The Choice of Contract-enforcement Institutions: A Review

Abstract

All public- and private-order institutions have strengths and weaknesses when it comes to the enforcement of contracts. In general, the availability of a low-cost legal system and multilateral reputation institutions is found to be more important for the long-term development of a country than bilateral reputation and private enforcement. The efficiency and cost of institutions differ considerably from place to place. The studies have observed that the cost of using private-order institutions is often lower than public-order institutions in underdeveloped economies. While the existing literature has substantially added to our understanding of contract-enforcement institutions, the issue of complementarity among these institutions has only recently received attention. Investigating this issue may considerably enhance our understanding of enforcement institutions and their economic impact.

JEL: K12, K42

Keywords

Public-order institutions private-order institutions law social norms bilateral reputation multilateral reputation

Introduction

Institutions can be broadly understood as a set of rules that govern the actions of the people (Menard & Shirley, 2005, p. 1). North (1990) argued that the historical difference in growth of economies is the result of difference in the ability of their institutions to secure property rights and enforce contracts at a low cost. Despite the favourable impact of efficient institutions, the countries do not always adopt them (Greif, 1994 studied the role of cultural beliefs in such deviations of institutional structure). As a result, inefficient institutions may persist for a long time and can be the main reason behind the underdevelopment of an economy (Scully, 1988).

One of the important ways in which institutions influence economic activity is through the enforcement of contracts (Acemoglu et al., 2007; Zak & Knack, 2001). The mutually agreed contracts lead to economic development by helping in the efficient allocation of resources and facilitating the division of labour and specialisation. However, the uncertainty regarding the future and the intentions of the other party are major obstacles in the formation of a contract.

A party enters into a contract expecting a positive net payoff from the agreement. The expected payoffs of a party depend on the likelihood of other party performing as per the agreement. A higher probability of default by one party lowers the expected gains of other parties, which, in turn, lowers their probability of getting into an agreement. There can be a number of reasons for a party not to hold their end of the bargain. A party may not perform if non-performance becomes more gainful than the performance in future. It may happen if the party finds the cost of performance to be higher or gains to be lower than the earlier estimates. The party may also receive a better offer for the same performance after the contract. Even if the situation does not change, the time lag between the performances of two parties provides an opportunity for the breach (see Golobardes & Pomar, 2011; van der Beek, 2011 for discussion on problem of enforcement in long-term contracts). The party, which has already received the performance, can always gain by not performing.

A party, who finds breach more beneficial than performance, will keep its promise only if there is a mechanism to punish it in such a way that the breach no longer remains beneficial to her. The contract-enforcement institutions can provide such a mechanism and ensure a trustworthy environment to the contracting parties. There are a number of institutions that may ensure the enforcement of a contract. These enforcement institutions can be broadly divided into two categories, private-order (or informal) institutions, and public-order (or formal) institutions (McMillan & Woodruff, 2000).

Private-order institutions are developed spontaneously out of society’s need to secure contracts (Menger, 1985, pp. 129–138). These institutions are often built on reputation-based punishment. An observable default hurts the reputation of the defaulter with the cheated party as well as other potential partners. Therefore, a default leads to the breaking of ties with the cheated party and lowers the possibility of gainful contracts with any party in the future. The defaulter’s loss due to the breaking of the relationship with the cheated party is called bilateral reputation effect. The contracts which are enforceable through bilateral reputation are called self-enforcing contracts. If the loss of reputation leads to either breaking of ties with a third party (a party who was not part of the contract on which the default has happened) or less likelihood of having a business deal with a third party, then it is multilateral reputation based punishment.

A large number of contracts in a person’s day-to-day life are enforced through a bilateral or a multilateral reputation based punishment. The reputation-based punishment is often supported and influenced by social norms. Social norms also act as enforcement institutions in themselves. They use punishments, such as physical harm, social stigma, social exclusion and feeling of shame, to shape the behaviour of the people and control their actions (Basu, 2000; Elster, 1989). A social norm that forbids people from defaulting on their promises leads to punishment in the event of a breach of contract. This possibility of punishment lowers the likelihood of default.

Public-order institutions are the legal and regulatory systems designed by the state or the ruler having coercive power. Public-order contract-enforcing institutions set the formal rules and create organisations to administer economic exchange and use legal sanctions to deter breach of the contract. Law changes payoffs of contracting parties in a way that cheating no longer remains the best option, thereby, ensuring cooperation. It is argued that, in the long run, an appropriately designed legal system encourages parties to be honest in their dealings, which lowers the likelihood of default.

Private-order institutions can also be designed (Banner, 1998). Unlike public-order institutions, designed private-order institutions are created by the private economic agents through deliberate efforts. Such institutions may result from the efforts of the interacting parties (such as business associations) or a third party (like rating agencies). The designed private-order institutions often need the legal structure provided by public-order institutions or social norms to sustain. In addition to these institutions, parties may use coercion or violence to prevent the breach of contract.

The existing studies have discussed the strengths and the weaknesses of public- and private-order institutions of contract enforcement. The present study reviews these studies to provide an overview of the relative importance of public- and private-order institutions. Also, the existing literature considers often study public- and private-order institutions as substitutes. However, a few recent studies have pointed out the complementarity between the two (Bartling et al., 2021; Bodoh-Creed, 2019). We shall look at the issue as the recent direction of the literature.

The article is divided into eight sections. After the introduction, the second section discusses the bilateral and multilateral reputation as a contract enforcing institutions and conditions for their effectiveness. In addition, it discusses the importance of social norms in the functioning of the reputation-based mechanism. The third section examines the role of social norms in contract enforcement beyond multilateral reputation. The fourth section discusses the importance and limitations of designed private-order institutions. The fifth section analyses law (public-order institutions) and its importance in relation to the role of private-order institutions. The use of coercion in contract enforcement is discussed in the sixth section. The seventh section looks at issue of complementarity of public- and private-order institutions. The last section summarises the discussion.

Bilateral and Multilateral Reputation

A large number of contracts are self-enforcing, that is, they do not require an external enforcement mechanism. A contract is self-enforceable when each party finds it more beneficial to perform than the default. Bilateral reputation may make the contract self-enforcing. Bilateral reputation works because the cheated party terminates the relationship with the defaulting party, as the former expects similar behaviour from the latter in the future as well. Moreover, not reacting to a breach may make default by her other partners more likely.¹ The loss of future business with the cheated party is a powerful disincentive against default when the parties expect a long-term relationship with repeated interactions (that is, repeated contract).

The multilateral reputation effect depends on the reaction of the third party to the default. Breach of the contract by a party in the past indicates the higher possibility of her repeating the same. It results in the defaulting party losing the trust of other potential contracting parties (Klein & Leffler, 1981). The loss of trust or reputation by the defaulting party in the market converts to financial loss, as she starts losing contracting opportunities with others. This fear of reputation loss may prevent parties from defaulting if the present value of these expected losses is higher than the gain from default. A large number of contracts depend on these two institutions for their enforcement. The effectiveness of bilateral and multilateral reputation institutions is contingent upon the meeting of certain conditions which are discussed in the following subsections.

Bilateral Reputation

The Folk Theorem predicts that a contract is self-enforceable when the interaction is repeated for infinite rounds and the payoffs of each party from cheating are lower than the aggregate value of their expected discounted payoffs from future interactions with the same party (Telser, 1980). Thus, the bilateral-reputation works if the parties neither know the time of ending their relationship, nor they discount the future payoffs at a very high rate.

If one of these conditions is violated, it can be logically deduced that the bilateral reputation will not work. Let us first consider the case where the parties know when the game will end.² Assuming that the parties are rational and know the number of rounds that they are going to play, then they would expect the default in the first round itself (Basu, 2000). One can use deductive reasoning to prove it. To understand the logic, let us suppose that A and B are two parties. In the absence of a breach, both parties expect to benefit from a contract. Assume a complete absence of third-party enforcement, so that only those incentives which are based on mutual interactions can prevent a breach. Thus, a party’s decision to play any round in a repetitive contract depends entirely on her expectation about the net gains of the other party from defaulting in that round. If a party expects to play more rounds, the loss of payoffs of all future rounds will prevent her from defaulting by keeping the net gains (which includes gains of all future rounds) negative. It will happen even though the party may have gained in one round. A party may gain by defaulting in the last round default in the last round if parties do not expect to interact any further. With deductive reasoning, we can show that it would mean no contract at all if the number of rounds are finite and known. Suppose A is that party. If the parties know when the game will end (an implication of having a finite and known number of rounds), B would foresee the round in which the default will happen. Knowing about the expected cheating, B will be better off by not performing in the last round. Expecting this from B, A will cheat one round earlier. B will again foresee A’s move by putting herself in A’s shoes. If we extend this reasoning, then at each round A will find that it is beneficial to cheat one round earlier. This logic can be extended to cover all rounds and B will expect cheating in the first round itself. Therefore, the contract, though beneficial for both the parties, will not happen.

This reasoning implies that the bilateral reputation may not work if one of the parties has a high discount rate. A party will default if her discount rate is high enough to make the aggregate present value of expected gains (from the repeated contract) less than her gains from cheating. In addition, the cheated party must know about the default for this mechanism to work. If the cheated party cannot confirm that the breach has happened (which may happen in cases, such as principal-agent problem), then bilateral reputation may not be an effective institution for contract enforcement. Despite the difficulties, the bilateral reputation may support contracts in a number of situations (see MacLeod, 2007). The importance of bilateral reputation increases with age of relationship (MacChiavello & Morjaria, 2015).

Bilateral reputation supports exchange in a limited number of situations, as its effectiveness largely depends on the cost of verifying the quality of good, and certainty and observability of the outcome. In comparison, multilateral reputation institutions are based on a wider information set and can impose severe sanctions, which make it more effective. In fact, multilateral reputation may increase the effectiveness of bilateral reputation.

Multilateral Reputation

The possibility of losing business with the third party is a powerful disincentive against the default. Multilateral reputation works because people expect a defaulter to repeat the behaviour. An important condition for the multilateral reputation to work is that the cost of avoiding adverse selection must be low enough for the parties to detect potential defaulters. In other words, for the multilateral reputation to be an effective institution, the parties must be able to screen their potential partners at low cost before entering into a contract (Aleem, 1990; Bernstein, 2001; Biggs et al., 2002; Singh, 2016). The high cost of screening may render a contract unviable.

The information about past business dealings and conflicts of the parties is an important way to know about a person’s discount rate (Posner, 2000). Nonetheless, it is often costly to acquire information. The cost of obtaining information increases considerably with size of the group or the economy. In such situations, public and private information sharing institutions may prove effective. For example, the records of business or trade associations can provide credible information about the history of a firm (Bernstein, 1996, 2001). Similarly, the public and private credit registries may prove useful in screening.

The studies have highlighted the role of information sharing institutions in the improvement of contractual relations. Based on analysis of 129 countries (Djankov et al., 2007), have found that the information sharing institutions (along with creditor’s rights) have a positive impact on credit availability. The effect of these institutions is especially high among less developed countries. Zazzaro (2005) argues that reforms which improve the quality of information always increase the availability of credit.

Institutions of multilateral reputation provided an effective way of enforcing contracts in the pre-modern world too. For example, Greif (1993) points out that the Maghribi merchants developed a commercial network that allowed them to punish the agents for cheating (also see Greif, 1989). They did it by developing institutions of information sharing and a set of cultural norms. The information-sharing about prices and other aspects has increased the possibility of a merchant to spot cheating. The cultural norm ensured that the Maghribi merchants employ Maghribis as agents. These norms governed the actions of merchants as well as their agents. An agent who cheated was not hired by other merchants. Fearing for their children’s reputation, the agents, even in their old age, refrained from cheating. Similarly, Clay (1997) finds that the reputation-based mechanism facilitated inter-merchant trade between 1830 and 1846 in California.

The institutions of bilateral and multilateral reputation spontaneously arise in response to the need for securing contracts in a given social, political and economic environment. The availability of such institutions benefits all parties who enter into a mutually accepted agreement. For instance, in the example of the Maghribi merchant, the presence of the institution of multilateral reputation must have benefited the agents too. The absence of multilateral reputation would not only have hurt trade but also job prospects of the agents. Thus, the parties have incentive to create (or participate in creating) institutions or mechanisms which make default costly for them. By doing so, they increase the other party’s confidence in them, thereby, increasing the likelihood of other party entering into the contract. An increase in business due to the availability of such institutions benefits even those parties who otherwise would have found default more rewarding. Kadens (2012) contended this perspective. He argued that commercial law resulted from formal institutions rather than customs (also see Börner & Hatfield, 2017). Nonetheless, there is strong evidence to support the role of customs and reputation-based institutions (Alesina & Giuliano, 2015). Studies have shown that the community responsibility may sustain cooperation (Deb, 2020).

Gow et al. (2000) study one such case where the contracting parties, the sugar processing firm and the sugar beet growers, created an internal contract enforcement mechanism. The investment by beet growers was asset-specific. The parties, in an asset-specific investment, enter into a contract only if they believe that default has a high cost for the other party, hence, is unlikely. In the presence of weak legal enforcement, the loss of business with an aggrieved party and other potential partners imposes a cost on the defaulting party. Hence, they are important deterrents to default. The study points out that a party does not default until the benefits of default cross certain threshold level. Using an example from the study, suppose firm A promises firm B to supply a good at a price, p. The good requires an asset-specific investment, and it is costly for any party to default. Suppose that A will default if it can get a price more than p^A and B will default if it can get the same good at a price lower than,p^B . In other words, if p^M is the market price, A will default whenever $p^{M} > p^{A}$ and B will default whenever $p^{M} < p^{B}$ . No firm will breach for a market price within the range $p^{B} - p^{A}$ , that is, the contract is self-enforcing for a market price p^M if the condition $p^{B} \leq p^{M} \geq p^{A}$ holds. Klein (1996) called it a self-enforcing range of the contract.

Gow et al. (2000) argued that a party by increasing the cost of default may increase the self-enforcing range of the contract, which, in turn, will lower the possibility of default. A party may increase this range by framing the contract in a way that the potential defaulter has a higher loss in case of default. Based on this argument, the study analysed the innovative methods used by sugar processing firm, Juhocukor a.s., to make its contracts with sugar beet grower in Slovakia self-enforcing. The Slovak government started economic reforms in 1989, and sugar-processing firms were privatised. After the reforms, Juhocukor, the largest firm in Slovakia, started defaulting on the supplier contracts by delaying the payments to beet suppliers. Prior to the reforms, the production and the processing of sugar were centrally planned, and contracts were enforced through the central authorities. This mechanism was not available under the new structure. The production of sugar beet requires asset-specific investment, as the cost of transporting raw beet was high and Juhocukor was the largest buyer of sugar beet in the area. Since the legal system in Slovakia was not efficient enough to protect the suppliers, the hold-ups of contracts led to a decline in beet production as well as its delivery to Juhocukor. In 1993, a majority shareholding of Juhocukor was purchased by a joint venture of foreign firms, Tate and Lyle and Saint Louis Sucre.

It was not possible for Juhocukor to vertically integrate the production activities, as foreign firms were not allowed to buy or lease agricultural land. Therefore, the new management started making efforts to motivate producers to supply high-quality beet. Juhocukor brought about many innovative strategies to make the contract self-enforcing. Juhocukor used its contract with the growers to increase its own cost of the breach. The new long-term contract included programs to help the producers. Juhocukor, through repayment guarantees, started facilitating the purchase of inputs, and investment in farm machinery and working capital. It started providing technical support and other extension services to producers. In addition, Juhocukor committed itself to timely payment for the produce. Through these contractual innovations, Juhocukor increased the self-enforcing range of own side, which, in turn, lowered the risk of default for beet growers and encouraged them to enter into a long-term contract. Between 1993 and 1997, these changes led to a rise in the yield of beet as well as the contracted area for beet supply. During the same period, Juhocukor recorded a more than three-fold increase in its sugar production.

The reputation-based institutions play a crucial role in the enforcement of contracts in a large number of situations. Their importance further increases with the less developed legal system. Even when the legal remedy is available, the low cost of the reputation mechanism makes them a popular choice. The success of these instruments depends on a number of factors of which the most important are the efficiency of the institutions that govern their interactions and the availability and effectiveness of coercion-constraining institutions (Greif, 2005).

The institutions of bilateral and multilateral reputation are influenced by cultural and social norms. As discussed earlier, bilateral reputation may prevent default in a repeated contract. However, the repeated contracts among the economic agents are susceptible to uncertainties involved in the business. The success of these contracts requires institutions to resolve disputes at a low cost. The parties often use the prevailing social norms to solve their disputes. Social norms help parties to form expectations from a relationship. For example, the trust-based expectations may prevent breach even when the parties know the number of rounds in a repeated contract. Social and cultural norms play a crucial role in the working of multilateral reputation too. They provide rules regarding information sharing, identifying cheating and punishment of the defaulter. Hence, the success of these institutions partially depends on the efficiency of social and cultural norms as well.

Social Norms

Social norms are a set of rules that govern the interactions and exchanges of the people within and outside the community. Any deviation from the social norms may lead to punishments such as social exclusion, feeling of shame, social stigma, criticism and feeling of guilt. Society controls the actions of its people and shapes their preferences by punishing those who break the norms (often termed as ‘rule breakers’).

The studies have noted the importance of social norms as a third-party enforcer of the contract (Fehr & Fischbacher, 2004; Frank, 2008; Kandori, 1992). It is an important alternative to legal enforcement (discussed in the next section). They can ensure that parties perform as per the contract even when a contracting party has an incentive to default. The punishment by society acts similar to legal action. It deters the members of society from certain actions. Experimental economics has shown that people do not always behave in self-interest. They care about their image in the society and fairness of their action, keep promises, and tend to punish those who break the norms. These punishments may either lower the utility of the defaulter or lead to monetary loss. People do not default if the cost of breaking the social norm is higher than their gains. In other words, people behave selflessly in certain cases due to prevailing social norms. Social norms, which encourage selfless behaviour, promote trust-based contracts. The enforcement of such contracts is generally less costly as they require fewer formalities.

It should be noted that even though the institutions of multilateral reputation use cultural or social norms as rules, the effect of social norms goes beyond the scope of multilateral reputation. Unlike the multilateral reputation, people who punish a party for defaulting may not directly benefit from this arrangement. Multilateral reputation is limited to an arrangement among a group of economic agents who are engaged in a common or related economic activity. In contrast, social norms are enforced by people from a social group who may not be interested in economic transactions with the defaulting party. In addition, certain punishments, such as the feeling of guilt for breaking a norm, do not involve reputation.

Basu (2005) argued that people are not guided by their selfish motives alone but act selflessly and care about fairness. The study points out that people do not walk-off without paying taxi fare even though they may have the incentive to do so. In this case, the fear of getting beaten up by the driver, as some may argue, cannot be the reason to pay the fare, because it does not explain why does a taxi driver not take more money by threatening or beating up the passengers as she could do in the absence of a payment? The study argues that social norms are the reason for the payment of taxi fare. Similarly, in a large number of contracts, which have a time lag in exchange and both parties are interacting just once, people do not default because of the social norms, even though the default is the best strategy in these cases.

Lower transaction cost makes social norms more suitable to handle small day-to-day contracts. Therefore, people usually prefer social norms to coordinate their activities and resolve their disputes and have little knowledge of the existing laws (Posner, 2000). Even when they are aware of the law, they often choose to ignore it due to its high cost. Ellickson (1991) found that cattlemen of Shasta County are often unaware of the existing laws that govern sharing of fencing cost and cattle trespassing. They resolve their dispute using the existing social norms. The punishments for breaking the norms include gossips and mild physical reprisals. The effectiveness of social norms declines with the increase in monetary incentives of not following the norm. People are also less likely to follow the norm if they believe that their relationship is for a short period. The study concluded that cattlemen prefer social norms because of their lower transaction cost as compared to those of formal institutions.

The lower transaction cost led studies to argue that social norms, ethics and moral codes exist because they promote society’s common interest and are needed to correct market failure. Arrow (1971) argues that social norms can be considered as agreements among people to provide those commodities which cannot be supplied through the market mechanism. In the absence of these norms, no one will trust each other which will adversely affect economic activity. Even if it is possible to provide these commodities through the market mechanism, it will be very costly to include new entrants.

Social norms are not the same in all societies, and there are large variations among societies as far as the types of norms are concerned. Henrich et al. (2004), in an anthropological game-theory experiment conducted in 15 small-scale economies, find considerable differences among societies in their fairness and cooperation norms. They find that the social corporation in productive activities and society’s integration with the market increase cooperation and explain most of these differences.

The above arguments show the importance of social norms in day-to-day economic activities. Nonetheless, social norms, as an institution for contract enforcement, have limited scope compared to a well-established legal system. Social norms generally require regular interaction between the potential rule-breakers and people who can punish her, to be effective. That is why they are more effective in small groups, where people repeatedly interact with each other (Cross, 2002). Since the chance of regular interaction declines with size of the group, the cost of breaking social norm declines and it becomes difficult to ensure compliance. Also, an increase in the number of rule-breakers increases the cost of punishment, thereby lowering the likelihood of being punished. An increase in the default rate lowers the number of punishers. It lowers the cost of default which, in turn, increases the likelihood of default. In addition, society needs to know the details of default and some evidence to punish the rule breaker. The society may not punish if the information on default is incomplete or vague. For example, society can criticise a defaulter only if they know about the default and reason behind it. Knowing the reasons becomes even more important if social norms allow unavoidable defaults. Social norms will be less effective if the cost of providing information is high. These limitations make social norms less effective as an enforcement institution in many situations.

Despite the importance of social norms as a contract-enforcing institution, they do not always promote common interest and many norms make the whole society worse-off (Elster, 1989). In certain cases, these may prohibit the happening of useful activities and socially beneficial contracts. Further, these may promote harmful activities in certain situations. Akerlof (1976, 1980) argues that in many cases, people do not make profitable transactions because of the fear of social sanctions. According to him, people who follow social norms may benefit more in the long run as compared to those who break the law and have to bear social sanctions. Studies point out that the social norms related to the caste system in India may be creating inefficiencies by inhibiting the free movement of labour in different occupations. In this case, people, who follow the code of social custom, may be better off than those who do not, because the deviants have to bear the punishment. Thus, the whole society may get trapped in a lower-level equilibrium due to those social sanctions which prevent welfare-enhancing activities. The fact that social norms neither promote cooperation nor increase efficiency in all cases, makes it crucial to study the relative importance of law and social norms.

Designed Private-order Institutions

Designed private-order institutions are established intentionally by economic agents for a specific purpose (unlike other private-order institutions which arise spontaneously). These institutions, like public-order institutions, have formal rules and may be established by interacting parties or a third party (see Greif, 2005). These institutions include trade and business associations, credit rating agencies, market trading companies, and the stock market. The designed private-order institutions use economic sanctions by its members to prevent cheating. These institutions create an information-sharing mechanism and coordinate the actions of their members to increase the effectiveness of sanctions.

Bernstein (2001), in her study of the cotton industry, finds that trade association can ensure the effectiveness of reputation as an institution of contract enforcement by providing credible information about the history of a firm. Similarly, Quinn (1997) discussed private-order banking institutions designed by the goldsmith-bankers of London in the seventeenth century. These goldsmith-bankers developed a system for mutual debt acceptance and inter-banker clearing. The web of inter-banker clearing helped in wider acceptance of bank-issued exchange media in England. The system was sustained by mutual self-interest supported by social ties and close relationships among the bankers.

Designed institutions may lower the likelihood of default by altering the incentive structure of the economic agents through a change in the structure of their interactions. For instance, the replacement of infrequent dealings among many parties with the frequent exchange between the two will increase the effectiveness of reputation-based institutions. Credit cards and stock exchange are two private-order designed institutions which work by replacing multiparty infrequent transections with frequent transactions between two parties (see Banner, 1998 for discussion on the development of the New York stock exchange in the nineteenth century).

Designed private-order institutions, like the legal system, often has higher establishment cost due to the cost of collecting information, making formal rules regarding its working (these rules must be able to support the enforcement) and attracting parties to join the organisation. Once established, the marginal cost of including new members is generally low. The individuals who control these designed institutions may benefit from exploiting their position. The possibility of losing customers and future profits, however, acts as a strong deterrent against such tendencies making the occurrence of such incidence highly unlikely. For the fear of losing future profit to work as a deterrent, the present value of their future profits to be sufficiently high and other parties must be able to verify the facts at a low cost. Therefore, the success of a designed institution depends on the incentive structure and flow of information within the institution.

The existence of the designed institutions often depends on social norms and customs or law for support. For instance, many institutions, such as Community Responsibility System in medieval Europe, were based on intra-community enforcement (Greif, 1989, 2005). Such intra-community enforcement generally depends on social norms and customs. Similarly, credit rating agencies require public institutions to verify the identities of their members.

The designed private-order institutions may be developed because of the inability of the existing institutions to support beneficial economic activity or their inefficiencies. Bernstein (1992) finds that the diamond industry prefers its internally developed rules and institutions due to their superiority over legal enforcement. Such institutions may significantly affect the contract-formation and enforcement strategies of the parties.

The designed private-order institutions need not be always efficient. Kali (1999) argues that business networks have to be sufficiently large to be efficient. Some of the designed institutions, such as civil societies, may arise to thwart the enforcement to benefit a particular section.

Law

Law is the most important mechanism available to the parties for resolving their disputes. The reason for its higher importance than others is that it can provide clear rules to the disputing parties on different aspects of the disagreement. The clear rules help the parties to form expectations about the gains before entering into a contract (Hay & Shleifer, 1998). Law is the most suitable institution to enforce contracts in a larger group as the informal institutions often play a relatively minor role in securing them (Ramseyer, 1991). It is especially so when the gains from defaulting are large and there is a significant time gap between writing the contract and its performance. In addition, the private-order institutions may be vulnerable to changes in the economic environment such as liberalisation of trade (Woodruff, 1998). This is why many researchers point out that a high-quality legal system is better than depending on informal institutions, such as social norms.

Cross (2002) argues that informal enforcement is generally costlier, difficult to monitor, creates violence and inhibits change from inefficient to efficient rules. The absence of efficient formal rules has a negative impact on economic growth by limiting competition, division of labour and specialisation by hindering the beneficial transactions among the members of a larger group. The study points out that formal rules need not necessarily destroy cultural-ties. Informal arrangements may prevail within a formal institutional structure where the formal rules may reduce the cost of enforcement by providing an extra layer of protection (also see Kornhauser, 1983).

These arguments do not establish the ineffectiveness of private-order institutions in a large group. They do, however, establish the necessity of formal institutions for the expansion of economic activity, where both public- and private-order institutions can help in establishing a more efficient system by correcting the drawbacks of each other. Law can also improve the system by changing the inefficient social norms. Cooter (1998) argues that law can create or destroy the social norm by creating a focal point that can tip the system to a new equilibrium. Law can compel people to follow a rule even if the existing social norm does not allow it. If the law is efficient, then people will be better off by following it rather than social norms. The gains of following efficient rules will increase the number of people following the law. In the long run, the efficient law will change individual values of rational persons, as they will internalise legal rules due to its benefits. Thus, the law may benefit rational people by providing an opportunity for Pareto self-improvement.

The effectiveness of law depends on the efficiency of its rules and its low-cost implementation.³ The efficiency of legal rules is the first requirement of an effective law. A Pareto optimal solution may require the law to be flexible. For example, a default may also lead to Pareto improvement (Barton, 1972; Posner, 2003). An efficient legal system must allow Pareto improving defaults while discouraging the others.⁴

The efficient rules are necessary but are not enough to secure the contract. The ability of the legal system in securing contracts is contingent upon the efficiency of law-enforcement. Litigation is not costless. The decision of a court is based on ex-post verification of the facts on the parties’ actions and calculation of damages of one party due to the action (or inaction) of the other. The time taken by the court to verify facts and take decision may enhance the cost of litigating parties. While entering into a contract, the parties add this expected cost of enforcement to the cost of undertaking a project. Thus, a higher cost of enforcement may make a large number of mutually beneficial contracts unviable. In addition, the effectiveness of the law to enforce contracts depends on the possibility of the abuse of power by public servants, judges, and politicians which may affect the expected cost of enforcement.

The next two subsections provide insights into issues with regard to the efficiency of legal rule and problems associated with the legal enforcement of the contract.

Efficiency of Legal Rules

Efficient legal rules are a must for the contract enforcement leading to a Pareto-optimal solution. By the definition, a legal rule is efficient if it allows Pareto-improving breaches but prevent others (see Cooter & Ulen, 2004). In other words, the breach of the contract should happen only if it can make at least one party better off without making anyone else worse off. Since a dispute happens because the breach makes someone worse off, the Pareto condition often proves to be inappropriate for examining efficiency of a legal rule. Therefore, a conditional definition of efficiency is used to analyse the law. The conditional definition requires gains of the better-off party from breach to be large enough to compensate the total-loss of worse off parties (this definition does not require actual compensation).

The efficiency analysis of law needs to consider the cost of enforcement too. For instance, if two rules are considered as possible solutions to a problem and both are efficient based on Pareto criterion, then the rule, which is less costly to use (that is, which minimises enforcement cost), is considered better. It is argued that optimal rules for contract enforcement are those, which increase the aggregate welfare of all the parties, that is, the legal solution maximises the net gains (after deducting the cost of legal enforcement) of the parties (Goetz & Scott, 1977). Here, it should be mentioned that a rule, which leads to Pareto improvement in theory, might not do so in reality due to the problems in implementation. Nonetheless, a theoretically efficient rule has a higher probability of leading to an efficient outcome than an inefficient rule.⁵ Further, the law is not meant to solve all disputes through the court. It must be able to encourage and guide the parties to reach a mutually agreeable solution to their dispute without going to the court (which lowers the enforcement cost too). Hence, the efficiency of a legal rule must be understood in terms of the incentive system shaped by it which prompts parties to choose a Pareto-optimal solution without going to the court.

A law is considered efficient if it resolves the dispute based on the terms agreed upon by the parties. This is so since, the parties agree to a term only if each one of them is expected to benefit from it, which signifies Pareto-improvement. By implication, it means that the courts can ensure the Pareto optimal solution of the dispute by enforcing mutually agreed terms of the contract. This efficiency attainment through the enforcement of contract terms is only possible if the parties have written a complete contract that foresees all possible contingencies and provides a solution for each one of them.

Despite the obvious benefits of writing a complete contract, bargaining on all remote possibilities may cost more than the expected loss due to them. Moreover, the parties may not have the information on all possible contingencies. Therefore, it is efficient to leave gaps in the contracts (Ayres & Gertner, 1989). In such a situation, the contract law which fills this gap can ensure Pareto optimal solution. Shavell (1980) argued that the damage-remedy fills the gaps in contracts by requiring the defaulting party to pay for the loss of the second party caused by her breach of promise. To ensure efficiency, the law must prevent a breach if the loss of the aggrieved party is higher than that of the defaulter but allow any default that improves the overall welfare of the parties. With the availability of expectation damage remedy, a party will only default if her gain from defaulting is larger than the loss of the aggrieved party that she has to pay. Since the damage-remedy allows breach only when a party can gain enough from it to pay for the loss of others, it results in a conditional Pareto-optimal solution.⁶ Thus, the damage-remedy allows efficient breaches and prevents all inefficient ones (Cooter & Ulen, 2004; Yorio, 1982).

A huge literature is available on efficiency implication of various legal rules. A large number of studies examine the difference in the legal provisions that govern the contracts in various countries and their efficiency implications. In a number of cases, the differences in legal provisions came from the legal origin of the country. For example, many legal provisions in common law countries differ significantly from those in civil law countries. Legal provisions are not the same even among countries with the same legal origin. For example, some of the legal provisions in India are different from other common law countries (Singh, 2013). Further, there are strong disagreements among ‘law and economics’ scholars over the efficiency impact of many rules. A number of issues regarding contract law have been extensively debated in the literature. These differences arise because of the different results produced by the theory under different assumptions, and many of the debates remained inconclusive due to the lack of empirical studies to test the theory (Geis, 2005).

Though law and economics scholars disagree on some important issues, the four decades of research on contract law has provided important insights into the implications of the legal rules on economic activities. The difference in the legal rules may create significant inefficiencies in the economy. The efficiencies, in fact, maybe part of the working of a legal system itself. For example, La Porta et al. (1997b, 1998) often referred to as LLSV in the literature, found that common law countries are better at protecting the interest of shareholders than civil law countries (also see Charron et al., 2012). In addition, civil law (especially French civil law) countries have weaker creditor protection than common-law countries. This weaker protection is the result of both weaker legal rights of investors and weaker enforcement of the rights. Further, it was shown that the legal systems with better protection of creditors and outsider-shareholders are associated with a more developed financial system (La Porta et al., 2008; see Djankov et al., 2003, 2006, 2007; Haselmann et al., 2006; Rajan & Zingales, 1998; Visaria, 2009, for discussion on similar issues).

Levine (1998) found that countries with better creditor’s rights and strong enforcement of contracts have a more developed banking system than the countries where creditor are less protected and enforcement is weak. In addition, the components of banking development, defined by the instrumental variable set for legal origin, and for creditor’s rights and efficiency of legal enforcement, have a positive effect on the growth of per capita GDP, capital stock and productivity. Similarly, Djankov et al. (2008), based on the analysis of bankruptcy law of 88 countries, argue that legal rules in developing countries, which are made to protect creditors, create significant inefficiencies. The study finds that 80% of the insolvent firms in developing countries end up being sold piecemeal due to inefficient rules. In contrast, the bankruptcy laws in developed countries (though time-consuming and expensive) generally succeed in saving the firm. These findings indicate the importance of efficient law and legal enforcement in economic development.

Problems of Legal Enforcement

The efficient enforcement of the law is an important indication of an efficient legal system. Costless and unbiased enforcement of an efficient law helps parties to enter into Pareto improving contracts. In reality, the enforcement is hardly ever costless and unbiased. The higher cost of enforcement and bias in the system discourage the aggrieved party from going to court and prompts the defaulting party to attempt to manipulate the outcome. It results in a higher probability of inefficient defaults and less likelihood of mutually agreeable solutions (which may mean higher enforcement cost). A legal system becomes more and more successful as it gets closer to providing low cost and unbiased enforcement of the law.

There are a number of reasons for the inefficient enforcement of the law. The inefficient legal and administrative system is a major reason behind costly and faulty enforcement. The lack of proper records, ambiguous rules, and corruption in public offices cause a delay in the court decisions and lead to a higher level of error. The longer trial duration increases the transaction cost for the plaintiff, and lowers the value of the contract, thereby affecting the economic activity adversely (Fabbri, 2001).

Corruption among the public officials and the judiciary leads to serious inefficiencies in the enforcement. The legal system often requires the litigants to reveal information about their wealth. If the parties believe that people who hold public offices may abuse their power, then they may not use legal institutions fearing that it will weaken their property rights (Greif, 2005). Those in power may use corruption and bias in administration and legal system to manipulate justice system by to their own advantage.

A number of empirical studies analysed the effect of inefficiencies in legal enforcement on economic outcomes. These studies have found the low quality of legal enforcement to have a significant negative impact on economic activity. Fabbri (2001) investigates the effect of an increase in trial duration on the value of collateral for the lender in the credit market and found a negative relationship between the two. The study shows that the availability of the funds to the corporate sector depends on the efficiency of legal enforcement of credit contracts. A more efficient legal enforcement (which takes lesser time) is associated with a higher level of private investment.

In another study, Fabbri and Padula (2004) developed a model to understand the relation between the quality of the legal system and the availability of credit. The model is empirically tested using data on credit availability to Italian households in different judicial districts and the quality of legal enforcement in those districts. The results show that an increase in the pendency of the cases had a significantly positive relationship with the probability of turning down the credit to a household. Shifting a household from a high-cost judicial district to a low-cost judicial district found to have lowered its probability of being credit-constrained by 50%. Similarly, Magri (2007) examines the effect of enforcement cost on the participation of Italian households in the debt market. The article found that an increase in the cost of enforcement lowers the likelihood of a household participating in the debt market and the loan size was negatively affected by the higher enforcement cost.

The quality of legal system is often found to be positively associated with the average firm size. Laeven and Woodruff (2007) examine the impact of quality of legal system on firm ownership and firm size in Mexico. The study finds that one standard deviation improvement in the quality of legal system is associated with a 0.15 to 0.30 point increase in firm size. Cungu et al. (2008) study the effect of inefficient contract enforcement on the level of investment in Hungary. The effect is found significant for higher level of investment.

The studies argue that the excessive formalism of the legal system is one of the main reasons behind enforcement inefficiencies and is found to be positively associated with the trial duration. In this context, Djankov et al. (2003) study the procedures of evicting the tenant for non-payment of rent and collection of bounced checks in 109 countries. The study finds that the expected duration of dispute resolution is positively associated with formalism in the judicial system. The level of formalism is found higher in the civil law countries and in the developing countries. Some studies argue that formalism can be efficient in some countries as it may reduce judicial error and prevent external influence on judicial decisions. However, the article rejects this view. It finds that a longer trial duration increases the cost for the disputing parties, thereby, making the courts less attractive way of resolving disputes. The association of legal origin with formalism and economic outcomes indicates that formalism is less likely to be efficient.

Chemin (2009) studies the effect of speed of the judiciary (measured in the form of judicial procedural ambiguity and complexity) on economic activity in India. The article, at first, establishes that the amendments in the Code of Civil Procedure by High Courts (which increase its procedural complexity) and the conflicting decision by High courts in different cases (which lead courts to spend more time on choosing among conflicting views) are significantly related to longer trial duration. Then, the effect of a longer trial duration on economic activities is examined. The study finds that the farmers had less access to the credit due to higher trial duration, which, in turn, adversely affects agricultural development. The regression results suggest that the judicial inefficiencies have a negative impact on contract-intensive sectors of the economy, such as registered manufacturing as well as the overall economy. Koehling (2000), in a similar study, finds a negative impact of long trial duration and uncertainty regarding the trial outcome on the economic growth of India.

Efficient enforcement requires a high probability of enforcement of rules. The studies point out that the higher nominal sanctions cannot substitute an efficient legal system, as some people may believe. Schwartz and Tullock (1975) argued that the lower probability of enforcement of rights, though associated with the lesser cost of enforcement, has a high cost of error. Therefore, substituting a lower probability of enforcement with an increase in nominal sanctions (to keep the expected sanctions at a higher level) does not reduce the cost of enforcement. To make the argument clear, let us assume that efficient enforcement requires the court to award damages y to the aggrieved party. Suppose, the court may award damages x with probability p and zero with probability (1–p), so that, $p x + (1 - p) .0 = y$ . If $p < 1$ , then the damages awarded may be higher (x) or lower (zero) than the actual damages (y). This difference between damages awarded and actual damages is an error, which will increase with a decrease in p. Even though the average damages awarded may remain the same, the increased error in awarding damages may allow Pareto inefficient defaults and prevent Pareto efficient defaults in a large number of cases. This error makes it difficult for the contracting parties to form expectations leading to considerable losses.

The above discussion shows that the efficient legal rules may not be enough for an efficient legal system and the enforcement of these rules must be efficient too. The literature points out that the quality of legal enforcement is lower in developing countries. Due to weak enforcement of law, people tend to use alternative ways of enforcement (Fafchamps, 1996; Santhakumar, 2003).

Other Alternatives of Contract Enforcement

Coercion and use of violence are two commonly used alternatives of law and other private-order institutions to enforce contracts. The studies suggest that the alternatives to the legal resolution of a dispute may prove costly for the society than the efficient enforcement of the law (Bates et al., 2002; Santhakumar, 2003). The use of violence to enforce contracts may result in significant inefficiencies. It may not only result in enforcement of inefficient contracts but also adversely affects the economic activity by discouraging contracts due to the fear of severe punishment and by raising the overall crime rate. A high crime rate discourages investment by making property rights insecure.

The parties often resort to coercion and violence due to the inability of legal and private-order institutions to ensure low-cost enforcement. Fafchamps (1996) examines the enforcement of contracts among producers, resellers, and buyers in Ghana. The markets in Ghana are marked by unreliable quality of products and delayed supply. The late payment by buyers is commonplace. These delays and uncertainties increased the cost of doing business in Ghana. The study found that people prefer bilateral reputation to solve these problems. The majority of people try to preserve their relationship in the long run. The interest of parties in long-term business relations makes bilateral reputation the most important enforcement institution. Parties frequently reschedule the date of delivery of products or debt payment instead of terminating a relation. The multilateral reputation institutions were found to be largely ineffective due to the absence of information-sharing mechanisms among parties. Legal enforcement was also avoided due to its high cost. Only a few firms, among the total surveyed, had ever entered in a formal contract or gone to the court. In the absence of multilateral reputation and efficient legal enforcement, the likelihood of default was high especially in cases of debt payments. Parties commonly used coercion and regular visits to the debtor’s home or workplace for debt collection. There were cases when a debtor moves her business and home to a distant location or even becomes untraceable. The article argued that the growth of the firms in Ghana suffered because of the inefficient legal system and the lack of multilateral reputation institutions.

In some cases, the contract is enforced through private external enforcement. Private enforcement generally includes the use of violence by a third party to compel parties to perform. The third-party enforcer receives a fee in exchange for its services. Though violence or criminal activities may seem successful in a few cases, these may lead to greater inefficiencies in the economy. The mechanisms which are used by private enforcers are unclear and inflexible and the fear of violence discourages people to take up risky projects. Hay and Shleifer (1998) found widespread use of private (criminal) enforcement of the contract in Russia after the collapse of the Soviet Union. The legal system is used much less than their actual need due to its low quality. The private enforcement of contracts led to significant inefficiencies in Russia, as it failed to provide clear and efficient rules that can govern all cases. The lack of clear rules inhibited people from forming expectations from a project. The failure to form expectations lowers parties’ probability of entering into a mutually beneficial contract. In addition, the use of violence increased the cost of failure. The study points out that the arbitrary solutions of private enforcers of contracts do not lead to a better situation. Such enforcement mechanisms discourage entrepreneurship and hurt investments.

The common use of private external enforcement increases the overall crime rate, which, in turn, hurts the economic activity. Bonaccorsi di Patti (2009) studies the impact of the crime rate on the terms of bank loans. The study is based on the data on 330,000 bank-firm relationships of 67 banks in Italy. The results show that borrowers, in high crime areas, pay higher interest rates and pledge more collateral than borrowers in low-crime areas. They often resort to revolving credit lines than using asset-backed loans. These studies show that the use of violent alternatives to law, social norms, and reputation-based institutions may prevent economic activities from expanding and may keep the economy underdeveloped.

Are Enforcement Institutions Substitutes or Complements?

The studies have intensely debated the efficiency implications of public- and private-order institutions of contract enforcement (Cooter, 1998; Cross, 2002; Hay & Shleifer, 1998). While the literature is in agreement over inefficiencies of coercion and violence as instruments of enforcement (Hay & Shleifer, 1998), the disagreements over the relative effectiveness of legal institutions, reputation, social norms and designed private-order institutions remain.

Along with the disagreements, many issues are still largely unexplored. One important question that is not addressed is whether public- and private-order institutions are substitutes or complements. Majority of the existing literature suggests it to be the former. A prominent pattern, emerging in literature, is that people rely more on private-order institutions for small stakes, repeated contracts and interactions within the community. The main reason for preferring private-order institutions is their lower cost as compared to legal enforcement. In contrast, contracts involving a large amount of money suffer from the lack of an efficient legal system, especially the non-repeated and relation-specific contracts. In such cases, the cost of defying the private-order institution is often not high enough to prevent default.

This pattern and reasoning imply that law, reputation, social norms, designed private-order institutions and private enforcements are substitutes used by the parties depending on their cost. One can imagine the enforcement of a contract as the production of a commodity, where various institutions of enforcement can be seen as the factors of production. A party may choose multiple enforcement institutions based on their efficiency and cost-effectiveness under the existing situation. These choices change as the cost and the efficiency of institutions change.

The standard microeconomic logic used to analyse the production of a commodity (see Simon & Blume, 2010) will show that people will substitute an inefficient and high-cost institution for an efficient and low-cost institution. Applying the same, one would expect the use of public-order institutions to become more common, as the legal rules become more efficient and their cost of enforcement decreases. Hence, with the legal institutions becoming more efficient, there should be a clear trend towards people using them more often in their day-to-day transactions. However, there is no insinuation of this happening in the real world. Even in the developed countries with a relatively more efficient legal system, the contracting parties continue to depend on reputation and social norms for enforcement.

It does not mean that people do not see the various enforcement institutions as substitutes. The evidence does suggest that they consider law, social norms, reputation, designed private-order institutions as substitutes. Nonetheless, there seems to be complementarity between the public- and private-order institutions. The studies show that higher trust not only predicts the economic development of a country (Knack & Keefer, 1997; Zak & Knack, 2001) but also the efficiency of its judiciary (La Porta et al., 1997a). Also, an efficient legal system often co-exist with better working private-order institutions. For example, few would expect the private-order institutions governing the actions of cattlemen of Shasta County studied by Ellickson (1991) or the cotton industry studied by Bernstein (2001) to work the same way if the legal enforcement in the United States of America (USA) were of the same quality as that of Ghana.⁷ Similarly, most would agree that an improvement in the legal system in Ghana will increase the trust level in society so much that anyone trying to replicate Fafchamps (1996) would see a notable difference in the efficiency of private-order institutions.

Some recent studies have argued that there is a complementarity in public- and private-order institutions. Bartling et al. (2021) in an experiment found complementarity between public- and private-order institutions. Results of the experiment show that an independent improvement in trust has little effect on gains from trade in absence of strong contract enforcement (using public-order institutions). Likewise, strengthening contract enforcement provides a substantial gain in trade only if the trust level is high. Bodoh-Creed (2019) studied the implications of assuming complementarity in public- and private-order institutions (in addition to they being substitutes). The study shows that the initial improvements in public-order institutions may increase the efficiency of private-order institutions by increasing trust in the society. However, the study predicts the collapse of private-order institutions as the strength of enforcement by public-order institutions crosses a threshold.

These studies provide important insights into the issue of complementarity of enforcement institutions. However, we know little about the complementarity among contract enforcing institutions and its implications for contract enforcement and economic activity. A better grasp of this issue may greatly enhance our understanding of institutional changes and the development path that a country follows.

Summary

The studies have debated the importance and efficiency of law, social norms and other non-legal alternatives of contract enforcement. Social norms, bilateral reputation, and multilateral reputation are relatively low-cost institutions but are less effective when the contracts are among members of a large group or the gains from cheating are large. In comparison, the legal system can facilitate the long-term growth of a nation by enforcing contracts in a larger group and can correct the inefficiencies of private-order institutions. Nonetheless, the cost of legal enforcement is much higher. Although one institution of enforcement may prove more efficient than others in theory, the empirical findings do not give us a clear winner. Nonetheless, studies do agree on some aspects. People show a clear preference for using reputation and social norms in their day-to-day and repeated interactions. Contracts with large stakes and relation-specific contracts generally need legal enforcement. Literature is also in agreement that coercion and violence are inefficient ways of contract enforcement and negatively affect economic activity.

In addition to disagreements over the efficiency of public- and private-order institutions, the issue of complementarity among enforcement institutions is not sufficiently explored in the literature. The existing literature looks at public- and private-order institutions as substitutes. Nonetheless, a few recent studies have shown the possibility of complementarity among the public- and private-order institutions. The exploration of this issue may further shed light on institutional and economic changes in society.

Footnotes

Acknowledgements

The present article is based on my doctoral thesis and has immensely benefited from the comments of Professor V. Santhakumar and Dr N. Vijayamohanan Pillai. I would like to thank the anonymous referees for their suggestions. The seventh section is largely written based on their suggestions. Thanks is also due to Dr Ashapurna Baruah for her comments on the first draft of my article. Her comments were extremely useful in improving the argument.

Declaration of Conflicting Interests

The author declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.

Funding

The author received no financial support for the research, authorship and/or publication of this article.

Notes

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