Chapter 2: Political, Economic and Legal environment

CHAPTER 2: POLITICAL, ECONOMIC AND LEGAL

ENVIRONMENTS
2.1
Introduction

2.2 An
institution
based view
of
internation
al business

1. What must be remembered is that managers

must have a thorough understanding prior to
doing business in a foreign country. In other
words managers must understand the political,
economic and legal environments which
collectively can be called the rules of the
game for operating in a country.
If managers are aware of these rules then they will
be able to minimise:
uncertainity
transaction cost
constrain opportunism.
1. Peng and Meyer
Formal institutions consists of laws, regulations
and rules.
- Informal institutions consist of norms, cultures
and ethics
1.1 What is the purpose of Institutions?
They reduce uncertainty by limiting the range of
acceptable actions. Uncertainty increases
transaction costs (Williamson). Transaction costs
represent monitoring, enforcing and negotiating
costs. High transaction cost may dissuade firms to
do business in a country.
Institutions tend to evolve over time. For
example, the former USSR has been disintegrated
and transformed into market competition these are
known as transitional economies which require
institutional transition these are known as
fundamental and comprehensive changes to the
formal and informal rules.
See diagram below:
Two core propositions as indicated by Peng and
Myer.

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Chapter 2: Political, Economic and Legal environment

2.3
Political
Systems

1 How a country is governed

politically.
We can explain by the following ways:
a Collectivism
Individualism
b Totalitarian
a Collectivism
Collectivist goals are
more important than
individual freedom.

Democrative
a Individualism
individualism
individual freedom
and self expression

b Totalitarian The world b. Democrac

has four major forms of
people directly
totalitarianism
involved in making
decision
Representative
Commu Collectivis
Democracy
nism
m is
achieved
Characteristics
through
include
dictatorship
- freedom of
Theocra Political
expression
tic
power is
- free media
influenced
- regular elections
by religious
- fair court system
principles
- free access to state
information
Tribal
A political

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Chapter 2: Political, Economic and Legal environment

Right
Wing

power is by
having
influenced,
which are
representat
ive of the
whole
population
Individual
permits
individual
economic
freedom
but
prevents
political
freedom to
prevent rise
of
communis
m

2.4
1 Broadly
Economic
systems
Systems
Market
refers to
Economy
rules how
the country
is
governed
economical
ly.
Command
economy

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Political systems
governed by
Institutions
Rules laid down by
constitutions
There are variations
in the representation
methods
Why are political
systems important
for IB
- rules affect IB
- business can
influence the
legislative process
e.g. copyright laws
- frequent changes in
the rules is a cause of
concern for IB.

there are three types of economic

In a pure market economy, the goods
and services that a country produces,
and the quantity in which they are
produced, is not planned by anyone.
Rather price and quantity are
determined by supply and demand.
For a market economy to work, there
must be no restrictions on either
supply or demand
In a pure command economy, the
government plans what goods and
services a country produces, the
quantity in which they are produced,
and the price at which they are sold.
Resources are allocated for the
good of society. The government
owns most, if not all, businesses,
including even small businesses like
the bread bakery and the local farm.

Chapter 2: Political, Economic and Legal environment

2.5 Legal
Systems

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Mixed
Economy

A mixed economy includes some

elements of each. In Canada, for
example, while most business is
privately owned and operated under
market principles, health care,
electrical power, and liquor
distribution are run by state owned
enterprises in most provinces, e.g. in
France.

Coordinat
ed
market

Here the economy operates through

market signals and such signals
may bring some government
intervention.
E.g. In Germany, employees are in
involved at the Board level to ensure
good corporate governance unlike in
the UK and government support
vocational training. In Asia the
government provides economic
direction e.g. Singapore.

Liberal
Market

In this case the economy operates

through market signals. The price
mechanism has a lot to do on what,
how, when, where, why and by who,
goods and services are produced for
e.g. in UK, USA, Canada and Australia
( Anglo countries )

1. What are the

characteristics
of a legal
systems?

formal rules that regulate behaviour

process by which the laws of the country are
enforced
court system through which people can seek
justice for their grievances

2. What is the
importance of
legal systems?

sets down the rights and obligations in

business
how business transactions are done
how the law regulates business practices.

3. Collectivist
Totalitarian

Restrict private enterprise

4.
Individualistic
market

Support private enterprise and consumer

rights

Chapter 2: Political, Economic and Legal environment

Three
Broad
types of
legal
systems

Issues for
Internatio
nal
Businesse
s

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Common
Law

Relates to tradition, precedent and

customs
Judges look at previous cases to
decide on present cases
Then base on new precedents laws
can be amended.
Based on statutes, customs and court
decisions

Civil Law

Detailed laws organised into codes /

codified into books of law
Judges lead the proceedings,
questioning and deciding.

Religious
Law

Based on religious teachings

Islamic law most Muslim state
But this law has to be adjusted to
modern times so Islamic law combined
with common law and civil law.

Property
Rights

Property rights refer to the bundle of

legal rights over the use to which a
resource is put and over the use made
of any income that may be derived
from that source. Property rights
can be violated by either private
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Chapter 2: Political, Economic and Legal environment

Intellectual
Property
Issues

action (theft, piracy, blackmail, Mafia)

or public action (governmental
bribery and corruption,
nationalization). Lack of
confidence in a countrys fair
treatment of property rights
significantly increases the costs and
risks of doing business.
rights over ownership of intellectual
property e.g. software, chemical
formula, movie or music. The
intellectual property can be protected
in 3 ways:
i. Patent gives the inventor
exclusive rights
ii Copyright authors, composers,
artists, publishers
iii Trademark allows manufacturers
to differentiate themselves from other.
200 countries have signed the
Paris convention for Protection of
Industrial Property to protect
intellectual property rights and are
part of World Property Organisation

Product
safety and
product
liability

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Intellectual property rights

(patents, copyrights, and trademarks)
are important for businesses if they
are to capitalize on what they have
developed. Firms like Microsoft, Levis,
Coca-Cola, or McDonalds would have
little reason to invest overseas if other
firms in other countries were able to
use the same name and copy their
products without permission.
When product standards are lowered
in other countries, firms face an
important ethical dilemma. Should
they produce products only of the
highest standards even if this puts
them at a competitive disadvantage
relative other producers and results in
not
maximizing
value
to
shareholders?
Or should they
produce products that respond to
local differences, even if that means
that consumers may not be assured

Chapter 2: Political, Economic and Legal environment

of the same levels of safety in

different countries? One serious
example I use involves the flame
retardant
nature
of
childrens
pajamas.
In
many
countries
restrictions on the level of flame
retardency are very low and even
nonexistent, and it is perfectly legal
to manufacture that product without
protective
standards.
Should
international
firms
continue
to
manufacture to higher protection
levels, with resulting increased costs
that may put them at a competitive
disadvantage?
Corporate
This relates to how shareholders and
governance other stakeholders are able to control
corporate decision makers.
In Germany there is the two-tier
board the supervisory board that
supervises the decisions of the
executive directors; while in
Singapore big organisations appoint
Independent directors or nominated
executive directors to supervise the
decisions of the normal directors.
There is a variation on how corporate
governance is ensured across
countries.
2.6
Country
developme
nt:
political,
economic
and legal
issues

1. Note that Political, Economic and Legal

factors can have a significant impact on the
economic development of a country as well as it
attractiveness to lure FDI.
2 The measurement of economic growth:
a. Usually the measurement is GDP per capita but
some say that this is misleading as it does not take
into considerations the cost of living
3 The proper measurement is PPP- adjusted GDP
and if we consider idea it is only 6% of the average US
consumer would consume. Still the middle class in
India is huge and hence it will be silly to the discount
the Indian market based on the statistics mentioned.
4 Other ways to measure economic
development? Sen ( 1999) provides such a

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Chapter 2: Political, Economic and Legal environment

measure considers the capabilities and opportunities

of people when measuring economic development.
So the measurements would include:
- removing restriction to freedom e.g. tyranny,
poverty, neglect of public facilities and democracy
- basic health care and education is a must for
economic growth
Note: UN has incorporated Sens idea in its Human
Development Index ( HDI ) this is based on life
expectancy at birth, education, average income
5 Another Question that need to be asked is
Why some countries succeed while others fail?
The answer lies hereunder:
investment and technological progress higher
productivity and economic success
innovation and entrepreneurship are the long
term drivers to economic growth and must be support
by market economy and good strong laws to protect
property rights
higher education is key to prosperity
sound macroeconomic policy of government
low inflation, stable exchange rate, low trade barriers
and low budget deficits
Peng and Meyer ( 2011 ) and North ( 2005 )
see that political, economic and legal institutions are
the basic determinants of the economic progress of
the country as it affects the cost of doing business in
the country.

Short Q & A

QUESTION 1: Free market economies stimulate greater economic

growth, whereas state-directed economies stifle growth. Discuss.

ANSWER 1: Over the past 30 years, the countries that have

achieved the highest levels of GNP per capita or GDP per capita with
PPP are clearly free market economies. Making crude comparisons
with individual countries over this same period (i.e. North Korea vs.
South Korea, USSR vs. USA, Germany vs. Poland) leads to the same
conclusion - free market economies stimulate greater economic

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Chapter 2: Political, Economic and Legal environment

growth. But when looking at growth rates over just the 1980s, the
fact that countries like India and China have some of the highest
growth rates needs to be explained in light of the economic
management of these countries. While neither of these countries
can be considered to be a free market economy, their recent high
growth may be explained by two factors. Firstly, like the other high
growth countries of South Korea and Thailand, they began with a
very low base level and hence had a high capacity for growth.
Secondly, in both cases there were free market reforms that
coincided with the growth. Thus there would appear to be a basis
for saying that free (or at least freer) market economies stimulate
growth.
QUESTION 2:
A democratic political system is an essential
condition for sustained economic progress. Discuss.
ANSWER 2: There are a number of situations that can be cited
where economic growth has been rapid under totalitarian regimes.
It is rare, however, to have sustained (decades) of strong economic
growth without democratic principles at work. Thus it is perhaps
most accurate to say that we in the west believe that democratic
regimes are far more conducive to long-term economic growth than
a dictatorship, even a benevolent one. A free political system allows
for the stable transfer of powerthrough electionsand political
stability is always a necessary condition for rapid economic growth.
QUESTION 3: What is the relationship between corruption in a
country (i.e. bribe taking by government officials) and economic
growth. Is corruption always bad?
ANSWER 3:
By its very definition, corruption means that
government officials are subordinating the interest of their country
in favor of their personal gain. Certainly it is true that bribery and
corruption must be viewed in a cultural sense, because cultural
attitudes are significantly different in different countries. Some
peoples appear to be more open about taking bribes while others,
the United States included, show public contempt for the practice
(although bribery certainly exists even in the United States.)
Nevertheless, many nations with rampant bribery appear to be
among the most economically underdeveloped. The decision to pay
a bribe creates a conflict between what is ethical and what is
expedient. In some countriesGermany, France and Japan, for
instance, bribes are considered a legal corporate tax deduction.
QUESTION 4: The Nobel Prize winning economist Amartya Sen
argues that the concept of development should be broadened to
include more than just economic development. What other factors
does Sen think should be included in an assessment of
development? How might adoption of Sens view influence

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Chapter 2: Political, Economic and Legal environment

government policy? Do you think Sen is right, development is about

more than just economic development? Explain.
ANSWER 4: Sen sees freedom as the ultimate goal of economic life
and the most efficient means of realizing general welfare. It is a
good to be enjoyed by the world's entire population. Sens
philosophy also confronts the human dilemma that "despite
unprecedented increases in overall opulence, the contemporary
world denies elementary freedoms to vast numbers--perhaps even
the majority--of people." Sen explains individual human freedom-the exclusive possession, of no particular nation, region or historical,
intellectual or religious tradition--contains the capacity for political
participation, economic development and social progress.
Governments that are influenced by Sens philosophy would value
greater freedom for its citizens, usually by exchanging economic
development in favor of greater individual freedom. Sen is clearly
righteconomic development is only one measure of a countrys
overall development, and a country that is economically prosperous
while still limiting or imprisoning its citizens surely will ultimately
wither because it will be stifling the individual entrepreneurship that
often leads to economic vitality.
QUESTION 5: During the late 1980s and early 1990s China was
routinely cited by various international organizations such as
Amnesty International and Freedom Watch for major human rights
violations, including torture, beatings, imprisonment and executions
of political dissidents. Despite this, in the mid-1990s China received
record levels of foreign direct investment, mainly from firms based
in democratic societies such as the United States, Japan, and
Germany. Evaluate this trend from an ethical perspective. If you
were the CEO of a firm that had the option of making a potentially
very profitable investment in China, what would you do?
ANSWER 5: While there are those who argue that investing in
totalitarian countries provides comfort to dictators and can help
prop-up repressive regimes, in the case of China these arguments
appear to have been ineffective. Western firms have continued to
invest in spite of these concerns, either out of opportunism or a
belief in a different ethical perspective.
The alternate ethical
perspective suggests that investment by a Western firm, by raising
the level of economic development of a totalitarian country, can
help change it from within. Since economic well being and political
freedoms often go hand in hand, and investment can create jobs
and provide needed goods for individuals, an investment may be
good for the people both in the short and the long run. Perhaps it
was based on this rationale that the Bush administration claimed
that US firms should continue to be allowed to invest in Mainland
China even after the 1989 crackdown on the democracy movement.
As the CEO of a firm that had the option of making a potentially very

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Chapter 2: Political, Economic and Legal environment

profitable investment in China, students should consider not only

the ethical tradeoff but also the importance of the opportunity and
the ethical responsibility one has to shareholders. If there are
opportunities in China, passing these up may simply be allowing a
competitor to gain a first mover advantage that will be difficult to
overcome. Unless all potential competitors from all countries have
the same ethical principles, it is likely that some firm will decide to
undertake the investment in spite of the ethical concerns. (The
withholding of foreign investment, like any other form of collusion or
sanction adherence, requires compliance by all parties if it is to be
effective.) Hence the CEO must consider the ethical responsibility to
shareholders to maximize the value of the firm. In the end the
decision must rest on both ethical concerns about doing business in
China and ethical concerns about what is in the best interest of
shareholders. There is no right or wrong decision, as each involves
different tradeoffs.
QUESTION 6: You are the CEO of a company that has to choose
between making a $100 million investment in either Russia or the
Czech Republic. Both investments promise the same long run
return, so your choice of which investment to make is driven by risk
considerations. Assess the various risks of doing business in each of
these nations. Which investment would you favor and why?
ANSWER 6: When assessing the risks of investment, one should
consider the political, economic, and legal risks of doing business in
either Russia or the Czech Republic. At this time (Fall 2001), the
political risk in Russia is still high but it is undergoing continual
governmental changes. Putin is attempting to unite all parts of
Russia, and is meeting mixed reaction. Recently he threatened to
side with the U.S. in opposition to the oil cartel (although he later
capitulated). At the moment the nuclear arms treaty with the U.S. is
a major source of disagreement with the U.S. In addition, there are
significant divisions in the country both ideologically and ethnically.
Relatively, the Czech Republic is more stable, but it may have less
potential. On the economic front, both countries have inflation and
high economic turmoil as unproductive factories are still struggling.
From the legal perspective, the Czech Republic is making clear
progress, while the situation in Russia is unclear. Thus at this time,
the risk in Russia would clearly be higher. Depending upon when
you are using the book, this situation could be different. (You also
may want to substitute other countries into this question depending
on current events and the countries with which you feel your
students will be most familiar.)

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Chapter 2: Political, Economic and Legal environment

Sample Examination Questions

1.
a. What are the main political systems an international
business
faces when operating in another country?
b. What are the main economic systems?
c. What are the main legal systems?
d. Describe the issues these differences can create for an
international firm.
e. How can these challenges be dealth with? Use examples
and cases to illustrate your points

Tutorial Questions
1.
a. If you were going to start business in a foreign country,
what types of political, economic and legal systems might you have
to
assess?
( 12 marks )
b. Consider how supportive or otherwise these different
systems
might be for international business and the likely
business risks you
would undergo with each system.
( 8 marks )
c. Use country and case examples to illustrate your points.
( 5 marks )

EXAMINATION QUESTIONS
May 2014
1. Environmental analysis is critical for international business. In
the light of this statement discuss:
a.
b.

The main components of a PESTEL analysis

(6marks)
What SWOT analysis is and how a Minimax approach to
developing strategy can be performed, using a company
example of your choice.
(9 marks )
c.
The components and importance of Gehmawats CAGE and
AAA framework, using examples to illustrate your points. ( 10
marks )
Minimax - ( minimising possible
loss) Minimax theory has
been extended to decisions where there is no other player, but

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Chapter 2: Political, Economic and Legal environment

where
facts

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the

consequences of decisions

depend on unknown

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