Contract Enforcement: A Political Economy Model of Legal Development

Abstract

In an effort to understand why the relative usage of relational and legal contracts differs across societies, this article builds a political economy model of legal development where legal quality of contract enforcement is a costly public good. It finds that legal investment tends to be too small under elite rule but too large under majority rule in comparison with the socially optimal level. Furthermore, elite rule, low legal quality, and high-income inequality may form a self-perpetuating circle that hinders economic development. In contrast to the conventional view, this article suggests that the often-observed association between heavy reliance on relational contracts and under development is most likely caused by the presence of elite rule rather than by a more collective-oriented culture per se because it is optimal for societies better at using relational contracts to start legal investment relatively late and to have lower quality of legal enforcement. (JEL O1, K49, H40, C72)

National integration and institution building

“…One significant difference between this paper and Dixit (2003) is that the choice of institutions is not addressed in his model. Huang (2013) addresses why societies differ in their relative usage of relational and legal contracts, and the key tradeoff is that a relational contract has gains from learning while an outside trading opportunity may lead to a larger gain. She offers a political economy consideration in the choice of contract enforcement when the elite and the mass differ in their interests in developing legal institutions.…”

A Simple Model of Contract Enforcement Institutions

“…Although they derive conditions under which an institution that monitors each agent's misconduct in voluntary public goods provision is endogenously formed, they do not study institutional quality or contract enforcement. In contrast, Sonin (), Hoff and Stiglitz () and Huang () develop models in which the initial political environment (i.e. what kind of party is initially in power) determines institutional quality.…”

“…Hoff and Stiglitz's () model explains why a strong rule of law is established in poorly resourced post‐communist states but not in highly resourced post‐communist states. Huang () proposes a political economy model in which the legal quality of contract enforcement is determined by legal investment. Her model demonstrates that legal investment tends to be too low under elite rule but too high under majority rule.…”