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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.
