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Lawlessness and economics

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
May 2003
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Economists generally agree that law underpins markets, Dixit explained. For markets to perform successfully, there must be a legal framework to protect property and enforce contracts. Even the most ardent libertarian economists, he noted, accept that a legal framework is necessary for markets to work, and they look to governments to provide this function. Some theorists take this view even further, arguing that legal frameworks are sufficient for markets to operate. However, most economists recognize that markets may fail for other reasons.

Since the 1960s, economists have also moved away from the notion of law as the necessary underpinning of a functioning market and have begun to look at the way economic choices and economic equilibrium respond to law and legal liabilities. The new theoretical concepts draw from the realization that, in all countries historically and in many developing and transition countries now, laws have been either too weak, too slow, or too corrupt and biased to allow economic actors to conduct transactions efficiently.

Dixit cited the example of Indian courts, in which 25 million cases are pending. It will take more than 300 years to go through this backlog. In Russia, while adjudication has improved, enforcement is still an issue. Despite such legal failings, some form of governance nonetheless takes place. Indeed, even in systems with functioning legal systems, most transactions are settled through informal means “in the shadow of the law.”

Formal law, therefore, is neither a necessary nor a sufficient condition for markets to work, Dixit argued, because when legal frameworks fail or are weak, alternative frameworks emerge that enable economic activity to continue. He has coined the label “lawlessness and economics” for the field that studies the relation between these alternative forms of governance and economics; it is a subfield of new institutional economics. While the pioneers of new institutional economics, such as Douglass North and Oliver Williamson, look at institutions broadly, this subfield focuses on institutions that protect property rights and enforce contracts.

Institutions and organizations

North distinguishes between institutions and organizations, Dixit said. North defines institutions as the broad frameworks of formal and informal rules and constraints that govern the way organizations, as groups of people, function. Constitutions, for example, are institutions, while legislatures are the organizations that operate under the constitution. The interaction between the two affects the costs of transac-tions—the primary concern of both North and Williamson. For both, the key is the design of rules, and the operation of policymaking under those rules, in ways that minimize the costs of transactions.

Williamson, Dixit noted, focuses on several kinds of transaction costs, including a combination of asset specificity (the degree to which investments are specialized) and incomplete contracting, which promote opportunism or delay. For example, to undertake a successful venture, one party has to make an irreversible investment. If complete information is available and the complexity of the transaction is fully manageable, the two parties can specify in a binding way how the first party will be compensated for its investment. But these conditions are almost always lacking; hence, contracts unavoidably become incomplete and assurances are not credible. As a result, the second party has an incentive to renege on the agreement. In essence, whether an organization wants to make its own inputs or buy them from another is governed by these types of considerations. Williamson also focuses, Dixit explained, on the ways in which organizations evolve to cope with such considerations.

Then there is Williamson’s concept of private order-ing—when nongovernmental parties come together in voluntary arrangements. Here, Dixit explained, one must distinguish between the observability of an item and its verifiability. Two parties to a transaction may both observe the facts of their situation, but it may not be possible to verify the information to a court or other third parties, in which case a contract may not be feasible. While private ordering can use this information, courts cannot, at least not without great cost; so private ordering, as a system of governance, evolves to save on those costs.

But to work, private arrangements must be self-enforcing—that is, both parties must have a mutual interest in continuing the arrangement. Employment contracts often fall in this category, as do semiprivate means of enforcement, such as arbitration. In the latter case, the arbitrator has no means of enforcement, but courts often uphold the verdict because they trust the “disinterested” third party’s judgment. This, in many ways, is how private ordering operates under the shadow of the law.

Institutional interaction

In many developing and transition economies, there is interaction between the formal institutions of imperfectly functioning government and the informal institutions that operate under its shadow. In these societies, “relational contracts” based on repeated interactions are common and exist even in countries where courts seem to function well. In a relation-based system, Dixit explained, two parties develop ongoing interactions on which they build trust. This system works when opportunities for more formal arrangements are bad, and the cost of switching to other options is high. One might think that relational contracting is more likely to be sustained if government enforcement is weak, but research has shown that effective courts mattered most at the beginning, when they helped establish mutual trust. Once the relationship was established, whether or not the courts functioned did not seem to matter.

Property rights protection

In systems of economic governance, property rights protection holds a key place. Property rights consist of control over property, entitlement to income from property, and the right to sell property. All are subject to formal and informal constraints—legal, familial, and communal. And, because of the cost, protection of none of these rights is certain. People might try to encroach on another person’s property rights, but what the latter decides to do about it depends on how much it costs to enforce that right (see box for an example of institutional reform).

Costs and benefits can change over time and in response to transaction technology—such as information and enforcement. Thus, property left to the public domain because of the high cost of dispute resolution may, at a later date, be worth pursuing if the cost of enforcement has gone down or the benefits of claiming it have increased.

Drawing on the works of Yoram Brazel, Dixit explained that property rights had multiple dimensions that interacted, sometimes in complementary ways and sometimes as substitutes. The relation between these dimensions can be used to specify contractual arrangements. For example, deciding how long a rental lease should be and who is responsible for the upkeep of the property depends on how the two dimensions interact: if the lease is long term, the tenant has an incentive to invest in the upkeep, and the contract will reflect this. But in short-term leases, the tenant has no incentive to invest, and this will be reflected in the rent.

First rule of institutional reform: Do no harm

Anthropologist Jean Ensminger’s study of the Orma tribe in Kenya analyzes the interaction between state and nonstate governance in light of new institutional economics. The study chronicles the attempts made first by the British and then by the Kenyan government to define a system of formal land titles and to enforce property rights within the tribe.

Historically, the tribal chief allocated land to members of the tribe, but land could not be transferred to anyone else or used without the tribal chief’s approval. In an effort to change this system, outsiders created a system under which farmers could borrow against the land to improve it and raise production. Formal titles were introduced and plots consolidated for economies of scale. But the changes proved to be disastrous. Potential lenders knew they could not use the land as collateral because others had claim to it as well. Moreover, no one had bothered to ask why the tribe relied on small parcels of land. The purpose was to protect farmers from climate change; shortages in rainfall that affected one parcel of land often did not affect land a mile away.

Over time, the revised system is being allowed to expire and is being brought back into line with realities. The lesson for the IMF? It must study norms carefully before trying to change them.

Systems of social norms

Dixit next examined property rights in the context of collective action or common-pool resource problems. These are cases where, in the absence of effective social arrangements, individual incentives lead to a degradation of resources. He drew in particular from political scientist Elinor Ostrom’s empirical study of communities attempting—some successfully, others not—to regulate the use of common resources. Ostrom’s study shows that, in contrast to the prediction of “the tragedy of the commons,” problems of common resource pools can sometimes be solved more successfully through voluntary organizations than through state intervention.

But when are these alternative arrangements likely to work? Ostrom finds that small, stable communities with good communications, adequate information, and ongoing interaction built on trust have a higher likelihood of creating workable alternative arrangements. These arrangements also rely on sanctions. Successful sanctions usually employ graduated punishment: first comes a rebuke and an opportunity to make restitution; a more severe sanction is involved only if the first one fails.

Social and business networks

Networks can serve several functions, Dixit explained. For example, social networks can make the search for better matching of business opportunities more efficient and, hence, less costly. Moreover, repeated exchange within a network helps sustain cooperation and honesty, although studies have shown that networks work well only in small and well-connected groups.

The reason, Dixit said, lies in the contrast between the cost structure of relation-based and formal rule-based governance systems. As researcher Shuhe Li has observed, a relation-based system has low initial costs, but as business expands, connections weaken, relations become temporary, and risks rise. The marginal cost of the system rises as well.

A rule-based system, in contrast, requires high initial investment, but marginal costs stay low and may even decrease as the number of players increases. Therefore, total governance costs of the rule-based system are lower for large societies, whereas the costs of the relational system are lower for small, stable communities. Although the two systems can and do coexist, rule-based governance becomes more common as economies expand.

Arbitration: Private intermediaries

Finally, Dixit discussed the role of arbitration in economic governance systems. Private, profit-motivated systems evolve when one party does not trust the courts of another party. In such situations, the parties go to an arbitration body, which has dealings with, and can be trusted by, both.

Arbitration bodies can be centralized, with formal rules or procedures, or they can rely on informal structures. Often, they are specialized and are thus better able to provide verifiability. And when verifiability is easier, more detailed contracts specifying more contingencies can be written. But arbitration bodies have no enforcement authority. So, when a party avoids fulfilling its obligation under the arbitrator’s judgment, enforcement has to rely on courts or other group sanctions. In cases with high potential for enforcement problems, parties must use centralized arbitration systems, while parties with long-standing relationships are better off with informal structures.

In the context of arbitration, Dixit used the work of Diego Gambetta to discuss the role of mafias as an alternative governance response. When neither party trusts the other and both have an incentive to cheat, they need a third party, sometimes a Tony Soprano, to provide information and, if necessary, enforcement. The transaction costs of each differs, depending on the risks. But in this type of alternative governance, the provider of the service often enjoys a monopoly and may trap the participants into a bad outcome from which they can escape only through collective action to depose the Mafioso.

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