Understanding Formal Institutions:

Politics, Laws, & Economics

SGMA 371 – Topic 2
 Agenda
• Explain the concept of institutions and their key role in reducing uncertainty.

• Articulate the two core propositions underpinning an institution-based view of global business.

• Identify the basic differences between democracy and totalitarianism.

• Outline the differences among civil law, common law, and theocratic law.

• Understand the importance of property rights and intellectual property rights.

• Appreciate the differences among market economy, command economy, and mixed economy.

• Participate in two leading debates concerning politics, laws, and economics.

• Draw implications for action.

 Understanding institutions
• Institution-based view – a leading perspective in global business that
suggests the success and failure of firms are enabled and constrained by
institutions
• Institution – formal and informal rules of the game, which govern individual
and firm behavior
Institutional transitions
• Institutional transitions – fundamental and
comprehensive changes introduced to the
formal and informal rules of the game,
which affect firms as players
• January 20, 2021: Joe Biden, 46th President of the
United States
◦ Historic first female, Asian and African American VP

• August 16, 2021: Taliban will run the government in

Afghanistan
◦ China, Russia, and Pakistan will have more influence
◦ https://foreignpolicy.com/2021/09/02/afghanistan-withdrawal-chin
a-russia-outflank-geopolitics-united-nations/
◦ https://www.nbcnews.com/specials/taliban-takeover-afghanistan-5
-days/
Formal institutions
• Formal institution – institution represented by laws, regulations,
and rules
◦ Regulatory pillar – the coercive power of governments
◦ Example: Biden will issue executive orders today for US to rejoin Paris
Agreement on climate change and nullifying the permit for the TransCanada
Keystone pipeline.
◦ https://www.cbc.ca/news/canada/calgary/biden-keystone-xl-permit-revoke-inauguration-1.5
880268
Informal institutions
• Informal institutions – institutions represented by cultures, ethics, and norms
• Supported by two pillars:
◦ Normative pillar – the mechanism through which norms influence individual
and firm behavior
◦ Norms – values, beliefs, and actions of relevant players that influence the
focal individuals and firms
◦ Cognitive pillar – the internalized (or taken for-granted) values and beliefs
that guide individual and firm behavior
What do institutions do?
• Institutions influence decision-making process of individuals and firms
◦ By constraining the range of acceptable actions
◦ Creating incentives for appropriate behaviors

• Economic uncertainty leads to greater transaction costs

◦ Source is opportunism- the act of seeking self-interest with guile

◦ Transaction cost – the cost associated with economic transactions or, more
broadly, the costs of doing business
What do institutions do?
• Unstable and unreliable institutional frameworks:
◦ Increase transaction costs
◦ Decrease transactions
• Transition economies
◦ A subset of emerging economies, particularly those moving from central
planning to market competition (such as China, Poland, Russia, and Vietnam)
Exhibit 2.2: Institutions, firms, and firm
behavior
Exhibit 2.3: Two core propositions
Political systems
• Political system

◦ The rules of the game on how a country is governed politically

◦ Structures, processes and activities by which a nation governs itself

◦ Characterized by who participates and to what extent they participate

◦ Wide vs. narrow participation

◦ Example: Kuwait bars non-Muslims from becoming citizens

Influence of history and culture
Each nation’s political and legal systems
are rooted in factors such as its:
• History and culture
• Demographics
• Economic context

National history and culture are then

reflected in values such as:

• Individual responsibility
• Law and order
• Free enterprise
• Role of family
Political ideologies

Totalitarianism Pluralism Anarchism

Both private and public

groups need to balance
each other’s power
Examples:
Every aspect of Democracy,
Only individuals and
people’s lives must be Constitutional monarchies,
Certain aristocracies private groups can
controlled to preserve order preserve personal liberties
Examples: Examples?
Communism, Fascism
Totalitarianism

 Leaders govern without people’s support

 Government controls much of people’s lives
 Leaders do not tolerate opposing viewpoints

Lack of
Imposed Restricted
constitutional
authority participation
guarantees
Forms of totalitarianism
Pros and cons of
doing business in
Theocratic totalitarianism totalitarian
(totalitarian religious leadership) countries?

Secular totalitarianism
(military and bureaucratic leadership)

Communist totalitarianism

Tribal totalitarianism

Right-wing totalitarianism
Types of totalitarianism
• Communist totalitarianism – centers on a communist party
• Right-wing totalitarianism – is characterized by its intense hatred against
communism
• Theocratic totalitarianism – refers to the monopolization of political power in
the hands of one religious party or group
• Tribal totalitarianism – refers to one tribe or ethnic group (which may or may
not be the majority of the population) monopolizing political power and
oppressing other tribes or ethnic groups
Democracy
• A political system in which government leaders are elected by the
wide participation of the people (or their representatives)
• Most nations resort to a representative democracy:
◦ Freedom of expression Does democracy Pros and cons of
◦ Periodic elections guarantee economic doing business in
growth? democratic
◦ Full civil and property rights India vs. China countries?
◦ Minority rights
◦ Nonpolitical bureaucracies
Different perspectives on U.S.
political institutions
MIT Professor:
https://www.project-syndicate.org/commentary/repairing-us-institutions-after-tr
ump-by-daron-acemoglu-2021-01
Chinese Media Outlet:
https://www.globaltimes.cn/page/202101/1213436.shtml

Heritage Foundation (Right Wing Think Tank):

https://www.heritage.org/progressivism/commentary/bidens-radical-agenda-ens
ures-weaker-poorer-more-divided-americ
a
Cross-border activities involve risk
• Country risk (shows interdependence of several risks)
• Economic risk
• Political risk The likelihood that a government or society will undergo political
changes that negatively affect local business activity

• Institutional/legal risk
• Reputational risk
• Strategic risk Macro vs. Micro Risks
Examples of political risk
• Rebellions against government
Conflict and violence •
•
Territorial disputes
Ethnic, religious conflicts etc.

Terrorism and kidnapping •

•
Political statements such as 9/11
Funding terrorist activities via ransom

Property seizure
• Confiscation (Cuba)
• Expropriation (Repsol & YPF)
• Nationalization (Chavez & oil)

• Foreign ownership restrictions

Policy changes •
•
Tax rules
Cross border investments

• Protects local producers, employees

Local content requirements • Workforce, quality issues
Conflict & terrorism:
The FARC in Colombia
• Favorable investment terms led to Colombia's crude oil
production doubling within the past 10 years
◦ 1 million barrels per day (b/d) in 2013.

• Persistent attacks on oil and natural gas pipelines by

militant groups have led to ongoing supply disruptions.
◦ In 2015, attacks disrupted about 41,000 b/d of oil supply.

• Video:
https://www.theguardian.com/world/video/2015/nov/2
7/farc-guerrillas-last-days-of-blood-in-colombia-video
Policy changes: Vodafone in India
• In 2012, India’s Supreme Court ruled that http://economictimes.indiatimes.com/e
Vodafone was not liable for any tax on its t-now/daily/negotiations-stalled-betwe
en-vodafone-govt-on-tax-dispute/video
Hutchison India acquisition show/51513897.cms
◦ Overseas transaction in Cayman Islands
http://www.moneycontrol.com/news/b
• The government then changed the law usiness/bombay-hc-rulesfavourvodafon
◦ Retrospectively, demanding more than $2 ers-8500cr-tax-case_3487941.html
billion be paid.

• In 2014, Vodafone then sought

international arbitration of the dispute
◦ Not yet settled
◦ Recent Mumbai High Court ruling in its favor
Small group discussion
• Discuss: Conflict and violence
◦ How can different risks affect business activities? Terrorism and kidnapping
◦ How can firms manage such risks? Property seizure
◦ Focus on one risk (per group) Policy changes
Local content requirements
Legal systems
• Legal system – the rules of the game on how a country’s laws are
enacted and enforced
• Legal systems reduce transaction costs by:
◦ Minimizing uncertainty
◦ Combating opportunism
◦ Form the primary regulatory pillar that supports institutions
Legal Traditions
• Civil law: Uses comprehensive statutes and codes to form
legal judgments
◦ Less flexible - Judges apply the law
• Common law: Shaped by precedents from previous judicial
decisions
◦ Flexible - Resolves disputes based on judges’ interpretation of
the law
• Theocratic law: Based on religious teachings
Exhibit 2.4: Three legal traditions
Property rights
• Legal rights to use an economic property (resource) and to derive
income and benefits from it
◦ Property document is required to prosecute violators through legal means
◦ Facilitates economic growth
◦ Insecure property rights in developing countries:
◦ Reduce firm size
◦ Result in the use of technologies that employ less fixed capital
◦ Do not entail long-term investment
Intellectual property rights (cont’d)
• Intellectual property right (IPR) – right associated with ownership
of intellectual property
• Patent – exclusive legal rights of inventors of new products or processes to
derive income from such inventions
• Copyright – exclusive legal rights of authors and publishers to publish and
disseminate their work
• Trademark – exclusive legal rights of firms to use specific names, brands,
and designs to differentiate their products from others
Intellectual property rights (cont’d)
• IPR enforcement is difficult
• Piracy: Unauthorized use of intellectual property rights
◦ Widespread around the world
Economic systems
• Economic system – rules of the game on how a country is governed
economically
• Market economy – an economy characterized by the “invisible hand” of
market forces; the government takes a hands-off approach known as laissez
faire
• Command economy – an economy characterized by government ownership
and control of factors of production
• Mixed economy – an economy that has elements of both a market economy
and a command economy
State owned enterprises
• State-owned enterprise (SOE) – a firm owned and controlled by the
state (government)
Exhibit 2.5: Private ownership versus state
ownership
Exhibit 2.6:
How Many of the Top Firms in the World Are
SOEs?
What drives economic development?
• Culture
• Geography
• Institutions
Exhibit 2.7: Implications for actions