the formal and informal rules of the game that affect firms as players.

Institution-based view is a leading perspective in global business that suggests that

the success and failure of firms are enabled and constrained by institutions.

Institutions are formal and informal rules of the game.

Normative pillar is the mechanism through which norms influence individual and

firm behavior.

Norms are the values, beliefs, and actions of relevant players that influence the focal

individuals and firms.

Regulatory pillar is the coercive power of governments.

II. WHAT DO INSTITUTIONS DO?

1. Key Concept

The key function of institutions is to reduce uncertainty.

2. Key Terms

Opportunism is the act of seeking self-interest with guile.

Transaction cost is the cost associated with economic transactions or, more broadly,

the costs of doing business.

Transition economies are a subset of emerging economies, particularly those

moving from central planning to market competition (such as China, Poland, Russia,

and Vietnam).

III. AN INSTITUTION-BASED VIEW OF GLOBAL BUSINESS

1. Key Concepts

Proposition 1: Managers and firms rationally pursue their interests and make choices

within the formal and informal institutional constraints in a given institutional

framework.

Proposition 2: While formal and informal institutions combine to govern firm behavior,

in situations where formal constraints are unclear or fail, informal constraints will play a

larger role in reducing uncertainty and providing constancy to managers and firms.

2. Key Terms

Bounded rationality is the necessity of making rational decisions in the absence of

complete information.

IV. POLITICAL SYSTEMS

1. Key Concepts

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 over the population.

2. Key Terms

Communist totalitarianism is a type of totalitarianism that centers on a communist

party.

Democracy is a political system in which citizens elect representatives to govern the

country on their behalf.

Political risk is risk associated with political changes that may negatively impact

domestic and foreign firms.

Political system is the rules of the game on how a country is governed politically.

Right-wing totalitarianism is a type of totalitarianism that is characterized by its

intense hatred of communism.

Theocratic totalitarianism is a type of totalitarianism that monopolizes political

power in the hands of one religious party or group.

Totalitarianism (dictatorship) is a political system in which one person or party

exercises absolute political control over the population.

Tribal totalitarianism is a type of totalitarianism in which one tribe or ethnic group

(which may or may not be the majority of the population) is monopolizing political

power and oppressing other tribes or ethnic groups.

V. LEGAL SYSTEMS

1. Key Concept

Laws in different countries are transplanted from three legal traditions. 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. Key Terms

Civil law is a legal tradition that uses comprehensive statutes and codes as a primary

means to form legal judgments.

Common law is a legal tradition that is shaped by precedents and traditions from

previous judicial decisions.

Copyrights are the exclusive legal rights of authors and publishers to publish and

disseminate their work.

Intellectual property (IP) is intangible property that is the result of intellectual

activity.

Intellectual property rights (IPRs) are rights associated with the ownership of

intellectual property. IPRs primarily include rights associated with (1) patents, (2)

copyrights, and (3) trademarks.

Legal system is the rules of the game on how a country’s laws are enacted and

enforced.

Patents are exclusive legal rights of inventors of new products or processes to derive

income from such inventions.

Piracy is the unauthorized use of intellectual property.

Property right is the legal right to use an economic property (resource) and to derive

income and benefits from it.

Theocratic law is a legal system based on religious teachings.

Trademarks are the exclusive legal rights of firms to use specific names, brands,

and designs to differentiate their products from others.

VI. ECONOMIC SYSTEMS

1. Key Concept

An economic system refers to the rules of the game on how a country is governed

economically. 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. Key Terms

Command economy is an economy characterized by government ownership and

control of factors of production.

Economic system is the rules of the game on how a country is governed

economically.

Market economy is an economy characterized by the “invisible hand” of market

forces. The government takes a hands-off approach known as laissez faire.

Mixed economy is an economy that has elements of both a market economy and a

command economy.

State-owned enterprises (SOEs) are firms that are owned and controlled by the

state.

VII. DEBATES AND EXTENSIONS

1. Key Concept

Two leading debates are (1) drivers of economic development and (2) private ownership

versus state ownership.

2. Key Terms

Beijing Consensus is a view that questions Washington Consensus’s belief in the

superiority of private ownership over state ownership in economic policymaking,

which is often associated with the position held by the Chinese government.

Moral hazard is recklessness when people and organizations (including firms and

governments) do not have to face the full consequences of their actions.

Washington Consensus is a view centered on the unquestioned belief in the superiority of

private ownership over state ownership in economic policymaking, which is often spearheaded

by the US government and two Washington-based international organizations: the International

Monetary Fund and the World Bank.

VIII. MANAGEMENT SAVVY

1. Key Concept

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.