metadata: authors: 0: author: Dhillon,Amrita
1: author: Rigolini,Iamele P.
count: World
docna: 0: docna: Development and the interaction of
            enforcement institutions
docty: Policy Research Working Paper
subtopic: Investment and Investment Climate,Energy Policies & Economics,International Trade and Trade Rules,Transport Services,Crime and Society
teratopic: Macroeconomics and Economic Growth,Private Sector Development,Finance and Financial Sector Development
abstracts: cdata!: The authors examine how institutions
            that enforce contracts between two parties-producers and
            consumers-interact in a competitive market with one-sided
            asymmetric information and productivity shocks. They compare
            an informal enforcement mechanism, reputation, the efficacy
            of which is enhanced by consumers investing in
            "connectedness," with a formal mechanism, legal
            enforcement, the effectiveness of which can be reduced by
            producers by means of bribes. When legal enforcement is
            poor, consumers connect more with one another to improve
            informal enforcement. In contrast, a well-connected network
            of consumers reduces producers' incentives to bribe. In
            equilibrium, the model predicts a positive relationship
            between the frequency of productivity shocks, bribing, and
            the use of informal enforcement, providing a physical
            explanation of why developing countries often fail to have
            efficient legal systems. Firm-level estimations confirm the
            partial equilibrium implications of the model.
repnme: repnme: Development and the interaction of
            enforcement institutions
display_title: Development and the interaction of
            enforcement institutions
listing_relative_url: /research/2006/12/7259034/development-interaction-enforcement-institutions
topicv3: Investment Climate m1326293 405,Transport m1326661 135,Trade m1326924 698,Power and Electricity Sector m1327094 515,Crime m1439217 3041
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Macroeconomics and Economic Growth,Private Sector Development,Finance and Financial Sector Development
no_of_pages: 21
author_keys: 0: author_key: 877184
1: author_key: 642557
model_extractions: WPS4090

# Development and the Interaction _*_ of Enforcement Institutions

Amrita Dhillon _University of Warwick_ Jamele Rigolini _The World Bank_

## **Abstract**

We examine how institutions that enforce contracts between two parties, producers and consumers, interact in a competitive market with one-sided asymmetric information and productivity shocks. We compare an informal enforcement mechanism, _reputation_ , the efficacy of which is enhanced by consumers investing in “connectedness,” with a formal mechanism, _legal enforcement_ , the effectiveness of which can be reduced by producers by means of bribes. When legal enforcement is poor, consumers connect more with one another to improve informal enforcement; in contrast, a well-connected network of consumers reduces producers’ incentives to bribe. In equilibrium, the model predicts a positive relationship between the frequency of productivity shocks, bribing, and the use of informal enforcement, providing a _physical_ explanation of why developing countries often fail to have efficient legal systems. Firm-level estimations confirm the partial equilibrium implications of the model.

JEL: D02, D7, L14, O12. Keywords: Contracts, Institutions, Corruption, Reputation, Uncertainty.

World Bank Policy Research Working Paper 4090, December 2006 _The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at_ _<u>http://econ.worldbank.org.</u>_ _*_ We thank Franklin Allen, Jonathan Cave, Philip Keefer, Andy Newman, Carlo Perroni, Johannes Hörner, Roger Myerson, Jennifer Reinganum, Myrna Wooders, seminar participants at Georgetown University, Northwestern University, The Harris School of Public Policy, University of Warwick, Vanderbilt University, the 2005 PET conference, the 2005 Conference on Liberalisation Experiences in Asia, and especially Avinash Dixit for extremely useful comments.
# **1 Introduction**

Good institutions have long been recognized as crucial for economic transactions. A large literature has by now documented people’s reliance on informal enforcement mechanisms when formal mechanisms work poorly.<sup>1</sup> However, less attention has been given to the details of their interaction: how do institutions affect one another? How do they evolve over time? And how do they vary with the level of development? Institutions are not monoliths. They are influenced by technology, politics, and by people’s transactions.<sup>2</sup> It is on the latter aspect that we focus attention.

In this paper we examine how institutions that enforce contracts under asymmetric information, such as courts of law and informal community enforcement, interact with one another, and how economic development - measured, as in Kremer (1993), by the frequency of bad productivity shocks in the production process - affects this interaction. We consider two mechanisms that enforce contracts between two parties, producers and consumers, when consumers cannot observe quality: a “formal” enforcement mechanism, _legal enforcement_ , and an “informal” mechanism, _reputation_ . By studying how those institutions affect one another, and how the frequency of productivity shocks affects the interaction between the two institutions, we provide a theory of how alternative contract enforcing institutions evolve and interact as a country develops.

Our theoretical framework builds on the reputation model of Allen (1984) to allow for legal enforcement, consumers’ investment in connectedness, and stochastic, firm-level productivity shocks.<sup>3</sup> We consider a competitive economy where firms produce a good of variable quality, and consumers can observe the quality only after they have bought the good. Bad quality arises either because of a bad productivity shock, or because firms did not put in the effort required to produce high quality, so that a one-sided asymmetric information problem arises. In such an environment, we look at how the efficiency of legal enforcement affects consumers’ incentives to “connect” with other consumers to find out about underperforming firms. _Vice-versa_ , we study how the efficiency of the reputation mechanism affects 1See, for instance, Greif (1993) and Greif _et al._ (1994) for examples of contract enforcement in the Medieval Age; Esfahani (1991) for a discussion on informal enforcement mechanisms in developing countries; Battigalli and Maggi (2004) for how uncertainty and costly contracting influence the choice of contract; Besley _et al._ (1994) for a comparison of ROSCAS and credit markets; Kandori (1992) and Ellison (1994) for a discussion of the role of community enforcement in repeated games; and the discussions on contract enforcing institutions in Mookherjee (1999), Dixit (2003), Greif (2004), and MacLeod (2006).

> 2See, for instance, North (1981), Kranton (1996), and Acemoglu _et al._ (2005). In North (1981) technological progress drives institutional change. In Kranton (1996) the use of reciprocal exchange decreases with the use of money-based exchanges, and in Acemoglu _et al._ (2005) property rights are endogenously derived from the distribution of political power.

> 3See also Klein and Leffler (1981), Shapiro (1983), H ̈orner (2002), and Kranton (2003).

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firms’ incentives to bribe the judicial system. Therefore, as both consumers’ connectedness decisions and firms’ bribing decisions depend on the relative efficiency of the two mechanisms, formal and informal mechanisms interact via consumers and firms’ investment decisions.

The model has both “partial” and “general” equilibrium implications. At the partial equilibrium level, results only partly confirm the common belief that formal and informal institutions substitute each other. More precisely, we find that _consumers invest more in building informal enforcement networks when legal enforcement works poorly_ ; on the other hand, however, _well-performing informal enforcement networks improve legal efficiency, as firms have less incentives to bribe court officials_ . This last result is consistent with the analyses of Putnam _et al._ (1993) and Knack and Keefer (1997), who find a positive relationship between social capital (interpreted, however, as _trust_ ), institutional quality, and economic performance. At the general equilibrium level, we study how the equilibrium institutional mix is affected by uncertainty in the production process, measured by the frequency of bad productivity shocks. Shocks can be of different types, such as physical (e.g. electricity shortages, transportation difficulties, unskilled labor), socio-political (e.g. crime and corruption), or stemming from policy uncertainty.<sup>4</sup> _Ceteris paribus_ , when the frequency of productivity shocks increases, firms bribe more, and consumers connect more with one another. Adding up all the partial effects, we obtain that - up to a certain threshold - increased uncertainty leads to lower legal efficiency, and to increased reliance on informal enforcement mechanisms. Therefore, in accordance with common wisdom, _in equilibrium_ corruption in the legal system is associated with a more widespread use of informal enforcement, via increased uncertainty in the production process.

To conclude, we present empirical evidence of the link between uncertainty, corruption, and consumers’ incentives to rely on informal enforcement mechanisms. We use firm-level data from the _Investment Climate Assessments_ of the World Bank, which survey more than 28,000 firms in 58 countries, and provide information on firms’ characteristics, firms’ productivity, and the investment climate. In a context of intra-industry trade, firms are both producers and consumers: we use therefore _membership to business association_ as a proxy for the use of informal enforcement networks. In accordance with the theory, we find that firms that suffer more from corruption, and firms that face a more uncertain production climate, are more likely to be members of business associations. Interestingly, the relationship continues to hold when we look at firms in Sub-Saharan Africa, Asia, Latin America, and East-

> 4A growing body of literature documents how policy uncertainty is a serious concern for businesses in developing countries. See, for instance, Hallward-Driemeier and Stewart (2004), World Bank (2005), and The Economist Intelligence Unit (2005).

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ern Europe alone, suggesting that the results are not driven by regional attributes. To the extent that developing countries face higher uncertainty in the production process, both the theoretical and empirical analyses point therefore to a _physical_ explanation (i.e., unreliable production processes) for why developing countries often fail to have well-performing legal systems.

The paper is organized as follows. Section 2 presents the basic model under exogenous institutions; Section 3 endogenizes connectedness and legal efficiency; Section 4 presents the empirics, and Section 5 concludes.

# **2 Contract Enforcement under Imperfect Institutions**

The economy consists of a measure one of consumers, and of firms producing a homogenous good of variable quality. At every period firms can choose to provide high or low effort. If they choose low effort they produce a low quality good which is costless, while if they put in high effort they produce a high quality good with marginal costs _c_ . Firms are also subject to an exogenous “bad” productivity shock that happens with probability 1 _− θ_ , in which case the good becomes of low quality. Our uncertainty variable 1 _− θ_ captures in a simple way the difficulty in using observed quality as a signal of effort. It represents production uncertainty faced by firms, such as infrastructural problems, regulation uncertainty, or the prevalence of an unreliable labor force, and as in Kremer (1993) we say that countries (sectors) with a higher “reliability parameter” _θ_ are more developed.

Quality is unobservable to consumers until after they have bought the good, and consumers cannot observe if low quality is due to a bad productivity shock, or due to the firm’s decision to produce low quality. Shocks are persistent, and when a firm has faced a bad productivity shock it stops producing high quality forever: hence, consumers face both moral hazard and adverse selection problems. To avoid repetitions, we will call firms that have always produced good quality in the past “good” firms, and firms that have produced bad quality at least once “bad” firms.

At each period, consumers and firms meet randomly in the market. Consumers need to buy one unit of the good each period, and derive utility _U_ ( _p_ ) = _U − p_ from high quality, and utility 0 _− p_ from low quality. The maximum price consumers are willing to pay for high quality is thus _~~p~~_ = _U_ , while consumers are not willing to spend money on low quality. However, consumers who decide not to buy from a firm have to wait until next period to randomly trade with another partner. Notice that consumers do not know why a given firm did not produce good quality in the past. Thus, their best reaction is to stop buying from _any_ firm delivering low quality, since - given a high effort equilibrium - firms that produce low quality today will always produce low quality.

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<!-- Start of picture text --> Consumers Observe<br>Nt New Firms Price and Quality Shock Consumers Buying<br>Prices and Choose<br>Enter. Decisions. Realization. Get Informed. Decisions.<br>Firms.<br><!-- End of picture text --> Figure 1: Timing of the stage game.

Figure 1 shows the timing of the stage game. In each period there are _Nt_ new firms entering the market and investing a sunk cost of _T_ units in building capacity. The sunk cost allows them to produce up to one unit of output per period, and the number _Nt_ of firms that enter the market in each period is such that entrants face zero expected profits.<sup>5</sup> Next, all firms choose prices and quality simultaneously, after which shocks are realized and firms produce either high or low quality. Consumers then observe prices, go randomly to a firm posting a price at which they wish to buy the good, get informed about the firm’s history, and decide whether to buy the good or not. Finally, after all transactions have occurred, each firm faces an exogenous probability of closure 1 _−δ_ . An _equilibrium_ is therefore a sequence of prices and quality choices, along with consumers buying decisions, such that consumers maximize utility given the firms strategies, new firms decide whether to enter or not, and all firms in the market choose prices and quality to maximize profits given the consumers strategies (see the Appendix for a formal discussion). In what follows, however, we restrict attention to _perfect Bayesian equilibria in stationary strategies_ that maximize consumers’ payoff. In a stationary equilibrium, there are _N/_ (1 _− δ_ ) firms in the market, and _N/_ (1 _− δθ_ ) good firms in each period.

We then consider two institutions that can induce firms to produce high quality: _reputation_ and _legal enforcement_ . Reputation works through the repeated interaction of consumers and firms in the market, while legal enforcement works through the reimbursement of consumers who go to court after having experienced bad quality. We denote by _φj_ the probability that firm _j_ has to reimburse consumers if it delivers low quality, and by Φ = � _φjdj_ the average level of legal efficiency in society.<sup>6</sup> Similarly, we denote by _qi_ the probability that consumer _i_ is informed

> 5We depart therefore from conventional models of reputation in two ways (see, among others, Klein and Leffler, 1982, Shapiro, 1983, Allen, 1984, H ̈orner, 2002, and Kranton, 2003): first, as in H ̈orner (2002), we introduce _shocks_ . Second, as we aim to analyze the interaction of institutions in a competitive setting where firms do not internalize the consequences of their own bribing on institutions, we introduce sunk rather than fixed costs, so that with free entry a single firm cannot capture all the market share.

> 6 Thus, we assume that _ex-post_ quality is verifiable.

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about the firm she is trading with, and refer to the average level of information in society _Q_ = � _qidi_ as _connectedness_ , because consumers need to “connect” to other consumers to be informed about “bad” firms. In this section we assume _qi_ and _φj_ to be exogenous and equal across people and firms, so that _qi_ = _Q, φj_ = Φ. Finally, we consider a situation where _U_ is sufficiently high so that consumers always prefer firms producing high quality. The expected utility of consumer _i_ in each period is thus equal to: where _p_ is the price of the good, and 1<sup><u>1</u></sup> _−_<sup>_−_</sup> _δθ_<sup>_<u>δ</u>_is the share of “good” firms in the economy.</sup> Good firms have a bad shock in the current period with probability 1 _− θ_ , in which case the consumer gets utility 0 _−_ (1 _−_ Φ) _p_ as she will be reimbursed with probability Φ. On the other hand, if the consumer meets a bad firm and she is informed, she will not buy from that firm and gets utility _U_ = 0, while if she is uninformed she buys at price _p_ and is reimbursed with probability (1 _−_ Φ). Notice that consumers’ welfare is maximized when _p_ is minimized, and that price competition between firms guarantees that the equilibrium price is the lowest stationary price that is compatible with high quality. Hence, given a price _p_ , the expected payoff of a good firm _j_ from always putting in high effort is: where 1 _/R_ is the discount rate and _Vj_<sup>_B_</sup> = _R_ (1 _− φj_ ) _pxL/_ ( _R − δ_ ) represents the discounted profits of a bad firm facing judicial efficiency _φj_ .<sup>7</sup> On the other hand, if firm _j_ shirks, it faces an expected payoff equal to _Vj_<sup>_L_= (1</sup><sup>_−φj_)</sup><sup>_pxH_+ (</sup><sup>_δ/R_)</sup><sup>_V_</sup> _j_<sup>_B_.</sup> In order to sustain high quality we must have that _Vj_<sup>_H_</sup> _≥ Vj_<sup>_L_.Thus,as</sup><sup>_qi_=</sup><sup>_Q_and</sup> _φj_ = Φ are equal across agents and firms, high quality equilibria are sustainable only if: We call inequality (3) the _No Milking Condition_ (see Shapiro, 1983, and Allen, 1984), and the lowest price that satisfies condition (3) the _No Milking Price p_<sup>_NM_</sup> ( _θ,_ Φ _, Q_ ). The no milking condition shows that sustaining high effort requires a “carrot and

> 7Equation (2) implicitly assumes that consumers stop buying from a bad firms independent from winning or losing in court, as in a high quality equilibrium firms deliver bad quality only if they have been hit by a bad shock.

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stick” strategy: in order to be able to reward firms for high effort, price must be above marginal costs (the carrot); on the other hand, consumers must also punish shirking firms by boycotting them (the stick). Notice that the no milking price _p_<sup>_NM_</sup> has two components: the _marginal cost_ component _c/θ,_ and the _markup_ component (represented by the first fraction in (3)). The markup is required to sustain high quality when legal enforcement is less than perfect, and decreases with the efficiency of either institution: Proposition 1 _p_<sup>_NM_</sup> _is the lowest stationary price that can be achieved as the outcome of a Perfect Bayesian equilibrium where no firm shirks. Moreover, ∂p_<sup>_NM_</sup> _/∂Q <_ 0 _, and ∂p_<sup>_NM_</sup> _/∂_ Φ _<_ 0 _._ In the Appendix we describe strategies and beliefs that support the high quality equilibrium with firms pricing at _p_<sup>_NM_</sup> .<sup>8</sup> Notice that _p_<sup>_NM_</sup> is the most plausible stationary outcome, as competition between firms and free entry ensure that stationary equilibria with prices higher than _p_<sup>_NM_</sup> are not chosen.<sup>9</sup> Moreover, if firms were to price lower than _p_<sup>_NM_</sup> consumers would know that they get low quality for sure, and would not buy. Thus, any firm that prices lower than _p_<sup>_NM_</sup> will get no market share, so that there are no stationary separating equilibria in our model.

Observe that in the reputational equilibrium (i.e. Φ _<_ 1) firms overinvest in capacity. This is because firms need to price above marginal costs to have the incentives to produce high quality. But because of the free entry of firms, all firms’ profits translate into excess capacity ( _xH <_ 1). Notice, also, that at high levels of institutional efficiency (Φ _, Q_ ), firms’ participation constraint can be violated, as firms cannot recover their sunk costs even under full capacity production _xH_ = 1. Therefore, if (Φ _, Q_ ) are too high, consumers and firms need to coordinate on a price _above p_<sup>_NM_</sup> . However, we do not discuss this case (see Esfahani, 1991).

Our repeat purchase mechanism model is set up to capture in a simple way the impact of legal enforcement and consumer connectedness on the incentive compatible price. A more realistic model would have consumers choosing whether to switch from a firm or not based on their experience and the information available from other consumers, and would have firms choosing to exit from the market when market share becomes too small. It is also true that there are other ways to solve the asymmetric information problem. For instance, firms can decide to form associations to accredit standards (thus signalling their type), or the government may publicize

> 8As shocks are persistent, the equilibrium is also renegotiation proof.

> 9Sustaining higher prices would require collusive strategies between firms, which seems unlikely with free entry.

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information on court cases against firms to inform consumers (see MacLeod, 2006). However, as our focus is to study the _interdependence_ between alternative enforcement institutions, we abstract from these issues.

# **3 Reputation and Legal enforcement as Endogenous Institutions**

We now let consumers invest in their own connectedness to increase the probability with which they are informed about the firm they are trading with. Similarly, we let firms choose how much to bribe court officials to decrease the probability of having to reimburse consumers. To be sure, a more general model would conceivably allow for consumers and firms influencing both variables _Q_ and Φ. Nevertheless, what we want to capture here is the fact that consumers have a comparative advantage in investing in connectedness, while firms have an advantage in bribing.

We begin by describing the consumers’ maximization problem. Let _mc_ ( _i_ ) denote consumer _i_ ’s investment in her own connectedness. Then individual connectedness is equal to _q_ ( _mc_ ( _i_ )), where _q_<sup>_′_</sup> _>_ 0, _q_<sup>_′′_</sup> _<_ 0, and to exclude corner solutions we assume that _q_ satisfies the Inada conditions _q_<sup>_′_</sup> (0) = _∞_ , _q_<sup>_′_</sup> ( _∞_ ) = 0.<sup>10</sup> In deciding how much to invest, consumers take the price _p_<sup>_NM_</sup> , average connectedness _Q_ , and judicial efficiency Φ as given, so that for constant values of _θ, Q,_ Φ the consumers’ maximization problem is: Notice that each consumer faces the same maximization problem (4). Thus, _ex post qi_ = _Q_ , and we can use the first order conditions of the maximization problem to characterize the average level of connectedness _Q_ : Proposition 2 _For each_ ( _θ,_ Φ) _there exists a unique level of connectedness Q resulting from the consumers’ maximization problem (4). Moreover, ∂Q/∂θ <_ 0 _, and ∂Q/∂_ Φ _<_ 0 _._ Intuitively, consumers invest in connectedness to be informed about bad firms in

> 10In a previous version we considered the case where _qi_ also depends on _average_ investment 1 _Mc_ = 0<sup>_mc_(</sup><sup>_i_)</sup><sup>_di_,capturingtheideathatindividualconnectednessincreasesproportionallymore</sup> if other consumers also invest in their own connectedness. This adds significant algebraic burden while conveying similar results.

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the market, and as _θ_ increases, the share of bad firms decreases. Moreoever, the gain of an extra unit of information per firm is decreasing with the price (which also decreases with _θ_ ), while the marginal cost is constant. Thus, as _θ_ increases consumers invest less in connectedness, both because of the direct effect on the share of bad firms, and of the indirect effect on _p_<sup>_NM_</sup> . The same logic holds for judicial efficiency Φ, which captures the net benefits of going to court.

We now turn to firm behaviour. Firms can decrease the probability of having to reimburse consumers by bribing. We presume that bribing has decreasing returns, so that _φ_<sup>_′_</sup> ( _mf_ ) _<_ 0, _φ_<sup>_′′_</sup> ( _mf_ ) _>_ 0, and we also assume that _φ_ ( _mf_ ) satisfies the Inada conditions. For constant values of _θ,_ Φ _, Q_ , the maximization problem of a firm that delivered low quality is: Notice that firms bribe the court _after_ a case has been brought against them, so that _x_ = _x_<sup>_L,H_</sup> . Using the first order condition of (5), we can characterize judicial efficiency Φ: Proposition 3 _Let φ_ ( _mf_ ) _satisfy φ_<sup>_′′_</sup> _/|φ_<sup>_′_</sup> _| >_ 1 _/c. Then for each_ ( _θ, Q_ ) _there exists a unique level of judicial efficiency_ Φ _resulting from the firms’ maximization problem (5). Moreover, ∂_ Φ _/∂θ >_ 0 _, and ∂_ Φ _/∂Q >_ 0 _._

Intuitively, in the high effort equilibrium an increase in _θ_ lowers _p_<sup>_NM_</sup> via marginal costs. Therefore, when reliability _θ_ is high, bad firms have lower incentives to bribe because gains are lower. Bribing, however, also has a general equilibrium effect because it increases the equilibrium price _p_<sup>_NM_</sup> , and hence firms’ profits: it is to rule out this perverse effect through Φ that Proposition 3 requires the condition on _φ_ ( _mf_ ).<sup>11</sup> We conclude by looking at the overall equilibrium institutional mix. Figure 2 shows the consumers’ and firms’ reaction functions _QC_ (Φ) _, QF_ (Φ): the reaction functions are monotonic and opposite in slope, hence the equilibrium is unique. Moreover, an increase in reliability _θ_ shifts both consumers’ and firms’ reaction functions downwards, so that connectedness _Q_ unambiguously decreases with reliability _θ_ . In contrast, the effect of changes in reliability _θ_ on judicial efficiency Φ remains _a priori_ ambiguous, as whether judicial efficiency Φ increases or decreases with _θ_ depends

> 11A similar effect also acts on consumers’ investment decisions in connectedness _q_ , but for consumers the indirect effect has the “right” sign.

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<!-- Start of picture text --> Q QF (θ0)<br>Q(θ0) QF (θ1 > θ0)<br>Q(θ1 > θ0) QC(θ0)<br>QC (θ1 > θ0)<br>0 Φ<br><!-- End of picture text --> Figure 2: Equilibrium levels of connectedness and of judicial efficiency.

on whether the firms’ reaction curve _QF_ moves downwards more or less than the consumers’ reaction curve _QC_ . At low levels of reliability, however, _QF_ is more elastic than _QC_ , so that bribing also decreases with _θ_ : Proposition 4 _1. Equilibrium connectedness always decreases with the reliability of the production process._ _2. There exists a threshold θ such that judicial efficiency improves with reliability θ for θ < θ._ Thus, in accordance with common wisdom, corruption in the judicial system is associated with a more widespread use of informal enforcement, _but via the reliability channel_ .

# **4 Empirics**

In a context of intra-industry trade, firms are often consumers of other firms’ products, and a stated reason for the existence of firms associations is to get information about other firms. We use this interpretation to test Proposition 2 – i.e. that consumer’s incentives to connect with one another (by becoming, in our case, mem10
bers of business associations) are affected by corruption and by uncertainty in the production climate.

We test this implication at the firm level using data from the _Investment Climate Assessments (ICA)_ of the World Bank, which survey more than 28,000 firms in 58 countries between 2000 and 2004, and provide information on firms’ characteristics, firms’ productivity, and the investment climate. Because not all questions are asked in each country, our final sample consists of 19,000 firms spread over 49 countries. The survey is not nationally representative, but is representative of specific sectors that are consistently surveyed across countries: in the sample, firms in the manufacturing sector represent 72% of the sample, firms in services 21%, and the remaining 7% of the sample consists of firms operating in agriculture and construction.

As a proxy for connectedness we use the variable _MEMBER_ , which indicates whether a firm is a member of a business association. Memberships to business associations are rarely compulsory, and there are usually few binding contractual obligations arising from membership. Therefore, business associations can be considered informal institutions that “connect” their members by mitigating information asymmetries, providing a basis for solving disputes with trade partners, and easing the transmission of information. This role of business associations is strongly supported by a recent study of Pyle (2005).

To be sure, a positive association between corruption, uncertainty, and membership to business associations could potentially also stem from bad governance, leading in the long term to low quality services, and firms’ increased incentives to lobby. Although with existing data we are not able to entirely exclude this hypothesis, we apply the following safeguards to avoid capturing such a relationship. First, we give the value one to the variable _MEMBER_ only if the firm identifies the ability to resolve disputes, to provide information on domestic product markets, or to accredit standards, as important functions of the business association: these functions should capture the ability of a business association to spread information about other firms, and to coordinate punitive actions, and give less importance to lobbying intentions. Moreover, our analysis is at the firm level, so that the macroeconomic relationship between corruption and lobbying should be captured by the country fixed effect. Finally, we construct an uncertainty index from variables that have (at least in the short run) little relationship with governance and lobbying. Specifically, we construct two uncertainty indexes using the following variables: 11
where _ELEC_ , _SKILL_ , _TRANSP_ , _CRIME_ , and _MACRO_ are dummies equal to one if a firm identifies respectively electricity losses, the lack of skills in the workforce, transportation, crime, and macro-economic instability as important business constraints, and the weights are derived using the method of principal components.<sup>12</sup> Note that the second index “expands” the first with with socio-political variables, but is more likely to pick up a relationship between bad governance and lobbying. Finally, as a measure of corruption _Cic_ we use a dummy variable equal to one if firm _i_ identifies corruption as a relevant business constraint. We then estimate the following Probit model: where _i_ denotes firms and _c_ countries, _Uic_ is the uncertainty index, _Cic_ the corruption index, _Yic_ represents firm characteristics, and the theoretical model predicts that both _βU_ and _βC_ are positive (see Proposition 2). Notice that the model also predicts a reverse causal relationship between average consumers’ connectedness and corruption. However, as we estimate the probability of a _single firm_ being a member of a business association, it can be shown that the estimates are consistent. Note, also, that we diverge from the theoretical model in two ways. First, we allow different firms to face different levels of corruption. This is because in the model all firms are producing the same product, but in the data firms are substantively different from each other and in principle could “suffer” differently from corruption. Second, strictly speaking the model requires _Uic_ to be the level of uncertainty faced by the _business partners_ of firm _i_ : unfortunately, this information is not available. As firms with similar activities and uncertainty levels tend to trade more often with one another, we assume that the level of uncertainty of each firm is a good proxy of the uncertainty level faced by its business partners.

Table 2 presents the results of the Probit estimation: Column 2 shows the estimation for all countries, while Columns 3–6 show the estimation by geographic region. In all regressions we have included country and sector dummies, have clustered the errors by country, and have weighted each observation by the total number of ob-

> 12See Theil (1971) and Alesina and Perotti (1996) for a description of the method of principal components and macro-economic applications.

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servations in the country. In accordance with the theory, higher levels of corruption and more uncertain production climates are both associated with a higher probability of firms being members of business associations. The relationship continues to hold when we disaggregate the analysis by region: with the exception of corruption in Sub-Saharan Africa, higher levels of corruption and uncertainty remain positively and significantly related to membership to business associations in all five regional estimations. Table 3 presents the results with the expanded uncertainty index: the results remain basically the same for uncertainty, while the corruption variable becomes insignificant in Eastern Europe and Central Asia. Lower significance is likely to stem from the new variables added in the uncertainty index, which correlate more with corruption.

# **5 Conclusions**

This paper studies the interaction between formal and informal institutions that prevent opportunistic behaviour. Our results are only partly consistent with the common belief that formal and informal institutions substitute each other: we find that when legal enforcement works poorly, consumers invest more in connecting with other consumers to enhance contract enforcement via the reputation mechanism; on the other hand, however, better informal enforcement _improves_ legal enforcement because it reduces firms’ incentives to bribe. In fact, in equilibrium we do observe a positive relationship between corruption in the legal system and the use of informal enforcement, _but only via increased uncertainty in the production process_ . Our analysis suggests therefore a physical explanation (i.e., uncertainty) for why developing countries often fail to have well-performing judicial systems. Empirical evidence appears to support the predictions of the model: using firm-level data, we find that firms are more likely to become members of business associations when they see corruption and uncertainty in the production process as severe business contraints.

The paper, however, abstains from studying how changes in the institutional mix affect consumers’ welfare. When the reliability of the production process increases, consumers’ welfare is affected both directly by better performing firms, but also indirectly through the institutional mix. As both consumers and firms do not consider the impact of their investment decisions on equilibrium prices, the effect of a change in the institutional mix on consumers’ welfare remains a priori ambiguous, and is a subject for future research.

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