Unit 2
Learning Outcomes
After completing this unit you should be able to understand how:
political systems of countries differ.
economic systems of countries differ.
legal systems of countries differ.
national differences in political economy influences management practices.
Prescribed Reading
The prescribed reading for this unit is Chapter 2 and 3 of the accompanying module text.
2.1 Differences in political, economic and legal systems
This unit discusses differences in national political, economic, and legal systems, highlighting the ways
in which managers in global settings need to be sensitive to these differences.
Political differences are described along two dimensions: collectivist vs. individualist and democratic
vs. totalitarian. Economic systems are explored in terms of market characteristics: market economies,
command economies, and mixed economies. Legal systems are discussed in terms of the protections
they offer for business: intellectual property, product safety, liability and contracts.
The opening case focuses on Ethiopia. It has made considerable progress in economic and social
development since 1992 after the Ethiopian People’s Revolutionary Democratic Front (EPRDF)
implemented an ambitious economic liberalization program. The closing case looks at France’s system
of welfare protection after the 2008 financial.
Unit 2 Political and Economic Environment
Previous: 2.1 Differences in political, economic and legal systemsNext: 2.2 Political Systems
Reflective Exercise 2.1
The Opening Case 'Ethipoa: A Land of Opportunity' in Chapter 2 (pp. 37-38) invites you to evaluate the
economic and political situation in Ethiopia. Due to the investment-friendly environment created by the
EPRDF in the country, the inflow of foreign direct investment (FDI) has been increasing over the past
two decades with companies from all over the world choosing to engage in business in the country.
Discuss the following questions:
Question text
1. Discuss how after 1991, Ethiopia’s political and economic environment has changed.
What hampered economic and social development before 1991?
2. Which are some of the economic development challenges Ethiopia still faces?
3. To what extent are personal and political networks important in Ethiopia?
2.2 Political Systems
A political system refers to the rules of the game on how a country is governed politically. Businesses
interact with political systems only indirectly, yet business persons need to understand the political
system because it shapes the commercial rules and regulations for business, and it is a major source
of risk. At a broad level, there are two primary political systems: (1) totalitarianism and (2) democracy.
At a more detailed level, democratic countries vary considerably in how they make and implement
rules.
Totalitarianism (or dictatorship) is defined as a political system in which one person or party exercises
absolute political control over the population. Although the number of totalitarian regimes has declined,
in recent decades, business may still encounter them. In Europe, at present probably only Belarus
would qualify as totalitarian. Why do totalitarian regimes persist when democracy has been sweeping
around the world? The answer is usually a combination of ideology and control over military and police
forces.
An important ideology supporting totalitarian regimes has been communism, which had been
embraced throughout Central and Eastern Europe and the former Soviet Union until the late 1980s. It
is still the official ideology in China, Cuba, Laos, North Korea and Vietnam. Other totalitarian regimes
are motivated by a combination of nationalism, religious motives and a fear of communism. In this
nationalist totalitarianism, one political party, typically backed by the military, restricts political freedom,
arguing that such freedom would lead to communism or chaos. In the post-war decades, Spain,
Portugal and most countries in Latin America and South-East Asia experienced periods of nationalist
totalitarianism before becoming democracies.
Democracy, as originally practiced by several city-states in ancient Greece, is based on a belief that
citizens should be directly involved in decision making. Most modern democratic states practice
representative democracy in which citizens periodically elect individuals to represent them.
Totalitarianism is a form of government in which one person or political party exercises absolute control
over all spheres of human life and opposing political parties are prohibited (Communist, theocratic,
tribal, right wing). Totalitarianism denies its citizens all of the constitutional guarantees asserted by
representative democracies.
Democracies however vary considerably in the way they translate the votes of the public into
legislation, taxation and other government actions. Like the economy, the political system is governed
by institutions. The rules are usually laid down in a constitution, and they determine how elections are
organized, how the public vote is translated into seats in parliament, and how much power the elected
officials or members of parliament attain. These democratic processes influence the relative influence
of different interest groups. Crucial variations among democracies include:
Proportional representation versus first-past-the-post: Most European countries have some form of
proportional representation which implies that, essentially, all votes are added up and seats are
allocated to political parties proportionately to the number of their votes. This system comes closest to
the ideal that all voters are equally important in choosing a country's leaders. Usually, such a system is
combined with a minimum threshold share of votes that parties have to attain, such as 2 per cent in
Denmark, 4 per cent in Sweden and 5 per cent in Germany. In the absence of such a hurdle, the
parliament may become fragmented and unable to support a stable government, as experienced for
example in Italy and Israel. In contrast, many Anglo-Saxon countries, including the UK, the USA and
India, have a first-past-the-post system, in which each constituency elects one representative only.
This system tends to favour the relative strongest political parties and gives less influence to smaller
parties (apart from regional parties).
Direct versus indirect elections of governments: Most European countries have an indirect democracy
where voters elect their representatives in parliament, who on their behalf elect and monitor the
government and the most powerful official in the country, normally the prime minister. However,
some countries directly elect a president with executive power who then appoints government
ministers, notably in France and the USA.
Representative versus direct democracy: In most countries, voters elect representatives (Members of
Parliament) who then act on their behalf. Thus the parliament by majority of the peoples'
representatives decides on for example new law, taxation or government spending. However, in some
territories, voters can vote directly for certain laws, notably in Switzerland and in several US states.
This system gives voters more power, but may lead to inconsistencies and rigidities in the overall legal
framework, as experienced recently in California.
Centralization of power: Normally, the national government is the centre of power, but people also elect
local representations and, in some countries, regional assemblies. The power vested in these sub-
national parliaments varies considerably. Especially in so-called federal systems such as Australia,
Germany and the USA, state-level governments actually wield considerable power, and may even
have to approve certain legislative changes at the federal level.
These are just some of the many subtle differences among democratic systems. Beyond politics, these
rules also determine what selection processes are considered fair and legitimate in other
organizations.
Reflective Exercise 2.2
Read the Country Focus ' Venezuela under Hugo Chavez, 1999-2013' in Chapter 2 (page 42), then
answer the following questions:
Question text
1. Under Chavez’s leadership, what kind of economic system is being put in place in Venezuela? How
would you characterize the political system?
2. How do you think that Chavez’s unilateral changes to contracts with foreign oil companies will
impact upon future investment by foreigners in Venezuela?
3. How will the high level of public corruption in Venezuela impact future growth rates?
4. Currently Venezuela is benefiting from a boom in oil prices. What do you think might happen if oil
prices retreat from their current high level?
5. In your estimation, what is the long run prognosis for the Venezuelan economy? Is this a country
that is attractive to international businesses?
2.3 Economic Systems
An economic system refers to the rules of the game on how a country is governed economically. The
theoretical prototypes are a pure market economy and a command economy, yet between them exists
a wide variety of capitalism.
A pure market economy is characterized by the ‘invisible hand’ of market forces first noted by Adam
Smith in The Wealth of Nations in 1776. The government takes a hands-off approach known as laissez
faire. All factors of production are privately owned and individuals are free to engage in all sorts of
contracts. The government only performs functions the private sector cannot perform (such as
providing roads and defence). A pure command economy is defined by a government taking, in the
words of Lenin, the ‘commanding heights’ in the economy. All factors of production are government– or
state-owned and controlled, and all supply, demand and pricing are planned by the government.
During the heyday of communism, the former Soviet Union approached such an ideal.
In practice, no country has ever completely embraced Adam Smith's ideal laissez faire. It boils down to
the relative distribution of market forces versus other forms of coordination. Historically, many countries
had a system that came close to the model of a pure market economy in the 19th century, notably the
UK and the USA. Yet, here is a quiz: at the outset of the 21st century, which economy has the highest
degree of economic freedom (the lowest degree of government intervention in the economy)? Hint: It is
not the USA. A series of surveys report that it is Hong Kong (notwithstanding that it is under Chinese
sovereignty since 1997). The crucial point here is that even in Hong Kong, there is still some noticeable
government intervention in the economy. During the aftermath of the 1997 economic crisis when
currency speculators short sold the shares of Hong Kong-listed firms to drive down the value of the
Hong Kong dollar. The Hong Kong government took the controversial action to use government funds
to purchase 10 per cent of the shares of all the ‘blue-chip’ firms listed under the Hang Seng index. This
action prevented the devaluation of the currency, and stabilized the economy by driving off the
speculators, but it temporarily placed the blue-chip firms partially into state-ownership.
Likewise, no country has ever practiced a complete command economy despite the efforts of
communist zealots throughout the Eastern bloc during the Cold War. Poland never nationalized its
agriculture. Many Hungarians were known to have second (and private!) jobs while at the same time
working for the state. Black markets hawking agricultural produce and small merchandize existed in
practically all (former) communist countries. In the early 21st century, almost all countries have
become market economies. In practice, when we say a country has a market economy, it is really a
shorthand version for a country that organizes its economy mostly (but not completely) by market
forces and that still has certain elements of non-market coordination. China, Russia, Sweden and the
USA all claim to have a market economy; yet, the ways in which participants in the economy
coordinate their activity varies considerably. The varieties-of-capitalism view suggests that economies
have different inherent logics of how markets and other mechanisms coordinate economic activity.
In a liberal market economy (LME), the coordination happens predominantly by companies reacting to
price signals of the market. Countries such as the USA, the UK and Australia fall into this category. In
these LMEs, companies are predominantly financed by issuing shares that are traded on the stock
exchanges, while labour markets are flexible and employees enjoy relatively little job protection. At the
other end of the spectrum, in a coordinated market economy (CME) such as Italy, Austria, Germany
and France, economic factors such as businesses, governments, trade unions and industry
associations coordinate their actions through a variety of mechanisms; they are not purely relying on
market signals. These countries provide employees with more legal protection – it is not possible to
just tell people ‘tomorrow you are no longer needed’. At the same time, firms have less opportunity to
raise capital through the stock market, or to incentivize managers by linking their salary or bonus to
stock market performance. In addition, employees may have representatives on corporate boards, and
businesses may be directly involved in the educational system, especially vocational training.
2.3 Economic Systems
An economic system refers to the rules of the game on how a country is governed economically. The
theoretical prototypes are a pure market economy and a command economy, yet between them exists
a wide variety of capitalism.
A pure market economy is characterized by the ‘invisible hand’ of market forces first noted by Adam
Smith in The Wealth of Nations in 1776. The government takes a hands-off approach known as laissez
faire. All factors of production are privately owned and individuals are free to engage in all sorts of
contracts. The government only performs functions the private sector cannot perform (such as
providing roads and defence). A pure command economy is defined by a government taking, in the
words of Lenin, the ‘commanding heights’ in the economy. All factors of production are government– or
state-owned and controlled, and all supply, demand and pricing are planned by the government.
During the heyday of communism, the former Soviet Union approached such an ideal.
In practice, no country has ever completely embraced Adam Smith's ideal laissez faire. It boils down to
the relative distribution of market forces versus other forms of coordination. Historically, many countries
had a system that came close to the model of a pure market economy in the 19th century, notably the
UK and the USA. Yet, here is a quiz: at the outset of the 21st century, which economy has the highest
degree of economic freedom (the lowest degree of government intervention in the economy)? Hint: It is
not the USA. A series of surveys report that it is Hong Kong (notwithstanding that it is under Chinese
sovereignty since 1997). The crucial point here is that even in Hong Kong, there is still some noticeable
government intervention in the economy. During the aftermath of the 1997 economic crisis when
currency speculators short sold the shares of Hong Kong-listed firms to drive down the value of the
Hong Kong dollar. The Hong Kong government took the controversial action to use government funds
to purchase 10 per cent of the shares of all the ‘blue-chip’ firms listed under the Hang Seng index. This
action prevented the devaluation of the currency, and stabilized the economy by driving off the
speculators, but it temporarily placed the blue-chip firms partially into state-ownership.
Likewise, no country has ever practiced a complete command economy despite the efforts of
communist zealots throughout the Eastern bloc during the Cold War. Poland never nationalized its
agriculture. Many Hungarians were known to have second (and private!) jobs while at the same time
working for the state. Black markets hawking agricultural produce and small merchandize existed in
practically all (former) communist countries. In the early 21st century, almost all countries have
become market economies. In practice, when we say a country has a market economy, it is really a
shorthand version for a country that organizes its economy mostly (but not completely) by market
forces and that still has certain elements of non-market coordination. China, Russia, Sweden and the
USA all claim to have a market economy; yet, the ways in which participants in the economy
coordinate their activity varies considerably. The varieties-of-capitalism view suggests that economies
have different inherent logics of how markets and other mechanisms coordinate economic activity.
In a liberal market economy (LME), the coordination happens predominantly by companies reacting to
price signals of the market. Countries such as the USA, the UK and Australia fall into this category. In
these LMEs, companies are predominantly financed by issuing shares that are traded on the stock
exchanges, while labour markets are flexible and employees enjoy relatively little job protection. At the
other end of the spectrum, in a coordinated market economy (CME) such as Italy, Austria, Germany
and France, economic factors such as businesses, governments, trade unions and industry
associations coordinate their actions through a variety of mechanisms; they are not purely relying on
market signals. These countries provide employees with more legal protection – it is not possible to
just tell people ‘tomorrow you are no longer needed’. At the same time, firms have less opportunity to
raise capital through the stock market, or to incentivize managers by linking their salary or bonus to
stock market performance. In addition, employees may have representatives on corporate boards, and
businesses may be directly involved in the educational system, especially vocational training.
Reflective exercise 2.3
Question text
1. Free market economies stimulate greater economic growth, whereas state-directed economies stifle
growth. Discuss.
2. A democratic political system is an essential condition for sustained economic progress. Discuss.
2.4 Legal Systems
When you are living or doing business abroad, you are subject to the law of the country in which you
operate; your home country's rules do not apply.29 Thus, you will face a different legal system with its
own laws and processes by which these laws are enacted and enforced. By specifying the do's and
don'ts, a legal system is the cornerstone of formal institutions. This section first introduces and
compares the two main legal traditions, civil and common law before introducing the specific areas of
law of particular concern to business: property rights and corporate governance.
The biggest and most widespread legal system is civil law. It is based on written books of law that have
been influenced by Roman law, and by the French code civil of 1804, which in turn is also partially
grounded in Roman law. In civil law countries, the legal text written and approved by the relevant
authorities, normally the parliament, is the foundation of law. The law thus derives its legitimacy directly
from the elected parliament. Scholarly work on abstract principles and systematic conceptualization
also influence both the drafting of legal texts and their interpretation in legal practice. Judges base their
decisions on logical reasoning grounded primarily in the text and the spirit and purpose of the law, and
on decisions by higher courts. Judicial practice has over time filled gaps in the legal texts, but (contrary
to common law) this is a supplementary source.
Common law, which is English in origin, is shaped by statutes as well as precedents and traditions
from previous judicial decisions. It gives more weight to customary law, and the courts play a more
central role in defining the law, the so-called case law. Statutes passed by legislators cover only
specific areas, and tend to be interpreted narrowly. Hence, common law is continuously evolving as
judges resolve specific disputes with primary reference to precedents set in previous cases of similar
nature. Such extensions of the law then may give new meaning to the law, which will shape future
cases.
Most countries of the world have adapted legal codes based on civil or common law. In British
colonies, the law usually developed along the principles of common law but incorporated local legal
traditions, and this mix was retained after gained independence. Countries that at some stage in their
history wished to introduce an entirely new and coherent set of rules often adapted civil law to local
conditions. For example, many Latin American countries opted for the French code civil, while Turkey
imported the Swiss civil code. German civil law is also the foundation of legal codes in East Asia,
notably Japan, Korea and Taiwan. Yet, application of the law is quite different in these Asian countries
as preference is given to peaceful conciliation and arbitrage rather than public proceedings in court.
Overall, legal systems are a crucial component of the institutional framework. They directly impose do's
and don'ts on businesses, and they influence both the political and the economic system. Two aspects
of the legal systems tend to be of particular concerns to business: property rights and corporate
governance.
2.4.1 Property Rights
Regardless of which legal family a country's legal system belongs to, a fundamental economic function
of a legal system is to protect property rights – the legal rights to use an economic property (resource)
and to derive income and benefits from it. Examples of property include homes, offices and factories as
well as intellectual property. Property rights provide the basic economic incentive system that shapes
resource allocation. In principle, property rights can be defined by formal arrangements or informal
conventions and customs regarding the allocations and uses of property. However, informal
conventions are rarely effective beyond clearly defined communities. The definition of property rights is
one issue; their enforcement is an entirely different one. The rise of the internet has created new
challenges to the definition and enforcement of IPR, including images, music, texts and movies. On the
internet, the enforcement of IPR is technologically difficult, and raises important civil liberties issues.
Some countries are also slow in enforcing conventional IPR. In fact, counterfeiting – the production of
copied products – is a thriving international business.
2.4.2 Corporate Governance
A second aspect of the legal framework that is essential for business is corporate governance that is
the rules by which shareholders and other interested parties control corporate decision-makers
(typically managers). The rules of corporate governance specify the distribution of rights and
responsibilities among different participants in the corporation, such as the board, managers,
shareholders and other stakeholders, and spells out the rules and procedures for making decisions on
corporate affairs. Corporate governance is important to ensure that managers act in the best interest of
the firm, rather than their personal interest. Without effective corporate governance no one would put
their money into someone else's firm -and thus firms would remain small.
Reflective Exercise 2.4
Please answer the following.
Question text
Read the Country Focus ' Corruption in Nigeria' in Chapter 2, page 50. Evaluate the impact of
corruption on Nigeria’s economy.
2.5 Impact of Political Economy on Management Practices
For managers, this unit suggests two broad implications for action. First, managerial choices are made
rationally within the constraints of a given political / economic systems. Therefore, when entering a new
country, managers need to do their homework by having a thorough understanding of the systems
affecting their business. A superficial understanding may not get you very far and may even be
misleading or dangerous. For example, understanding the legal system and codes applying to your
industry may help you understand why local firms act the way they do – and how a foreign entrant
might gain competitive advantage by doing business differently yet within the scope of what is
permitted.
Second, the political / economic systems are not fixed for all times, they do change. Such change is
usually gradual and based on clearly defined processes in the economic, political and legal systems.
Thus, business operating in other countries ought to closely follow what is happening in their host
country to anticipate possible changes such as a change in tariffs or taxation. Understanding these
processes reduces political risk, that is losses from unanticipated changes, and firms may even be able
to influence such changes through lobbying at the appropriate place
Reflective Exercise 2.5
Read the Closing Case 'France's Troubled Economy' in Chapter 2 (page 57) and answer the following
questions:
Question text
1. At times of economic crisis what are the advantages and disadvantages of the French model of
social protection?
2. Given that the leading French companies are more active internationally than domestically, why do
you think the French state still holds shares in them? How would you characterize the role of the state
in the French economy?
3. Do you think that the French social model can survive without radical structural reform? Please give
your reasons.
4. From the perspective of international business what factors might attract investors to France and
what factors might dissuade investors?
Self-Assessment Questions
Please answer the following.
Question text
SAQ 2.1
What is the relationship between corruption in a country (i.e., bribe- taking by government officials) and
economic growth? Is corruption always bad?
A democratic political system is an essential condition for sustained economic progress. Discuss.
End of Unit Summary
The political, economic, and legal infrastructure of a nation has a major influence on the way managers
make decisions. Political systems have two dimensions: the degree of collectivism versus
individualism, and the degree of democracy versus totalitarianism. These dimensions are interrelated;
systems that emphasize collectivism tend towards totalitarianism, while systems that place a high
value on individualism tend to be democratic. However, a large gray area exists in the middle. It is
possible to have democratic societies that emphasize a mix of collectivism and individualism. Similarly,
it is possible to have totalitarian societies that are not collectivist.
There is a connection between political ideology and economic systems. In countries where individual
goals are given primacy over collective goals, we are more likely to find free market economic systems.
In contrast, in countries where collective goals are given preeminence, the state may have taken
control over many enterprises, while markets in such countries are likely to be restricted rather than
free. There are three broad types of economic systems: the market economy, the command economy,
and the mixed economy.
Legal systems are the systems of rules or laws that regulate behavior along with the processes by
which the laws are enforced and through which redress for grievances is obtained. There are three
main types of legal systems – or legal traditions – in use around the world: common law, civil law, and
theocratic law. Common law is based on tradition, precedent, and custom. Civil law is based on a
very detailed set of laws organized into codes. Theocratic law is based on religious teachings.