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CHAPTER THREE

THE POLITICAL AND LEGAL ENVIRONMENTS


FACING BUSINESS

OBJECTIVES
• To discuss the different goals and functions of political systems
• To profile trends in the emergence and diffusion of political systems
• To identify the idea of political risk and approaches to managing it
• To understand how different political and legal systems affect the conduct of
business
• To profile trends in the evolution and diffusion of legal systems
• To examine the major legal issues facing international business companies
• To profile the idea of intellectual property and the basis of concern and controversy

CHAPTER OVERVIEW
When firms source, produce, and/or market products in foreign countries, they encounter
dynamic and challenging political and legal environments. Chapter Three provides a
conceptual foundation for the examination of the political and legal dimensions of
international business operations. It compares major political regimes, discusses their
potential influence upon the development of effective business strategies, and considers
the relevance of political risk. The chapter also examines the major types of legal
systems that exist today, as well as the strategic and operational concerns they pose. It
concludes with a discussion of intellectual property rights and the associated challenges
confronted in an age of globalization.

CHAPTER OUTLINE

OPENING CASE: CHINA’S BUSINESS ENVIRONMENT


[See Map 3.1.]
During its thirty years of communist rule, China prohibited foreign investment and
restricted foreign trade. Then, China enacted the Law on Joint Ventures Using Chinese
and Foreign Investment in 1978. China’s subsequent transformation has been fueled by a
landslide of foreign investments made in response to the country’s market potential,
market performance, improved infrastructure, enormous resources, and strategic position.
Frustrating this process, however, have been the politics of China’s elaborate
bureaucracy, as well as its ill-defined legal system and pervasive corruption. Historically
China has relied upon “the rule of man” and the belief that legal rights are derived from
the power of the individual. It has also endured a long-running legal battle between the
central and local Chinese authorities. Upon joining the WTO in 2002, China agreed to

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continue to reform its business environment and to move toward transparent, rules-based,
enforcement-oriented standards. Coming full circle, today’s fully-owned Chinese
enterprises are themselves becoming global investors, both by acquiring foreign firms
and investing in greenfield facilities in foreign lands.

TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Three. Also,
review the corresponding video clip, “Counterfeiting in China” [World News
Tonight, 3:10].

I. INTRODUCTION
For a multinational enterprise to succeed in countries with different political and
legal environments, its management must carefully analyze the fit between its
corporate policies and the political and legal conditions of each particular nation in
which it operates. Then its must determine how these factors affect the ways in
which the firm can capture opportunities and deflect threats. [See Fig. 3.1.]

II. THE POLITICAL ENVIRONMENT


A political system is the complete set of institutions, political organizations, and
interest groups, the relationships among those institutions, and the political norms
and rules that govern their functions. Thus, it integrates the various parts of a society
into a viable, functioning entity. It also influences the extent to which government
intervenes in business and the way in which business is conducted both domestically
and internationally. The ultimate test of any political system is its ability to hold a
society together.
A. Individualism and Collectivism
It is useful to profile the similarities and differences among political systems
according to the general orientation within a society about the primacy of the
rights and role of the individual versus that of the larger community. Under an
individualistic paradigm (e.g., the United States), political officials and
agencies play a limited role in society. The relationship between government
and business tends to be adversarial; government may intervene in the economy
to deal with market defects, but generally it promotes marketplace competition.
Under a collectivist paradigm, whether democratic (Japanese) or authoritarian
(Chinese) in nature, the government defines economic needs and priorities, and
it partners with business in major ways. Government is highly connected to and
interdependent with business; the relationship is cooperative.
B. Political Ideology
A political ideology is the body of constructs, theories, and aims that constitute
a sociopolitical program (e.g., liberalism or conservatism). Pluralism indicates
the coexistence of a variety of ideologies within a particular society. Although
shared ideologies create bonds within and between countries, differing ideol-
ogies tend to split societies apart. The two extremes on the political spectrum
are democracy and totalitarianism. [See Fig. 3.2.]

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C. Democracy.
A democracy represents a political system in which citizens participate in the
decision-making and governance process, either directly or through elected
representatives. Contemporary democracies share the following characteristics:
freedom of opinion, expression, and the press; freedom to organize; free
elections; an independent and fair court system; a nonpolitical bureaucracy and
defense infrastructure; and citizen access to the decision-making process. In
decentralized democracies, e.g., Canada and the United States, companies may
face different and sometimes even conflicting laws from one state or province to
another.) The defining characteristic of democracy is freedom. Measures of
political rights and civil liberties have been developed to assess levels of
freedom; a country may be rated as free, partly free, or not free. [See Map 3.2.]
D. Totalitarianism.
Totalitarianism represents a political system in which citizens seldom, if ever,
participate in the decision-making and governance process; power is
monopolized by a single agent and opposition is neither recognized nor
tolerated. In theocratic totalitarianism, religious leaders are also the political
leaders. In secular totalitarianism, the government imposes order through
military power. Variants of totalitarianism include authoritarianism and
fascism.
E. Trends in Political Systems.
Several factors have powered the democratization of the world. First, many
totalitarian regimes failed to improve the economic lives of their citizens, who
eventually challenged the right of the state to govern. Second, vastly improved
communications technology weakened the ability of regimes to control people’s
access to information. Third, many people who champion democracy truly
believe that greater political freedom leads to economic freedom and higher
standards of living. Although the world is experiencing general movements
towards democracy and more open economies, this does not necessarily indicate
an increasing homogenization of political systems. In fact, “differentialism”,
i.e., the clash of civilizations, refers to the argument that apparently innate and
largely irreconcilable differences among cultures can trigger a backlash against
Western ideas regarding political rights and civil liberties.

LOOKING TO THE FUTURE: Will Democracy Survive?

There is a clear link between political and economic freedom and economic growth.
However, democracy does not necessarily mean stability; in fact, in a transition economy
political risk is often quite high. The emergent democracies of the 1990s, especially
those of the former Soviet bloc, still wrestle with domestic unrest and security threats.
Although challenges to democracy are many, terrorism stands out above all others. Some
people argue that if a country is to flourish as a democracy, certain preconditions such as
economic development must be present. However, others argue that democracy is the
result of having political leaders who exhibit both the determination and the skills

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required to assure that democratization occurs. Still others feel that indirect support may
flow from Asia’s alternative conception of democracy, where economic freedom is
progressing more rapidly than political freedom. If democracy proves resilient and
resourceful, then managers will face the task of adjusting their operations during periods
of economic crisis, but if democracy falters, then managers will face the task of
rethinking their operations in a world of increasing state control and repression.

F. Political Risk.
Political risk reflects the expectation that the political climate in a country will
change in such a way that a firm’s operating position or investment value will
deteriorate. Leading sources of political risk are: expropriation or
nationalization, international war or civil strife, unilateral breaches of contract,
destructive governmental actions, harmful actions against people, restrictions on
the repatriation of profits, differing points of view, and discriminatory taxation
policies. [See Table 3.2.] The following types of political risk range from the
least to the most destructive.
1. Systemic Political Risk. Systemic political risk creates risks that affect
all firms because of a change in public policy. However, such changes do
not necessarily reduce potential profits.
2. Procedural Political Risk. Procedural political risk reflects the costs
of getting things done because of such problems as government corruption,
labor disputes, and/or a partisan judicial system.
3. Distributive Political Risk. Distributive political risk reflects
revisions in such items as tax codes, regulatory structure, and monetary
policy imposed by governments in order to capture greater benefits from
the activities of foreign firms.
4. Catastrophic Political Risk. Catastrophic political risk includes
those random political developments that adversely affect the operations of
all firms in a country.

POINT—COUNTERPOINT: Political Risk Management

POINT—ACTIVE POLITICAL RISK MANAGEMENT: Active political risk


management reasons that if one measures the right set of discrete events, one should be
able to calculate the degree of political risk in a country and estimate the likelihood that
politically risky disruptions, (e.g., civil strife, terrorism, regime change, ethnic tensions,
contract repudiation, financial controls) will occur. Hence, rigorous quantitative analysis
and modeling should detect, measure, and predict future instances of political upheaval.
Others opt to assess such risk with qualitative measures by polling a panel of country
experts who possess an expert sense of the situation. Then, likely scenarios are
developed and probabilities assigned for a finite period of time.

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COUNTERPOINT—PASSIVE POLITICAL RISK MANAGEMENT: Many firms
choose to treat political risk as an unpredictable hazard of international business. Given
that, the strategically responsible thing to do is find a cost-effective way to hedge the
firm’s exposure. Typically, these companies shield themselves from political risk by
purchasing insurance that protects their operations from various sources of risk, including
government expropriation, involuntary abandonment, or damage to assets due to political
violence. Organizations that offer such insurance include the Overseas Private
Investment Corporation (OPIC), multilateral development banks such as the World Bank
(IBRD) and its regional counterparts, as well as private insurance firms.

III. THE LEGAL ENVIRONMENT


A legal system is the mechanism for creating, interpreting, and enforcing the laws in
a specified jurisdiction. It is the means and methods a country uses to regulate
business practices, define how companies conduct business transactions, specify the
rights and obligations of those engaged in business transactions, and spell out the
methods of legal redress for those who believe they have been wronged. Generally,
legal systems fall into one of the following categories: [See Map 3.3.]
• Common law. Common law originated in the United Kingdom and is
based upon tradition, judge-made precedent, custom, and usage; therefore,
courts play an important role in interpreting the law. Common-law nations
include Australia, Britain, Canada, New Zealand, and the United States.
• Civil law. Civil law, aka Roman law, originated with the Romans and is
based upon a detailed set of laws that comprise a code that includes rules for
conducting business; therefore, courts play an important role in applying the
law. Civil law nations include France, Germany, and Japan.
• Theocratic law. Theocratic law is based upon religious precepts;
ultimate legal authority is conferred upon religious leaders who govern society.
The best example is Islamic law, or Shari’a, which is based on the Koran, the
Sunnah, the writings of Islamic scholars, and the consensus of Muslim
countries’ legal communities. (The key for business success is to adhere to the
constraints of ancient Islamic laws while maintaining sufficient flexibility to
operate in a modern global economy.)
• Customary law. Customary law anchors itself in the wisdom of daily
experience or great spiritual or philosophical traditions. Customary law may
play a significant role in matters of personal conduct in countries with mixed
legal systems.
• Mixed Legal System. A mixed legal system emerges when two or more
legal systems are used within a single country. Although the majority of such
countries are found in Africa and Asia, the United States’ legal system combines
both common and civil law.
A. Diffusion of Legal Systems
The evolution and diffusion of the civil and common law systems gives
managers a sense of the degree of current and likely convergence across
countries. The diffusion of the common law system is embedded in the

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colonization of the British Commonwealth. Other European countries followed
the lead of the Romans in developing their own civil law traditions and then
influenced the legal systems of many neighboring, African, and North and South
American countries. More recently, successful efforts to standardize laws,
particularly with respect to the conduct of business, can be seen in the actions of
the European Union and in the development of worldwide standards in
accounting, disclosure, and bankruptcy. [See Fig. 3.4.]

IV. LEGAL ISSUES IN INTERNATIONAL BUSINESS


National laws may affect day-to-day operations and a firm’s long-term competitive-
ness both within and beyond a country’s borders and pertain to both domestic and
foreign firms. Areas addressed include health and safety standards, employment
practices, antitrust prohibitions, contractual relationships, environmental practices,
intellectual property, cross-border investment flows, tariffs, and non-tariff barriers, to
name but a few. In addition, international treaties among nations may also affect the
nature and extent of business operations.
A. Operational Concerns
Efforts to start a business, to enter and enforce contracts, to hire and fire
employees, and to close a business are all affected by national laws and
regulations. While there appears to be an inverse relationship between a
country’s per capita income and its tendency to regulate business, the legal
systems of the more highly developed countries tend to regulate the major
operational features of business activity more consistently than do the less
developed nations. Further, those countries that make it easy to start a business
also tend to impose fewer and simpler regulations to hire and fire workers and
impose less regulation in their courts and bankruptcy systems. [See Table 3.3.]
B. Strategic Concerns
Many legal issues affect the process of value creation. The following legal
contingencies often shape an international competitor’s strategic plans.
1. Product Safety and Liability. Often products must be customized in
order to comply with local standards, which may be higher than those found
in a firm’s home market. While product liability laws are very stringent in
markets such as the United States, they are spotty, absent, and at times even
arbitrary in many less developed countries.
2. Marketplace Behavior. National laws determine permissible practices in
pricing, distribution, advertising, and the promotion of products, and they
vary widely from one country to another.
3. Product Origin. Local content is important to all nations, and most
countries push foreign firms to add value locally. In addition, product
origin determines applicable fees and may be subject to quantitative
restrictions as well.
4. Legal Jurisdiction. Every country specifies which law should apply and
where litigation should occur when agents are involved—whether they are
legal residents of the same or different countries.

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5. Arbitration. Most arbitration is governed by the New York Convention, a
protocol specified in 1958 that allows parties to choose their own mediators
and resolve disputes on neutral ground.
C. Intellectual Property Rights
Intellectual property rights (IPRs) consist of ownership rights to intangible
assets, i.e., the right to control and derive the benefits from writing and other
creative art forms (copyright), inventions (patents), and identifiers (trademarks).
Problems arise because intellectual property, whether in the form of literature,
music, design, software, scientific patents, or brand names, is difficult to create
but easy to duplicate. Cross-national and cross-cultural legal differences
complicate specifying, regulating, and enforcing intellectual property rights.
The costs of piracy, whether in terms of lost sales and royalties or future
creativity, are very high for registered owners.
1. Level of Economic Development. Generally, less developed
countries provide weaker legal protection for intellectual property than do
industrialized nations. While less developed nations feel they have little to
gain by protecting intellectual property, developed nations feel it is critical
to assuring continuing creativity.
2. National Cultural Attitudes. Countries with a more individualistic
orientation view intellectual property as intrinsically legitimate. In contrast,
countries with a more collectivist orientation extol the virtues of shared
ownership.

CLOSING CASE: Global Software Piracy [See Tables 3.4, 3.5, and 3.6.]

Software technology is plagued by the problem of digital piracy—the illegal copying


and/or distribution of software for personal or business use. An explosive issue, it
increasingly cuts to the perception, protection, and enforcement of intellectual property
rights. Presently software piracy ranges from a single individual’s making an
unauthorized copy of a software product for use, sale, or free distribution to a company’s
mismanagement of its software license. Principal types of piracy include: end-user
piracy, pre-installed software, Internet piracy, counterfeiting, and online auction piracy.
Countries where piracy rates were the highest in 2004 include China (92%), Vietnam
(92%), Ukraine (91%), Indonesia (88%), and Russia (87%). Countries where piracy rates
were the lowest in 2004 include the United States (22%), New Zealand (23%), Denmark
(26%), Austria (27%), and Sweden (27%). The pervasiveness and tenacity of software
piracy in the face of an ever-expanding set of intellectual property rights laws, policies,
and treaties raises profound questions for the software industry in particular and
intellectual property rights in general.

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Questions

1. What is the relationship among the various governments, institutions, organizations,


and companies in developing legal codes to combat software piracy?
Technically, the standards of software piracy are unequivocal. Thus, parties have
been hopeful that collective political arrangements and legal actions by companies,
associations, governments, and institutions would lead to a decline in global software
piracy. However, coordinated anti-piracy initiatives such as high-profile legal
proceedings against companies using illegal software, increased government
cooperation in providing legal protection for intellectual property, and the
criminalization of software piracy have proven to be largely ineffective. Even efforts
at the transnational level to get nations to sign treaties and to require them to protect
and enforce intellectual property rights according to global, not local, standards have
not yielded the desired results. Unfortunately, the ease with which software can be
duplicated, sold, and distributed continues to baffle the industry.

2. In your opinion, should software companies, industry associations, home


governments, or transnational institutions take the lead in aggressively negotiating
with the governments of countries with high piracy rates? Why?
Because of the enormous economic, technological, and political implications of the
problem, software companies, industry associations, home governments, and
transnational institutions should all take lead roles in negotiating with the
governments of countries with high piracy rates. Each of those parties has related
but slightly different arguments to put forth, and it is very important to make the
point that all of the parties are highly vested in the issue—therefore, they should all
step forward. Further, different parties will have stronger or weaker relationships
with the governments of high piracy nations. Those parties who have the most to
offer those governments will be in a position to make their arguments most
persuasively. Thus, efforts of all the stakeholders in the issue should be thoughtfully
coordinated.

3. Can the software industry expect to contain and control software piracy without
eventually relying on governments to take a more active role? Why would the
software industry dislike greater government regulation?
If the software industry could successfully develop technical and business measures
to thwart counterfeiters, government intervention would be unnecessary. Thus far,
the industry’s best efforts have been unsuccessful. Given the value of the products
involved, the “global” appeal of pirated software, and the relative ease with which
counterfeiting occurs on a worldwide basis, the temptation for counterfeiters to
continue their activities is irresistible. In spite of the need for assistance and
cooperation from all stakeholders, the software industry could presumably object to
greater government regulation; while innovation moves at lightning speed, regulation
tends to lag well behind technological developments and market realities.

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4. In your opinion, what rationale do you think consumers in high theft countries (see
Table 3.6) use to justify software piracy? Similarly, what ideas or conditions lead
consumers in lower theft countries to respect IPRs?
Consumers in high theft countries tend to share a collectivist mindset; they see property
as being common to all and existing for the benefit of all—often they do not understand
the basic concept of intellectual property rights. As with many other products, they
want to acquire them at the lowest possible cost. On the other hand, consumers in
lower theft countries tend to share an individualist mindset; the concept of intellectual
property rights is well understood and long established within their countries and
cultures. IPRs are seen to be a necessity for economic development and growth;
royalties and profits are seen as the just fruits of creativity and investment.

5. What sorts of political or legal solutions should the software industry lobby
governments to apply to the piracy problem?
First, the software industry needs to convince governments the world over of the
need for consistent, tough legislation to protect intellectual property rights.
Governments must also be willing to pursue and prosecute violators. To be
successful in these efforts, it may be necessary for software producers in North
America, Europe, and Japan to convince their governments to pressure the
governments in high theft countries to adopt and enforce appropriate legislation.
Second, the software industry should continue to lobby transnational institutions
such as the World Intellectual Property Association and the World Trade
Organization to help establish standards and police piracy.

WEB CONNECTION

Teaching Tip: Visit www.prenhall.com/daniels for additional information and


links relating to the topics presented in Chapter Three. Be sure to refer your students
to the online study guide, as well as the Internet exercises for Chapter Three.

_________________________

CHAPTER TERMINOLOGY:
political system, p.91 political risk, p.99
individualism, p.92 systemic political risk, p.100
collectivism, p.92 procedural political risk, p.100
political ideology, p.93 distributive political risk, p.102
pluralism, p.93 catastrophic political risk, p.102
democracy, p.93 legal system, p.102
totalitarianism, p.95 common law, p.102
authoritarianism, p.95 civil law, p.103
fascism, p.95 theocratic law, p.103
secular totalitarianism, p.95 customary law, p.103
theocratic totalitarianism, p.96 mixed legal system, p.103
intellectual property rights, p.108
_________________________

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ADDITIONAL EXERCISES: Political and Legal Factors

Exercise 3.1. Ask students to discuss the economic difficulties faced when a
country changes from a totalitarian to a democratic political system. Then have them
compare the political transition of a large country (e.g., Russia) to the transition of a
smaller country (e.g., Hungary). Ask whether political transition has been a
smoother process in one of the two countries and examine the reasons for both the
differences and the similarities in the two processes.

Exercise 3.2. Some people argue that the legal justification for ethical behavior is
the only truly important justification. However, others argue that such a position is
insufficient and note that everything that is unethical is not necessarily illegal. Ask
students to discuss possible guidelines they might use when underdeveloped legal
systems lack clear guidance with respect to business decisions.

Exercise 3.3. Ask students to identify companies, both domestic and foreign, that
operate internationally. Have them explore the possible sources of political risk for
each of those firms, given (i) the countries in which they have a presence and (ii) the
basic nature of their products and operations.

Exercise 3.4. Lead the class in a discussion of some of the economic costs
associated with the piracy and counterfeiting of intellectual property rights. Then
ask students to explore the basic issue in light of the following types of legal
systems: common law, civil law, and theocratic law. Is any one system better than
the others for effectively dealing with the problem? Why or why not?

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