Combining formal and informal contract enforcement in a developed legal system: a latent class approach

Abstract

How do firms combine a broad range of contract enforcement mechanisms into coherent governance structures? How often are distinct structures used in an economy? We develop a new empirical approach, based on latent class analysis, to answer these questions. Economy-level data from Hungary are used to derive a data-driven typology of contractual governance between firms. The joint use of law, morality, self-enforcing contracts, reputation and community norms is examined. They are shown to be combined into bilateral, third-party or comprehensive governance structures. The crucial governance choice is whether to move beyond bilateralism and, if yes, whether to use a mixture of (formal and informal) third-party mechanisms as a substitute or a complement. Complementarity is much more common. We find no instances of ‘impersonal exchange’; the law never stands alone. By implication, economic development may be best understood as a process from a narrower towards a broader set of enforcement mechanisms.

Mapping the Landscape of Transactions: The Governance of Business Relations in Latin America

“…Our results are broadly consistent with those of Mike and Kiss (2019). Given that these authors use different survey questions, study a different context (Hungary), and implement LCA in a different way, such consistencies point to robust general conclusions about landscapes of transactions.…”

“…Given that these authors use different survey questions, study a different context (Hungary), and implement LCA in a different way, such consistencies point to robust general conclusions about landscapes of transactions. Both this paper and that of Mike and Kiss (2019) find that bilateral mechanisms are important in all business relationships; that the key governance choice is between bilateralism alone, or bilateralism supplemented with other mechanisms; and that there are a significant number of firms that implement comprehensive governance. Nevertheless, there are differences between the two studies.…”

“…When constructing questions to be administered in a long survey and addressed to firms of all types, in different institutional settings, both conceptual and practical difficulties immediately arise. A first difficulty we faced in question design was whether to ask firms about their relations with transactional partners in general, as in Hendley and Murrell (2003), or to focus on highly specific transactions, as when Mike and Kiss (2019) asked about relations with a typical partner, allowing the respondent to choose the typical interaction. 9 Governance structures do vary within firms between transactions, suggesting that asking about a specific transaction corresponds to the daily thought processes of respondents.…”

“…Owen et al (2009) is distinctive in not applying LCA to individuals but rather to countries and their growth experience. We are not aware of any studies within economics that apply LCA to characterize different types of firms, apart from Mike and Kiss (2019) and Ebers and Oerlemans (2016).…”

“…Exploring the characteristics of the classes thus discovered is a key part of the investigation. In an examination of Hungarian data, Mike and Kiss (2019) have shown that latent class analysis (LCA) is particularly suitable for this task. 4 Thus, a second contribution of this paper is to develop the application of LCA for the discovery and estimation of governance structures, and apply it to the six-country dataset.…”