Hostname: page-component-848d4c4894-2pzkn Total loading time: 0 Render date: 2024-05-26T05:54:15.469Z Has data issue: false hasContentIssue false

Combining formal and informal contract enforcement in a developed legal system: a latent class approach

Published online by Cambridge University Press:  15 November 2018

Károly Mike*
Affiliation:
Faculty of Economics, Corvinus University of Budapest and HETFA Research Institute, Budapest, Hungary
Gábor Kiss
Affiliation:
HETFA Research Institute, Budapest Hungary (at the time of researching this article)
*
*Corresponding author. Email: karoly.mike@uni-corvinus.hu

Abstract

How do firms combine a broad range of contract enforcement mechanisms into coherent governance structures? How often are distinct structures used in an economy? We develop a new empirical approach, based on latent class analysis, to answer these questions. Economy-level data from Hungary are used to derive a data-driven typology of contractual governance between firms. The joint use of law, morality, self-enforcing contracts, reputation and community norms is examined. They are shown to be combined into bilateral, third-party or comprehensive governance structures. The crucial governance choice is whether to move beyond bilateralism and, if yes, whether to use a mixture of (formal and informal) third-party mechanisms as a substitute or a complement. Complementarity is much more common. We find no instances of ‘impersonal exchange’; the law never stands alone. By implication, economic development may be best understood as a process from a narrower towards a broader set of enforcement mechanisms.

Type
Research Article
Copyright
Copyright © Millennium Economics Ltd 2018 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

References

Agresti, A. (2002), Categorical Data Analysis, Hoboken: John Wiley.Google Scholar
Aoki, M. (2007), ‘Endogenizing Institutions and Institutional Changes’, Journal of Institutional Economics, 3(1): 131.Google Scholar
Arrighetti, A., Bachmann, R. and Deakin, S. (1997), ‘Contract Law, Social Norms and Inter-firm Cooperation’, Cambridge Journal of Economics, 21(2): 171195.Google Scholar
Baker, G., Gibbons, R. and Murphy, K. J. (2002), ‘Relational Contracts and the Theory of the Firm’, Quarterly Journal of Economics, 117(1): 3984.Google Scholar
Beck, T. and Laeven, L. (2006), ‘Institution Building and Growth in Transition Economies’, Journal of Economic Growth, 11(2): 157186.Google Scholar
Bernstein, L. (1992), ‘Opting out of the Legal System: Extralegal Contractual Relations in the Diamond Industry’, Journal of Legal Studies, 21(1): 115157.Google Scholar
Bernstein, L. (2001), ‘Private Commercial Law in the Cotton Industry: Creating Cooperation through Rules, Norms, and Institutions’, Michigan Law Review, 99(7): 17241790.Google Scholar
Bloom, N., Lemos, R., Sadun, R., Scur, D. and Van Reenen, J. (2014), ‘The New Empirical Economics of ManagementJournal of the European Economic Association, 12(4): 835876.Google Scholar
Bozdogan, H. (1987), ‘Model Selection and Akaike's Information Criterion (AIC): The General Theory and Its Analytical Extensions’, Psychometrika, 52(3): 345370.Google Scholar
Brousseau, E. (2008), ‘Contracts: From Bilateral Sets of Incentives to the Multi-Level Governance of Relations’. in Brousseau, E. and Glachant, J-M. (eds), New Institutional Economics. A Guidebook, Cambridge: Cambridge University Press, pp. 3766.Google Scholar
Campos, N. F. (1999), ‘Context is Everything: Measuring Institutional Change in Transition Economies’, World Bank Policy Research Working Paper, No. 2269.Google Scholar
Cao, Z. and Lumineau, F. (2015), ‘Revisiting the Interplay between Contractual and Relational Governance: A Qualitative and Meta-analytic Investigation’, Journal of Operations Management, 33–34: 1542.Google Scholar
Clague, C., Keefer, P., Knack, S. and Olson, M. (1999), ‘Contract-intensive Money: Contract Enforcement, Property Rights, and Economic Performance’, Journal of Economic Growth, 4(2): 185211.Google Scholar
Cooter, R. (1994), ‘Structural Adjudication and the New Law Merchant: A Model of Decentralized Law’, International Review of Law and Economics, 14(2): 215231.Google Scholar
Crafts, N. and Kaiser, K. (2004), ‘Long-Term Growth Prospects in Transition Economies: A Reappraisal’, Structural Change and Economic Dynamics, 15(1): 101118.Google Scholar
Crocker, K. J. and Masten, S. E. (1991), ‘Pretia ex Machina? Prices and Process in Long-term ContractsJournal of Law and Economics, 34(1): 6999.Google Scholar
Deakin, S., Gindis, D., Hodgson, G. M., Kainan, H. and Pistor, K. (2017), ‘Legal Institutionalism: Capitalism and the Constitutive Role of Law’, Journal of Comparative Economics, 45(1): 188200.Google Scholar
Dempster, A. P., Laird, N. M. and Rubin, D. B. (1977), ‘Maximum Likelihood from Incomplete Data via the EM Algorithm (With Discussion)’, Journal of the Royal Statistical Society, Series B, 39(1): 138.Google Scholar
Dixit, A. (2003), ‘Trade Expansion and Contract Enforcement’, Journal of Political Economy, 111(6): 12931317.Google Scholar
Djankov, S., La Porta, R., Lopez-de-Silanes, F. and Shleifer, A. (2003), ‘Courts’, Quarterly Journal of Economics, 118(2): 453517.Google Scholar
Ebers, M. and Oerlemans, L. (2016), ‘The Variety of Governance Structures beyond Market and Hierarchy’, Journal of Management, 42(6): 14911529.Google Scholar
Ellickson, R. C. (1991), Order without Law. How Neighbours Settle Disputes, Cambridge, MA and London: Harvard University Press.Google Scholar
Fafchamps, M. (1996), ‘The Enforcement of Commercial Contracts in Ghana’, World Development, 24(3): 427448.Google Scholar
Fafchamps, M. (2004), Market Institutions in Sub-Saharan Africa: Theory and Evidence, Cambridge, MA: MIT Press.Google Scholar
Gächter, S. and Falk, A. (2002), ‘Work Motivation, Institutions, and Performance’, in Zwick, R. and Rapoport, A. (eds), Experimental Business Research. Boston: Springer.Google Scholar
Goldberg, V. P. (1980), ‘Relational Exchange. Economics and Complex Contracts’, American Behavioral Scientist, 23(3): 337352.Google Scholar
Greif, A. (1993), ‘Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders' Coalition’, American Economic Review, 83(3): 525548.Google Scholar
Greif, A. (2006), ‘The Birth of Impersonal Exchange: The Community Responsibility System and Impartial Justice’, Journal of Economic Perspectives, 20(2): 221236.Google Scholar
Greif, A. (2008), ‘Commitment, Coercion and Markets: The Nature and Dynamics of Institutions Supporting Exchange’, in Ménard, C. and Shirley, M. M. (eds), Handbook of New Institutional Economics. Berlin and Heidelberg: Springer, pp. 727786.Google Scholar
Hadfield, G. K. and Bozovic, I. (2016), ‘Scaffolding: Using Formal Contracts to Support Informal Relations in Support of Innovation’, Wisconsin Law Review, 9811032.Google Scholar
Hagenaars, J. A. and McCutcheon, A. L. (eds) (2002), Applied Latent Class Analysis, Cambridge: Cambridge University Press.Google Scholar
Hall, P. A. and Soskice, D. (2003), ‘Varieties of Capitalism and Institutional Complementarities’, in Franzese, R., Mooslechner, P. and Schürz, M. (eds), Institutional Conflicts and Complementarities. Boston: Springer, pp. 4376.Google Scholar
Hayek, F. A. (2013[1982]), Law, Legislation and Liberty. Abingdon: Routledge.Google Scholar
Hendley, K. and Murrell, P. (2002), ‘Which Mechanisms Support the Fulfilment of Sales Agreements? Asking Decision-makers in Firms’, Economics Letters, 78: 4954Google Scholar
Hendley, K., Murrell, P. and Ryterman, R. (2000), ‘Law, Relationships and Private Enforcement: Transactional Strategies of Russian Enterprises’, Europe-Asia Studies, 52(4): 627656Google Scholar
Johnson, S., McMillan, J. and Woodruff, C. (2002), ‘Courts and Relational Contracts’, Journal of Law, Economics, & Organization, 18(1): 221277.Google Scholar
Kähkönen, S. and Meagher, P. (2001), ‘Contract Enforcement and Economic Performance’, Journal of African Development, 4(1): 930.Google Scholar
Kaufmann, D., Kraay, A. and Mastruzzi, M. (2009), ‘Governance Matters VIII: Aggregate and Individual Governance Indicators, 1996–2008’, World Bank Policy Research Working Paper, No. 4978.Google Scholar
Klein, D. B. (ed.) (1997), Reputation: Studies in the Voluntary Elicitation of Good Conduct, Ann Arbor: University of Michigan Press.Google Scholar
Kranton, R. E. (1996), ‘Reciprocal Exchange: A Self-sustaining System’, American Economic Review, 86(4): 830851.Google Scholar
La Porta, R., Lopez-de-Silanes, F., Shleifer, A. and Vishny, R. W. (1998), ‘Law and Finance’, Journal of Political Economy, 106(6): 11131155.Google Scholar
Landa, J. T. (1981), ‘A Theory of the Ethnically Homogeneous Middleman Group: An Institutional Alternative to Contract Law’, Journal of Legal Studies, 10(2): 349362.Google Scholar
Lazzarini, S. G., Miller, G. J. and Zenger, T. R. (2004), ‘Order with Some Law: Complementarity versus Substitution of Formal and Informal Arrangements’, Journal of Law, Economics, and Organization, 20(2): 261298.Google Scholar
Levine, R., Loayza, N. and Beck, T. (2000), ‘Financial Intermediation and Growth: Causality and Causes’, Journal of Monetary Economics, 46(1): 3177.Google Scholar
Lin, T. H. and Dayton, C. M. (1997), ‘Model Selection Information Criteria for Non-Nested Latent Class Models’, Journal of Educational and Behavioral Statistics, 22(3): 249264.Google Scholar
Linzer, D. A. and Lewis, J. (2011), ‘poLCA: Polytomous Variable Latent Class Analysis’, Journal of Statistical Software, 42(10): 129.Google Scholar
Linzer, D. A. and Lewis, J. (2013), ‘poLCA: Polytomous Variable Latent Class Analysis’, R package version 1.4. https://github.com/dlinzer/poLCA. (accessed: 20 September 2018)Google Scholar
Lu, Y. and Tao, Z. (2009), ‘Contract Enforcement and Family Control of Business: Evidence from China’, Journal of Comparative Economics, 37(4): 597609.Google Scholar
Macaulay, S. (1963), ‘Non-contractual Relations in Business: A Preliminary Study’, American Sociological Review, 28(1): 5570.Google Scholar
Macmillan, J. and Woodruff, C. (2001), ‘Private Order under Dysfunctional Public OrderMichigan Law Review, 98(8): 24212458.Google Scholar
MacNeil, I. R. (1978), ‘Contracts: Adjustment of Long-Term Economic Relations under Classical, Neoclassical, and Relational Contract Law’, Northwestern University Law Review, 72(6): 854905.Google Scholar
Malhotra, D. and Murnighan, J. K. (2002), ‘The Effects of Contracts on Interpersonal Trust’, Administrative Science Quarterly 47(3): 534559.Google Scholar
Masten, S. E. and Saussier, S. (2000), ‘Econometrics of Contracts: An Assessment of Developments in the Empirical Literature on Contracting’, Revue D’Économie Industrielle 92(2–3): 215236.Google Scholar
McCutcheon, A. L. (2002), ‘Basic Concepts and Procedures in Single- and Multiple-Group Latent Class Analysis’, in Hagenaars, J. A. and McCutcheon, A. L. (eds), pp. 5685.Google Scholar
Mike, K. and Kiss, G. (2017), ‘Beyond the Informal/Formal Divide: How do Firms Combine Contract-enforcement Institutions?’ HÉTFA Working Papers, No. 21, Budapest: Hétfa Research Institute, available at hetfa.hu/wp-content/uploads/2018/02/hetfa_wp_21_mike_kiss.pdf (accessed 20 September 2018).Google Scholar
Milgrom, P. R., North, D. C. and Weingast, B. R. (1990), ‘The Role of Institutions in the Revival of Trade: The Law Merchant, Private Judges, and the Champagne Fairs’, Economics and Politics 2(1): 123.Google Scholar
Milhaupt, C. J. and Pistor, K. (2008), Law and Capitalism. What Corporate Crises Reveal about Legal Systems and Economic Development around the World, Chicago and London: University of Chicago Press.Google Scholar
Murrell, P. (ed.) (2001), Assessing the Value of Law in Transition Economies. Ann Arbor: University of Michigan Press.Google Scholar
Murrell, P. (2003), ‘Firms Facing New Institutions: Transactional Governance in Romania’, Journal of Comparative Economics, 31(4): 695714Google Scholar
Murrell, P. (2008), ‘Institutions and Firms in Transition Economies’, in Ménard, C. and Shirley, M. (eds), Handbook of New Institutional Economics, Berlin and Heidelberg: Springer, pp. 667700.Google Scholar
Nee, V. (1992), ‘Organizational Dynamics of Market Transition: Hybrid Forms, Property Rights, and Mixed Economy in China’, Administrative Science Quarterly, 37(1): 127.Google Scholar
North, D. C. (1990), Institutions, Institutional Change and Economic Performance, Cambridge: Cambridge University Press.Google Scholar
Nylund, K. L., Asparouhov, T. and Muthén, B. O. (2007), ‘Deciding on the Number of Classes in Latent Class Analysis and Growth Mixture Modeling: A Monte Carlo Simulation Study’, Structural Equation Modeling, 14(4): 535569.Google Scholar
Peng, M. W. (2003), ‘Institutional Transitions and Strategic Choices’, Academy of Management Review, 28(2): 275296.Google Scholar
Pistor, K., Raiser, M. and Gelfer, S. (2000), ‘Law and Finance in Transition Economies’, Economics of Transition, 8(2): 325368.Google Scholar
Poppo, L. and Zenger, T. (2002), ‘Do Formal Contracts and Relational Governance Function as Substitutes or Complements?Strategic Management Journal, 23(8): 707725.Google Scholar
Prüfer, J. (2015), ‘Business Associations and Private Ordering’, Journal of Law, Economics, & Organization, 32(2): 306358.Google Scholar
Pyle, W. (2005), ‘Contractual Disputes and the Channels for Interfirm Communication’, Journal of Law, Economics, & Organization, 21(2): 547575.Google Scholar
Steer, L. and Sen, K. (2010), ‘Formal and Informal Institutions in a Transition Economy: The Case of Vietnam’, World Development, 38(1): 16031615.Google Scholar
Sykuta, M. E. (2008), ‘New Institutional Econometrics: The Case of Contracting and Organizations Research’, in Brousseau, E. and Glachant, J-M. (eds), New Institutional Economics. A Guidebook, Cambridge: Cambridge University Press, pp. 122141.Google Scholar
Telser, L. G. (1981), ‘A Theory of Self-Enforcing Agreements’, Journal of Business, 53(2): 2744.Google Scholar
Tönnies, F. (1957[1887]), Community and Society [Gemeinschaft und Gesellschaft], East Lansing: Michigan State University Press.Google Scholar
Tóth, I. G. (2010), ‘Elements of Social Cohesion: Trust, Norm Following, Justice and Responsibility – If Only They Existed…’, in T. Kolosi and I. G. Tóth (eds), Social Report 2010, Budapest: TÁRKI Research Institute, pp. 254–287.Google Scholar
Trebilcock, M. and Leng, J. (2006), ‘The Role of Formal Contract Law and Enforcement in Economic Development’, Virginia Law Review, 92(7): 15171580.Google Scholar
Upham, F. (2002), ‘Mythmaking in the Rule of Law Orthodoxy’, Rule of Law Series, Democracy and Rule of Law Project, Carnegie Working Papers, No. 30.Google Scholar
Wank, D. L. (1996), ‘The Institutional Process of Market Clientelism: Guanxi and Private Business in a South China City’, China Quarterly, 147(9): 820838.Google Scholar
Weber, M. (1927), General Economic History, New York: Greenberg.Google Scholar
Wedel, M. and DeSarbo, W. S. (2002), ‘Mixture Regression Models’, in: Hagenaars, J. A. and McCutcheon, A. L. (eds), pp. 366382.Google Scholar
Williamson, O. E. (1979), ‘Transaction Cost Economics: The Governance of Contractual Relations’, Journal of Law and Economics, 22(2): 233261.Google Scholar
Williamson, O. E. (1985), The Economic Institutions of Capitalism, New York: Free Press.Google Scholar
Williamson, O. E. (1991), ‘Comparative Economic Organization: The Analysis of Discrete Structural Alternatives’, Administrative Science Quarterly, 36(2): 269296.Google Scholar
Woodruff, C. (1998), ‘Contract Enforcement and Trade Liberalization in Mexico's Footwear Industry’, World Development, 26(6): 979991.Google Scholar
Woodruff, C. (2004), ‘Establishing Confidence in Business Partners: Courts, Networks, and Relationships as Pillars of Support’, in: Kornai, J., Rothstein, B. and Rose-Ackerman, S. (eds), Creating Social Trust in Post-Socialist Transition. New York and Basingstoke: Palgrave Macmillan, pp. 111125.Google Scholar
Yang, C. (2006), ‘Evaluating Latent Class Analysis Models in Qualitative Phenotype Identification’, Computational Statistics & Data Analysis, 50(4): 10901104.Google Scholar