Institutional voids and business group dynamics: Evidence from judicial reform in China1

Abstract

The influence of external institutional environments on the internal functioning of business groups remains a critical yet underexplored area of research. In this paper, we focus on China's pro-market judicial reforms and examine how these reforms affect internal product and service transactions within business groups, finding that such reforms significantly reduce intra-group transactions. We further demonstrate that this decline reflects a strategic substitution toward external market transactions rather than an overall contraction in firm operations, and that the effect is not driven by managerial self-dealing but aligns with institutional voids theory. The effect is particularly pronounced in regions with underdeveloped product markets and weaker informal institutions, and in firms with lower reputations and stronger political connections. Moreover, our results hold consistently across various transaction types, whether seller- or buyer-initiated, service- or goods-related, and remain robust across alternative regression models, explanations, and regardless of the geographic proximity of group firms. These findings contribute to understanding the role of internal transactions within business groups in addressing institutional voids and add to the broader literature on how business groups emerge and adapt in response to gaps in institutional frameworks.