The institution-based view suggests two core propositions on how institutions matter (Table 4.2). First, managers and firms rationally make strategic choices within institutional constraints. For example, hundreds of firms and thousands of individuals around the world are involved with counterfeiting. Close to 10% of all world trade is reportedly in counterfeits. Remember that this is not slavery and everyone involved has voluntarily entered this business. However, no high school graduate anywhere in the world, when filling out a form to determine what would be a desirable career to pursue after graduation, has ever declared an interest in joining counterfeiting. So what happened? Why are so many individuals and firms involved? The key is to realize that managers and entrepreneurs who make such a strategic choice are not amoral monsters but just ordinary people. They have made a rational decision (from their standpoint at least), given an institutional environment of weak intellectual protection and the availability of moderately capable manufacturing and distribution skills. Of course, to suggest that a strategy of counterfeiting may be rational does not deny the fact that it is unethical and illegal. However, without an understanding of its institutional basis, it is difficult to devise effective countermeasures.

Table 4.2.

Two Core Propositions of the Institution-Based View

Proposition 1	Managers and firms rationally pursue their interests and make choices within the formal and informal constraints in a given institutional framework.
Proposition 2	While formal and informal institutions combine to govern firm behavior, in situations where formal constraints are unclear or fail, informal constraints will play a larger role in reducing uncertainty and providing constancy to managers and firms.

Obviously, nobody has perfect rationalitypossessing all the knowledge under all circumstances. Proposition 1 specifically deals with bounded rationality, which refers to the necessity of making rational decisions in the absence of complete information. Without prior experience, managers from emerging multinationals getting their feet wet overseas and individuals getting involved in counterfeiting do not know exactly what they are getting into. So emerging multinationals often burn cash overseas and counterfeiters sometimes land in jail, which are examples of their bounded rationality.

The second proposition is that while formal and informal institutions combine to govern firm behavior, in situations where formal constraints fail, informal constraints will play a larger role in reducing uncertainty and providing constancy to managers and firms. For example, when the formal institutional regime collapsed with the disappearance of the former Soviet Union, it was largely the informal constraints, based on personal relationships and connections (called blat in Russian) among managers and officials that have facilitated the growth of many entrepreneurial firms.

Many observers have the impression that relying on informal connections is a strategy only relevant to firms in emerging economies and that firms in developed economies only pursue market-based strategies. This is far from the truth. Even in developed economies, formal rules only make up a small (although important) part of institutional constraints, and informal constraints are pervasive. Just as firms compete in product markets, so firms also fiercely compete in the political marketplace characterized by informal ties. The best-connected firms can reap huge benefits. For every dollar on lobbying spent by US defense firms, they reap $28, on average, in earmarks from Uncle Sam, and more than 20 firms grab $100 or more. Such enviable return on investment (ROI) compares favorably to capital expenditure (where $1 spent brings in $17 in revenues) or direct marketing (where $1 spent barely generates $5 in sales). Basically, if a firm cannot be a cost, differentiation, or focus leader, it may still beat the competition on other groundsnamely, the nonmarket political environment featuring informal relationships. To use the resource-based language, political assets may be very valuable, rare, and hard to imitate. Note that lobbying is not necessarily corruptionjust a demonstration of certain firms mastery of the rules of the game.

Is one type of institution better than the other? Why or why not? How do formal and informal institutions complement each other?