3 Different institutional environments

Political institutions can shape firm behavior through public pressure and public opinion

theoretical perspective that explains firm behavior and performance by differences in institutional frameworks.

An institutional framework is the set of formal and informal rules that govern individual and firm behavior in a country.

cost of organizing economic transactions

1. Reduction of Uncertainty

• Institutions reduce uncertainty in economic interactions

• Uncertainty reduces firms’ willingness to make long-term commitments (e.g. FDIs)

• Institutions signal what behavior is legitimate and acceptable

• With functioning institutions, firms know what to expect in a specific country

2. Reduction of Potential for Opportunistic Behavior

• Institutions reduce the risk of opportunistic behavior

• Without institutions, firms must take extra precautions

• Working institutions help enforce contracts and prevent violations

Forming legal safe space

• Institutions create legal certainty for firms

• Without institutions, the costs of doing business increase significantly

• Weak institutions discourage foreign and domestic investment

• Example: Firms left markets due to copycats and lack of legal protection

1. Managers and firms pursue their interests and make choices within formal and informal constraints of a given institutional framework.

2. When formal constraints are unclear or fail, informal constraints become more important and help reduce uncertainty.

👉 People then rely on norms, culture and shared expectations.

• Governments derive legitimacy from elections by their citizens

• National elections legitimize the creation of new business rules

• Democracies vary in:

  1. Proportional representation vs. first-past-the-post (winner takes all)

  2. Direct vs. indirect elections of governments

  3. Representative vs. direct democracy

  4. Degree of centralization of power

Back:

• Power is concentrated in the hands of one person or a small elite

• Individual freedoms are limited and submission to the leader’s authority is expected

• Strong ideology is combined with control over military and police forces

• Regimes are sometimes motivated by ethnic nationalism and/or an external enemy

• The distinction between democracy and authoritarianism is not always clear-cut

Back (Answer):

• Political systems determine who sets the rules and whose interests are reflected

• They determine where and how firms can influence legislation

• Political systems differ in stability and reliability, affecting business risk

Back:

• Invisible hand of market forces

• Laissez-faire principle

• Production factors are privately owned

• Freedom of contract

Back:

• Government commands the economy

• Production factors are state-owned and controlled

• Supply, demand, and pricing are planned by the government

Liberal Market Economy

• A system of coordination primarily through market signals (i.e. free labor markets)

• USA / UK / Canada

Coordinated Market Economy

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

• Germany / Sweden / Austria (i.e. welfare state, not totally rely on market signals)

Relevance of Legal Institutions

Property rights

• A fundamental economic function of legal institutions is to protect property rights

• Property rights provide a basic economic incentive system that shapes resource allocation

Corporate Governance

• Specifies the distribution of rights and responsibilities among different participants in the corporation

• Ensures that managers act in the best interest of the firm