978-1473758438 Chapter 2

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Instructor Manual

Chapter 2: Formal Institutions: Political, Economic and Legal

Systems

(Prepared by Klaus E. Meyer, March 2019)

Introduction to the Topic

Learning Objectives

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

2. Explain the basic differences between political systems

3. Explain the systemic differences between economic systems

4. Explain the basic differences between legal systems

5. Participate in three leading debates on institutions in international business

6. Draw implications for action

General Teaching Suggestions

This chapter introduces the first part of the institution-based view underpinning this book,

namely the formal part of the institution-based view. We do so by reviewing the economic,

political and legal institutions that underpin modern economies, and that explain variations

between them – and in consequence present challenges for those engaging in business across

borders.

The Debates and Extensions at the end of the chapter may give you some ideas for the

development of debate teams. If you regularly read national or international newspaper, you

will likely find something that might be used as a tool to bring out some aspects of this

chapter and might be effective simply because the topic is current.

Opening Case Discussion Guide

Turkey is in many ways similar to other European economies (e.g. the presence of major

businesses), yet in important ways it is not. Changes in a society and an economy can

sometimes occur through natural forces and the use of persuasion but that may take a long

time as opposed to making something happen now by simply passing laws or replacing ruling

party. The Turkish government has sought to use laws as a means of achieving what it views

as economic and social process: In the early 2000 when the focus was on economic reforms,

this brought Turkey closer to shared European rules, more recently social change initiative

have widened the gap. In the global economy where firms around the world can shift where

they do business, the rules of the game in any given country are issues that are of concern.

A particular feature of the opening case is the introduction of a variety of measures of

institutions, with data for Turkey and as benchmarks other Southern European or emerging

economies. Table 2.1 illustrates the challenges of classifying countries by institutional

development: The choice of indicators influences the outcome. It also provides a basis for

discussing the range of institutions included in the concept of formal institutions and thus

included in the Chapter.

The discussion of this case can be opened by asking, Is Turkey an emerging or mature

economy? In which ways does Turkey resemble EU countries, and which ways does it not?

The case can also be combined with the Integrative Case ‘Beko washes clothes across

Europe’, which focuses on a company expanding from Turkey across Europe.

Chapter Outline, Section by Section

Section 1: An institution-based view of IB

Key Ideas

This section introduces the key concepts related to the ’institution-based view, which is

mainly grounded in institutional economics (Douglass North) and organizational sociology

(Richard Scott). However, the intellectual underpinnings of this line of thought are closely

related those by European thinkers in the 19th and 20th century – the text mentions Max

Weber and Walter Eucken as examples.

The key functions of institutions are identified as to reduce uncertainty, curtail transaction

costs, and combat opportunism. The main insights of the institution-based perspective are

summarized in two propositions: 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.

Key Concepts

institutions

Formal and informal rules of the game.

institutional framework

Formal and informal institutions governing individual and firm behaviour.

institution-based view

A theoretical perspective in international business suggesting that firm performance is, at least in part,

determined by the institutional frameworks governing firm

transaction costs

The costs of organising economic transactions.

formal institutions

Institutions represented by laws, regulations, and rules.

informal institutions

Rules that are not formalized but exist in for example norms, values, and ethics

regulatory pillar

The coercive power of governments.

normative pillar

The mechanism through which norms influence individual and firm behaviour.

cognitive pillar

The internalized, taken-for-granted values and beliefs that guide individual and firm behaviour.

opportunistic behaviour

Seeking self-interest with guile.

institutional transition

Fundamental and comprehensive changes introduced to the formal and informal rules of the game that

affect organizations as players.

Section 2: Political Systems

Key Ideas

This section has been reorganized from the in the 3rd edition. The main focus is on decision

making within democratic systems, and their impact on businesses. This is a topic that I feel

particularly passionate about because of my experience of having lived in the UK and in

continental European countries. A lot of the differences in public life and politics can be

explained by the way political representatives are elected. It also explains certain differences

in decision making processes that can see within organizations, such as universities.

Instructors may use the structure of In Focus 2.1 to add other recent elections in their own

countries to emphasize these differences.

Key Concepts

political system

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

democracy

A political system in which citizens elect representatives to govern the country on their behalf.

proportional representation

Election system that allocates seats in parliament in proportion to the votes received by each party

(usually subject to minimum threshold).

first-past-the-post system

Election system by which in each constituency the candidate with the relative majority of votes gets the

seat.

authoritarianism

A political system in which power is concentrated in the hands of one person or a small elite.

lobbying

Making your views known to decision makers with the aim of influencing political processes.

corruption

The abuse of public power for private benefits.

political risk

Risk associated with political changes that may negatively impact domestic and foreign firms.

Section 3: Economic Systems

Key Ideas

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.

Beyond the traditional distinction between capitalism and socialism, we provide the ‘varieties

of capitalism’ perspective, which allows a differentiated discussion of market economies by

distinguishing liberal market economies and coordinated market economies (also see Figure

2.2).

In Focus 2.2 pushes the ‘European’ roots of the institutional thinking further by introducing

an economist whose work was very influential in Germany in the 1950s and 1960s; but who

is hardly acknowledged in the Anglo-Saxon literature that is usually cited as foundation of

the ‘institution–based view’.

This example illustrates also the danger of adopting Anglo-Saxon intellectual tradition rather

than local ones when shifting to English as a medium of instruction. I hope instructors using

this textbook will take a critical view on this issue, and introduce local traditions from their

own community to complement what we introduce in the book.

Key Concepts

economic system

Rules of the game on how a country is governed economically.

market economy

An economy that is characterized by the “invisible hand” of market forces.

command economy

An economy in which all factors of production are government– or state-owned and controlled, and all

supply, demand, and pricing are planned by the government.

varieties of capitalisms view

A scholarly view suggesting that economies have different inherent logics how markets and other

mechanisms coordinate economic activity.

liberal market economy (LME)

A system of coordination primarily through market signals.

coordinated market economy (CME)

A system of coordinating through a variety of other means in addition to market signals.

Apprenticeship system

Vocational training system for crafts and professions

Section 4: Legal Systems

Key Ideas

Another key difference among developed economies is the foundation of their legal system.

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. These

differences impact both the content of laws, but also important legal processes. We elaborate

these important differences in greater detail that other textbooks because my own experience

suggests that indeed they are very important for how people engage in business.

Key Concepts

legal system

The rules of the game on how a country’s laws are enacted and enforced.

civil law

A legal tradition that uses comprehensive statutes and codes as a primary means to form legal

judgments.

common law

A legal tradition that is shaped by precedents and traditions from previous judicial decisions.

case law

Rules of law that have been created by precedents of cases in court

legal certainty

clarity over the relevant rules applying to a particular situation

Section 5: Debates and Extensions

Key Ideas

This is the first ‘debates and extensions section’ as you will find it in all subsequent chapters

as well. This one focuses on three questions at the interface of legal and economic systems

that are hotly debated in scholarly circles, namely (1) property rights, (2) corporate

governance, and (3) political risks.

These debates introduce also important concepts that students may be familiar with from

other classes, but that merit review. On property rights, we also offer two In Focus boxes that

introduce internationally controversial issues likely to trigger a lot of debate, namely

intellectual property rights, and the extend of copyright.

Key Concepts

property rights

The legal rights to use an economic property (resource) and to derive income and benefits

from it.

intellectual property rights

Rights associated with the ownership of intellectual property.

patents

Legal rights awarded by government authorities to inventors of new technological ideas, who

are given exclusive (monopoly) rights to derive income from such inventions.

copyrights

Exclusive legal rights of authors and publishers to publish and disseminate their work.

trademarks

Exclusive legal rights of firms to use specific names, brands, and designs to differentiate their

products from others.

corporate governance

rules by which shareholders and other interested parties control corporate decision makers

Section 6: Implications for Practice

Key Ideas

The concluding section emphasizes the need to study and understand the (formal) institutions

of any foreign country where one is considering to do business.

Key Concepts

No new concepts

Review Questions

Review questions are provided to students on the website accompanying the book. They

directly ask to summarize the material provided in the text. Instructors may also use the

questions to structure their lectures or review sessions.

Review Questions

(as provided to students on the website)

Material in the Book

1. Explain what “institutions” are!

2. What are the differences between formal and

informal institutions?

3. Explain the concepts of regulatory, normative and

cognitive pillars of institutions as introduced by

Richard Scott.

4. How do institutions reduce transaction costs?

5. How do institutions alter the potential for

opportunistic behaviour?

6. What is institutional transition?

7. Explain two core propositions of the institution-

democracy?

9. Explain four variations in the procedures by which

democratic countries take major political decisions!

10. What are the consequences of proportional

11. What are the implications of a country adopting a

more authoritarian political system.

12. Why should businesses be concerned about

political systems?

13. Explain the key differences between a market

why it should be classified as CME or LME, and

how this classification may have changed over

time.

16. Outline the key differences between civil law and

common law countries!

17. What are the historical origins of respectively civil

19. Why are property rights, from a business

perspective, an essential element of any legal

system?

Page 32-34

Page 33

Page 33-34

Page 33-35

Page 33-34

Page 34

Page 35

Page 36-39

Page 36 and 37 (In Focus

Page 38

Page 39

Page 42-43

Page 43-45

Page 44-46 (incl. Tables 2.4

Page 46 and In Focus 2.3

Page 47-48

20. What are intellectual property rights, and what are

the main obstacles to their enforcement?

21. Why are corporate governance laws, from a

business perspective, an essential element of any

legal system?

22. What is political risk?

23. How does the institutional framework affect

political risk?

24. Why should managers study the formal and

informal institutions of a country before embarking

in business there?

Page 49

Page 49-50

Page 50

Page 51-52

Critical Discussion Questions

At the end the chapter, we provide discussion questions that aim to stimulate students

thinking beyond memorizing the material learned in the chapter. They are designed to be

used at a basis for in-class discussions, group work, or individual assignments. Below, we

provide some indicative answers of issues that may be raised in response to these questions.

Discussion Questions

(as provided in the book)

Indicative Responses

1. What are the relative merits of a

coordinated market economy (CME) and

a liberal market economy (LME)? Would

you rather work / study / retire in a CME

or an LME?

2. What is in your view the most legitimate

way to select student union

family firms that employ child labour in

rural Bangladesh. You are aware of the

corporate plan to phase out these products

investor and enjoys good profits in (1)

elections fail to meet normal European

standards. As a country manager, you

1. Key issues to discuss here are the

freedom for business – and hence the

opportunities – but also the risks

associated with a CME. An LME

provides greater stability and security

for those less capable of high

achievement.

likely, most are going to defend their

own country’s traditional system, and

should be challenged to appreciate the

corporations would presumably be

do all they can to try and stop it.

understand that your firm is pressured by

activists to exit these countries. The

alleged government actions, which you

personally find distasteful, are not directly

related to your operations. How would

you proceed?

4. The debate here is whether sanction

are a) legitimate and b) effective as a

means to put pressure on political

regimes deemed hostile to human

rights agendas.

My personal view is that, firstly,

historically economic sanctions have

never been effective in achieving

anything other than strengthening the

opposition against outside interference

(Turkey, Opening Case, being a

possible exception), and secondly,

businesses can achieve a lot through

the way they operate in these

countries – i.e. respecting and

advancing human rights in their own

operations and their suppliers – but

them getting involved in high politics

is creates more problems than it

solves.

Q3 & Q4 are ethical questions where the

students’ answer is not as important as the

thought process and the ability to clearly

articulate.

Closing Case

The closing case provides further opportunities to apply ideas and concepts learned in this

chapter in a real world setting. The Closing Case for this Chapter is “Carlsberg faces political

risk in Russia” and focuses on the challenges of doing business in a politically and

economically volatile environment. Starting from events around World War I, the case at the

expropriation or trade boycotts) that have arisen over the recent two decades.

Below are some indicative responses to the case discussion questions.

political risks?

3. If you were a board member of

Carlsberg, would you vote ‘yes’

or ‘no’ for a new project to

acquire a local company in

Russia?

availability of natural resources. For

example western companies often have

advanced technologies while Russia has

huge potential market. It depends on the

business proposal presented and the legal

protections in place at the time, among

other considerations.

3. The answer to question 3 depends on the

foregoing analysis. In view of the EU

sanctions regime, there may be

opportunities for ‘cheap’ acquisitions, but

since Carlsberg already has overcapacity

and political risk remains high, it will be

challenging to convincingly argue for a

‘yes’ vote.

Further Learning Activities

In addition to the cases and discussion questions provided in the book, instructors may want

to use any of the following activities to further engage students with the material.

1. In Focus 2.1 on elections around the globe provide an opportunity to discuss and

interpret any recent election discussed in the media. If the election in – say UK 2015 –

had been held by the rules of France, USA, India, Germany, how would the result have

been different? Students will be surprised to find how often the winner by one set of rules

would not actually have been the winner had another European country’s rules been

applied. Sadly, very few journalists seem to recognize that.

2. The Integrative Case “Xiaomi Challenges Global Smartphone Leaders” has been

written specially to discuss the fast-paced development of firms in emerging economies

(which likely will surprise many students in Europe), and thus the rapidly evolving role of

emerging economies in the global economy (Chapter 1). The case allows to highlight the

complementarity of the institutions-based (Chapter 2&3) and resource-based views

(Chapter 4) in explaining MNEs. It also provides leads into a discussion of the early

stages of internationalization (Chapter 11).

3. The Integrative Case “Tackling Corrupt Practices: GSK in China” brings together the

themes of corruption (Chapter 3), social responsibility in foreign countries (Chapter 10)

and headquarter-subsidiary relationships (Chapter 14). GSK has globally announced high

4. The Integrative Case ‘Just Another Move to China?’ has been written to discuss the

challenges faced by expatriates and their families as they cope with unfamiliar

environments, and have to make decisions over their international careers (Chapter 16). It

also allows to further deepen the discussion on how and why differences in formal and

informal institutions (Chapters 2 and 3) matter for international business.

5. Evaluating political risk is an important element of country risk analysis. In fact, your

personal interest relates to countries in the Middle East and North Africa region that have

a high political risk. Provide a brief overview of the region and the reasoning behind

assessing these countries that have been assessed with high political risk. From this list,

which country has the highest overall country risk?

One resource which can be used is “A.M. Best Country Risk Ratings”. This website

can be found by entering the search term “country risk analysis” at the globalEDGE™

Resource Desk search box located at http://globaledge.msu.edu/resourceDesk/. Once

at the A.M. Best Country Risk Ratings website, click on the “AMB Country Risk

6. Since you work for a diversified multinational corporation, economic risk across different

sectors of the world economy is an integral part of analysis as it indicates the future

business prospects for specific industries. Evaluate the risk assessment of three industry

sectors that are available to analyze. Prepare a report and provide a recommendation

concerning which industry and region would be most beneficial to your company.

One resource which can be used is “@rating”. This website can be found by entering

the search term “different sectors” at the globalEDGE™ Resource Desk search box

East/North Africa, CIS, Japan, Emerging Asia, and Latin America), and

Pharmaceuticals (Emerging Asia, North America, Western Europe, and Latin