Legal Institutions and Informal Networks

Abstract

The relationship between third-party contract enforcement and informal networks raises important sociological, political, and economic questions. When economic activity is embedded in social structures, what are the implications of third-party contract enforcement for the scope and nature of economic relations? What determines whether individuals rely on formal legal institutions or informal networks to sustain trade relationships? Do legal institutions erode informal networks? We develop a model in which a trade-off exists between size and sustainability of networks. By adding the possibility of fee-based, enforceable contracts, we provide a theoretical explanation for the coexistence of legal contract enforcement and an informal economy. We find that legal enforcement has little effect on networks until law becomes sufficiently inexpensive, at which point small decreases in the cost of law have dramatic effects on network size and the frequency of use of the legal system.