Affiliate & Associate

Research

Whither Formal Contracts?

Abstract: To measure the benefits of formal contract enforcement for society, I create a market with merchants and buyers, in which buyers can choose whether to buy, and whether to pay. A set of multiple ‘state-favored’ ethnic groups control the state. I experimentally vary formal contracts and the composition of buyer-merchant pairs. The design separately identifies the effect of the contracts on the buyers’ incentive to pay and on their incentive to buy. I document two ways in which society limits the benefits of contracts. First, contracts increase the buyers’ cost of cheating and merchants’ profits if the merchant is state-favored, but they do not when the merchant is not state-favored. Buyers’ beliefs show that contracts can only be enforced if the merchant is state-favored. Second, even when the merchant is state-favored, contracts have no effect on buyer choices when the buyer and the merchant belong to the same ethnic group. Buyers’ choices and beliefs confirm that, in that case, contracts can be enforced, but have no effect on buyers’ choices because reputation already governs trade within groups. The findings temper the view of the state as independent from society, offer a rationale for why contracts are not adopted, and nuance the notion of state weakness. 

Econometrica