Lawlessness and Economics by Avinash K Dixit
Never been asked by a cop for a bribe? You should read Dixit's book. It explains a great deal of relation-oriented economies for people who grew up in rule-occidented cultures, which means that readers like me will end up with slight headaches due to the relative frequency of facepalms. c.f. CN trying to abrogate oil contracts.
Granted, that's nothing compared to the sense of loss experienced when remembering the collapse of the Soviet Union. While we could have rolled out a Marshall Plan II for the transition, we really needed to have these game-theoretic frameworks well-understood.
The general finding is that arbitration based on its information advantage works well in conjunction with the formal legal system; the two may be said to be complementary to each other. This may explain why the law takes such a benign view of arbitration, respecting its verdicts adn even standing ready to enforce them. It may also offer a good approach to teh development of formal institutions in less-developed countries and transition economies.
Even in countries where courts are believed to function well, relational contracting based on repeated interactions is used extensively.
Prior information is important in assessing risk and offering credit in a new relationship.
Trust builds up quickly in bilateral relationships in response to good experiences.
Relational contracting works better if customers' switching costs are high.
If it is believed that courts work well, new customers or ones with low switching costs are more likely to be offered credit.
However, effectiveness of courts is irrelevant to the functioning of established relationships.
The set-up should suggest and immediate intuition about the resulting equilibrium. If a trader cheats his current partner, he gets an immediate gain as usual in the prisoner's dilemma. The potential cost is tha this future partners may hear of this, in whch case they will refuse to play with him. The option of not playing is what helps sustain cooperation....
In other words, small communities can achieve full self-governance using their own information systems and do not need external governance. In very large communities, the benefits that are available from trade with distant partners can only be realized by instituting a system of external governance at a cost. ... When an expanding economy reaches the size wehre external governance becomes just cost-effective, "it is darkest just before the dawn" for it. However, even very large communities with external governance may or may not be better than the optimal-sized self-governing small communities.
The model invites some unusual and speculative applications. One such pertains to the problem of the decline of civil society in the United States and some other modern societies, which has been much discussed and lamented following Putnam (2000). The kinds of links that are suppoesd to have frayed or disappeared -- churches, charities, local social and business associations like Rotary Clubs -- serve many purposes. Among other things, they provide the contacts and information networks, and repositories of social norms and sanctions, which make it possible for individuals to build reputations, and for the society to achieve self-governance in economic transactions.
Rubin (1994) points out that similar "crony socialism" existed under the central planning systems in socialist economies, and continued in the transition period.
But this compartmentalization of capital markets has a cost; it constrains the movement of captal to its most productive uses in response to changing conditions. Therefore, it comprises another source of diminishing returns for the relation-based system. Transition to a rule-based system would allow more efficient reallocation of capital to take advantage of productive opportunities outside the group.
The questionnaire work of Johnson, McMillan, and Woodruff (2002) show the great difficulties experienced by the governments of most transition economies in their attempts at such reputation-building. In many countries, the attempts of the top levels of the government at making and enforcing reliable governance systems can be ruined by some middle-level officials who attempt to make a quick profit from their new-found power.
The model captures several features of for-profit intermediation, and yields some results that are observed in reality. The finding that the traders may be trapped into an undesirable equilibrium under and enforcer is a good example, as is the result that the mafioso intermediary's commission is higher when he provides enforcement services than when he provides information only...
The model also finds that violence is more likely when the mafioso provides enforcement services and in the competition among rival mafiosi.