Beyond the Informal/Formal Divide. How do Firms Combine Contract-enforcement Institutions?

Abstract

This paper explores how a broad range of contract-enforcement institutions are combined in interfirm relationships under a developed legal system. We analyse managerial survey data to identify ideal-types of governance strategies that rely on distinct combinations of institutions. We find three ideal-types: (1) bilateral governance, using morality and self-enforcement; (2) third-party governance, leaning on a mix of courts, reputation and community norms; and (3) comprehensive governance, relying heavily on all institutions. Thus, the crucial governance choice is not between formal/informal but bilateral and third-party (both formal and informal) institutions. The two sets can be substitutes but are more often complements. Governance choice is primarily related to transaction characteristics rather than the firm’s environment.