Contracting , Enforcement , and Efficiency : Economics Beyond the Law Avner

interpretations, and conclusions expressed in this paper are entirely those of the author. They do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. Abstract Neoclassical economics maintains that a legal system is required to foster anonymous exchange and hence efficiency. In contrast, social scientists from other disciplines emphasize the importance of informal contract enforcement in fostering exchange. Using a game theoretical framework and anecdotal evidence, this paper argues against the interpretation of neoclassical theory that only legal contract enforcement enables anonymous exchange. At the same time it argues against overstating the extent to which either reputation or personal trust can govern exchange relations efficiently. It proposes that there is no uniquely optimal combination of contract enforcement institutions. One set of institutions may be more efficient in a particular economic situation but not in another. Furthermore, for a given economic situation, the nature and efficiency of the existing set of contract enforcement institutions is also a function of non-economic, social, cultural, and political factors. Hence, the optimal policy aimed at enhancing contract enforcement in a particular economy should be based on comprehending the interrelations between economic, social, cultural, and political factors particular to that economy. Ever since The Wealth of Nations, exchange in anonymous markets enabling the division of labor has been viewed as the path for economic efficiency and development. Hence, efficiency requires an impartial and efficient legal system that provides the contract enforcement enabling an anonymous markets. This view of the relations among markets, efficiency, and legal contract enforceability is implicit in that masterpiece of neoclassical economics, the general equilibrium model. It assumes that mutually beneficial exchange relations are not hindered by the need to ensure contract enforceability. Furthermore, the economic success of Western civilization is often invoked to support this neoclassical view as it is attributed to the emergence of a market economy based on an impartial legal system. This neoclassical view, that places the legal system at the center of contract enforcement in market economies, has been recently challenged based on empirical observations. Many exchange relations in the West, as well as in other economies, are informal in the sense that the legal system does not provide the required contract enforcement. Empirical studies of informal contract enforcement indicate that reputation, general morality, and personal trust within social networks underlie informal contract enforcement. Yet, the empirical observation that some …