Display

Looks at the central issue in transition – developing contract enforcement institutions. In the world of thin markets and immature legal systems, market failure arises due to contracting problems. Reputation mechanisms and collateralized contracts may alleviate such problems in static environments, but may not be fully effective in evolving, out-of-steady-state transition economies.

Building on insights from modern law economics corroborated by recent evidence, the authors propose a dynamic theory of adjustment of these two mechanisms. They model an economy with no public system of contract enforcement, where restructuring increases both productivity and exposure to hold-up.

The fundamental transition conundrum is how to make firms restructure, if the degree of restructuring is unobservable. The authors show that there exists a decentralized adjustment path along which firms restructure continuously, while signaling that they proceed at the common pace.

As the second part of the paper argues, only certain durable assets may serve as collateral, hence, on the adjustment path, collateral is a scarce resource. Consequently, not all socially profitable contracts are realized.

Thus, in the aftermath of transition, new contracts are excessively simple to economize on enforcement. The new social mechanisms for preventing violations of contracts take time to develop and will naturally crystallize when restructuring is complete. [Author]

• Full text of document
• Publisher details
• Send to a friend