Private order under dysfunctional public order.

• Author: McMillan, John

The freedom and extent of human commerce depend entirely on a fidelity with regard to promises.(1)

INTRODUCTION

Businesspeople need contractual assurance. Most transactions are less straightforward than a cash sale of an easily identifiable item. Buyers need assurance of the quality of what they are purchasing, and sellers need assurance that bills will be paid. The legal system may not always be available to provide contractual assurance -- and when the law is dysfunctional, private order might arise in its place.

Many developing and transition economies have dysfunctional legal systems, either because the laws do not exist or because the machinery for enforcing them is inadequate. In such countries, bilateral relationships, communal norms, trade associations, or market intermediaries may work in place of the legal system.(2) In this Article, we use data obtained from surveys of firms in five transition economies in Eastern Europe and the former Soviet Union as well as Vietnam to show that, at least in these economies, social networks and informal gossip substitute for the formal legal system, while business networks and trade associations work in conjunction with it.(3) These transition countries provide an informative place to examine the interaction between the formal legal system and private-order mechanisms because both are in a state of flux. Although market-oriented laws have begun to replace the bureaucratic controls of the old planned economy, private firms' access to the courts varies, from almost no access in Vietnam to considerable access in Poland and Romania. Even within these countries, the transitional state of the legal system means that managers vary in their perceptions of the courts' usefulness, and ultimately it is their willingness or unwillingness to utilize the formal legal system that shapes the development of private order.(4) Because the data from these economies contain more variation than would be found in a steady-state economy, we can run meaningful regressions relating firms' behavior to their perceptions of the courts' workability.

Many types of private-order mechanisms arise in market economies. Sometimes parties directly involved in the transaction arrange the private order. For example, if a buyer is locked in with a particular seller, either because the seller is a monopolist or because the buyer would face high costs of locating an alternative seller, the seller can make the contract self-enforcing by cutting off further dealings. Self-enforcement in these lock-in situations sometimes takes more imaginative forms. A New York cable television company, Paragon Cable, has a novel strategy to get its customers to pay their overdue bills.(5) It does not unhook the cable. Instead, using what is supposedly a far more effective bill-collection measure, Paragon runs C-SPAN, with its political speeches, debates, and hearings, on all seventy-seven channels.

In close-knit communities, where people interact with each other frequently and information flows freely, people may adhere to social norms of cooperation because it is in their long-term interest to do so. For example, this type of relational contracting has arisen spontaneously within groups such as whalers and neighboring cattle farmers, as Robert Ellickson has shown.(6) In Asia, especially among the ethnic Chinese, contracting typically rests on personal relationships, or guanxi.(7) In Japan, according to Ronald Dore, firms' opportunism is limited by "moralized trading relationships of mutual goodwill. The stability of the relationship is the key. Both sides recognize an obligation to try to maintain it."(8)

In the right circumstances, then, private order can be achieved spontaneously. In large, anonymous communities, however, where people can enter and leave and where alternative trading partners are readily accessible, spontaneous private order may not be feasible. Anonymity strips reputational constraints of their power; more is needed than social norms or self-enforcing dealings. Private order, if it is to operate at all, needs to be organized.

Market participants thus sometimes form themselves into groups such as trade associations to support contracting and create private order. Profit-seeking firms also sometimes provide private order: market intermediaries such as wholesalers and trading companies on occasion supply, among other services, contractual assurance for buyers and sellers. We argue below that private-order organizations of either kind have two roles in sustaining contracting: first, providing information about breaches, and second, organizing the responses to those breaches. Historical studies of notably diverse settings, from medieval Europe to present-day Mexico, demonstrate a consistency in this functioning of private-order organizations: a private organization (such as a market intermediary or a trade association) disseminates information about contractual breaches, and then coordinates the community's response to them. The usual sanction is to boycott the offender. These private-order organizations provide contract-enforcement mechanisms that lie between formal, state-supported order and informal, spontaneous order.

Private order unfortunately also has a down side. It sometimes harms efficiency by excluding new entrants from trading or by achieving price collusion. Private order also can cause or perpetuate racial or gender discrimination. Additionally, some private-order organizations' enforcement techniques overflow into criminal violence. Because of these disadvantages, private order can usefully supplement public law, but cannot replace it.

Our evidence comes from two sources. First, we review published descriptions of private-order practices in various countries. In reviewing this anecdotal evidence we aim to show how similar private-order mechanisms have arisen in quite diverse settings, from medieval Europe to present-day Mexico. Second, we analyze data from the surveys of entrepreneurs we conducted in countries in the process of transition to a market economy from central planning: Vietnam, Russia, the Ukraine, Romania, Slovakia, and Poland. In using this statistical evidence, we aim to examine, in depth, how the legal system affects the operation of private-order mechanisms, both spontaneous and organized.

In Part I, we discuss why private order is needed and why it sometimes needs to be organized, and argue that private organizations serve two functions -- to disseminate information about contractual breaches and to coordinate the responses of multiple parties. We then provide evidence in Part II to demonstrate when private order works spontaneously and when it does not. In Part III, we present evidence regarding the information provision and coordination roles of private-order organizations. In Part IV, we discuss evidence demonstrating how private-order mechanisms interact with the formal legal system. We conclude in Part V with a discussion of the downside of private order, and argue consequently that public order sometimes is preferable to private order.

1. REPEATED GAMES AND THE LAW

   In this Part, we describe the role and emergence of relational, informal contracting (private order) in relation to the relative adequacy of the existing legal system (public order). As a preliminary matter, we then describe the different types of private order (spontaneous and organized), the functioning of each, and, correlatively, when each type arises. In the subsequent parts, we explore more fully when and how these two types of private order function.

   1. The Law versus Relational Contracting

      Many business dealings have the character of the prisoner's dilemma. A seller can cheat by supplying inferior merchandise, and a buyer can cheat by not paying its bills. The best outcome for both, of course, is that neither cheats. In an isolated transaction, however, both parties may have an incentive to cheat, leading to an outcome that benefits neither.

      There are two ways to counter the self-defeating incentives of the prisoner's dilemma. One is the law. If the players can write binding contracts in advance promising not to cheat, with a sufficiently severe sanction for cheating, then it is rational not to cheat. The other countermeasure arises from repetition of the game, or relational contracting. Players may refrain from squeezing the last cent out of the current deal because they wish to do business in the future, either with this particular trading partner or with others who could learn of this behavior. Contracting thus becomes self-enforcing through the threat of retaliation and consequent loss of business. In other words, the shadow of the future can induce the trading partners to cooperate.

      If the legal system functioned perfectly, contracts would never need to be self-enforcing. A frictionless legal system would always work at least as well as relational contracting. In practice, however, laws meant to provide contractual assurance sometimes do not exist, and even when they exist, their application and enforcement may not be cost-effective or even possible.

      Some countries, especially developing and transition countries, have inadequate legal systems. Writing good laws does not automatically solve the problem, for it takes years to create the institutions of a functioning court system and to train judges and lawyers. Indeed, in some countries rampant corruption renders the courts entirely unreliable.

      Even in countries with sophisticated legal systems, the law may not work smoothly. For example, the transaction costs of appealing to the law sometimes exceed the transaction costs of using relational contracting. Market participants have some advantages over judges in deciding whether commitments have been fulfilled.(9) First, market participants possess greater expertise than courts in the monitoring of other participants' conduct. Second, their decisions and actions can be more nuanced than...