Legal Institutions and Informal Networks
| Date | 01 January 2006 |
| DOI | 10.1177/0951629806059595 |
| Published date | 01 January 2006 |
| Subject Matter | Articles |
Journal of Theoretical Politics 18(1): 40–67 Copyright &2006 Sage Publications
DOI: 10.1177/0951629806059595 London, Thousand Oaks, CA and New Delhi
http://jtp.sagepub.com
LEGAL INSTITUTIONS AND INFORMAL
NETWORKS
Ethan Bueno de Mesquita and Matthew Stephenson
ABSTRACT
The relationship between third-party contract enforcement and informal net-
works raises important sociological, political, and economic questions.
When economic activity is embedded in social structures, what are the implica-
tions of third-party contract enforcement for the scope and nature of economic
relations? What determines whether individuals rely on formal legal institu-
tions or informal networks to sustain trade relationships? Do legal institutions
erode informal networks? We develop a model in which a trade-off exists
between size and sustainability of networks. By adding the possibility of fee-
based, enforceable contracts, we provide a theoretical explanation for the co-
existence of legal contract enforcement and an informal economy. We find that
legal enforcement has little effect on networks until law becomes sufficiently
inexpensive, at which point small decreases in the cost of law have dramatic
effects on network size and the frequency of use of the legal system.
KEY WORDS .informal economy .informal networks .legal institutions .
social norms .transaction costs
1. Introduction
Third-party contract enforcement is thought to be one of the essential public
goods provided by governments. Nonetheless, in societies without well-
developed governmental institutions for the enforcement of contracts, co-
operative economic interactions still take place; informal networks make
such cooperation possible (Granovetter, 1973; Moore, 1978; Landa, 1981;
Weiss, 1987; Benson, 1990; Ellickson, 1991; Bernstein, 1992; Greif, 1993;
Winn, 1994). Examples of such networks include the club-like relationship
We are particularly indebted to Bob Bates, John Ohnesorge, Ken Shepsle, and Anne-Marie
Slaughter, for whose graduate seminars this paper was originally written. We have also benefited
from the comments of Scott Ashworth, Chris Avery, Bruce Bueno de Mesquita, Charles Cohen,
Eric Dickson, Amanda Friedenberg, Catherine Hafer, Andrew Martin, Matt Price, Jas Sekhon,
David Andrew Singer, Alastair Smith, Jim Snyder, Christine Taylor, and Leeat Yariv.
among Chinese rubber merchants in Malaysia (Landa, 1981), the informal
economy of Peruvian street vendors (De Soto, 1989), and the reputation-
based management of agency relationships established by medieval Jewish
merchants in the Mediterranean (Greif, 1993). Moreover, there is evidence
that such networks persist even with the development of sophisticated legal
enforcement (Macaulay, 1963; Landa, 1981; De Soto, 1989; Ellickson, 1991;
Fafchamps, 1996; DiMaggio and Louch, 1998) and within highly industria-
lized societies (Portes and Sassen-Koob, 1987). Indeed, it has been argued
that such networks, rather than formal institutions, are the chief building
blocks of sustainable economic relationships, even in modern economies
(Granovetter, 1973). Wisconsin businessmen, California ranchers, and Tai-
wanese entrepreneurs have all been observed to rely more on personal rela-
tionships and informal agreements than on formal legal enforcement
mechanisms (Macaulay, 1963; Ellickson, 1991; Winn, 1994).
The relationship between formal, legal contract enforcement and informal
networks raises a number of important question. First, if the government
fails to provide adequate third-party contract enforcement, what are the
implications for the scope and nature of economic interactions? Second,
what determines whether individuals will choose to rely on formal legal insti-
tutions or their informal social networks, when both are available? This
question is particularly important for governments attempting to build an
effective legal infrastructure. Third, to what extent does the introduction
of governmental contract enforcement erode the social networks that sustain
the informal economy? This is a matter of concern inasmuch as governments
value both the positive effects of social ties maintained through informal net-
works and the greater societal cohesion achieved by replacing narrow social
networks with a more formalized, integrated economy.
These issues lie at the nexus of several disciplines within the social sciences.
Sociologists have a long tradition of examining how social structures other
than the market – such as informal trade networks – affect economic inter-
actions (Polanyi, 1957; Granovetter, 1985; Powell and Smith-Doerr, 1994;
Uzzi, 1999; Uzzi and Lancaster, 2004). Further, the question of how govern-
ment policies and legal institutions impact economic outcomes and social
structures are of interest to sociologists, political scientists, and economists
alike (Skocpol, 1985; Shapiro, 1987; North, 1990; Platteau, 1994; Edelman
and Suchman, 1997).
In order to address these issues, we develop a model of informal networks
in the absence of legal contract enforcement. We then introduce the possi-
bility of legal contracts and analyze the effects on these networks. In our
model, cooperation in informal networks is sustained through repeated
play. The punishment-based enforcement mechanism limits the number of
trading partners with whom cooperation can be sustained. As the number
of potential trading partners grows, the probability of interacting repeatedly
BUENO DE MESQUITA & STEPHENSON: LEGAL INSTITUTIONS 41
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