Comparing Legal and Alternative Institutions in Commerce Franklin Allen Jun “QJ” Qian



Download 177.76 Kb.
Page3/4
Date conversion29.04.2016
Size177.76 Kb.
1   2   3   4

III. Legal Institutions vs. Alternative Mechanisms: Comparisons and Policy Implications

Based on the above examples, we now compare the advantages and disadvantages of conducting commerce based on the law and legal system vs. alternative mechanisms outside the legal system. Given the advantages and disadvantages of either system, we then derive conditions under which one of the two systems is superior. Finally, we provide discussions on policy implications based on our analysis.


III.1 Comparing Legal and Alternative Mechanisms

There are well-known advantages of using the law and legal system as the basis for commerce. The legal system in a democracy allows equal and full access by all and promises fairness in trials and settlements. Backed by the government and legislature, the legal system also has the ultimate authority in its decisions on any and all disputes. The legal system is also endowed with powerful enforcement mechanisms, including criminal penalties, such as imprisonment, as well as civil laws and financial penalties to affect people’s behavior. These enforcement mechanisms and penalties provide strong incentives for all agents to follow the resolutions endorsed by the legal system, which in turn provides long-term stability in the economy. The legal process including enforcement can be anonymous (e.g., details of a settlement of disputes (instead of trial) in many cases are rarely made public) or transparent (e.g., details of high-profile trials are publicly announced and covered in media). By using the entire legal operator and system, the marginal enforcement costs can be very low and this improves overall efficiency.

However, there are also disadvantages in using the legal institutions as basis for commerce. First, recent research on political economy factors, and in particular, work by Rajan and Zingales (2003a,b) argues that rent-seeking behaviors by vested interest groups can turn legal institutions into barriers to changes. We expect these problems to be much more severe in developing countries and the costs of building good institutions can be enormous in these countries. We argue that one way to solve this problem is not to use the law as the basis for commerce but instead to use alternative mechanisms. Second, in democracies there can be a lengthy political process before significant changes can be approved (by the majority of entire population and/or legislature), and the people in charge of approving or disapproving changes (e.g., politicians and judges) may lack the expertise of business transactions and have limited capacity (time and effort) to examine the proposed changes. The approval process of the Checking Clearing Act of the 21st Century in the U.S. above is a good example on this capacity. In addition, as discussed in examples above interest groups with more resources may receive more protection than individuals and this asymmetric protection system induces more rent-seeking behaviors and further deters innovations.

Unlike the legislature which has monopoly power and authority in defining and revising the law, one of the main advantages for alternative mechanisms is that it is more likely to have competition among different mediation/resolution agencies/organizations. The process of competition can ensure that the most efficient mechanism will prevail, which includes having only experts involved in the rule-changing process. Competition can also limit rent-seeking behaviors by one or more groups. Clearly, alternative mechanisms can be much faster in adopting new rules to deal with changes in commerce since these changes do not require the permission from the legislature or electorate.

One of the main disadvantages of the alternative mechanisms is their lack of enforcement power. Without the backing of the government and/or judicial system, alternative mechanisms can only rely on reputation along with economic and financial incentives (e.g., avoiding future losses due to sanctions by other members of the network resulting) and self-enforcing, implicit contractual agreements. These methods may not be sufficient to ensure good behaviors if future losses are not substantial (relative to the gains can be made today) and/or if these losses can be partially recuperated by entering other lines of business or networks. Another setback for alternative mechanisms is that by design they exist among a network (or networks) and thus are inaccessible to outsiders; a partial access by outsiders may come with the price of biased outcomes in dispute resolution favoring insiders. In addition, frequent changes adopted by a network (or networks) create instability and hence weak long-term incentives.

These advantages and disadvantages lead to the tradeoffs of using the law and courts vs. alternative mechanisms in different economic environments. In static environments with infrequent (and predictable) changes (i.e., mature and slow-growing economies and industries), the advantages of the legal mechanisms dominate their disadvantages. First, the strong incentives that can be provided by the enforcement of the legal system imply that efficient systems can be designed that do not rely solely on positive monetary incentives. Second, the fixed costs of using the legal system can be negated by the infrequent revisions of the law and by large scale transactions; also the legislature and the judicial system can appoint experts (and judges) to be involved with the process of changing the law and regulations and grant them with the authority in decision making. The above two factors also imply that there is stability in the system, which in turn creates long-term incentives for economic agents to ‘play by the (universal) rule.’

In dynamic environments with frequent (and unforeseen) shocks (i.e., emerging, fast-growing economies such as China and India), however, the disadvantages of the legal mechanisms are magnified and outweigh their advantages. The lengthy approval process by the legislature and electorate of any changes to the law, along with the lack of expertise by the judges and politicians, means that the legal system is slow in reacting to changes. Moreover, a legal system captured by interest groups can in fact oppose changes, and given its monopoly power it can become a barrier to competition and innovations. On the other hand, alternative mechanisms can adapt to changes much more quickly, since competition ensures that the most efficient mechanism will be implemented quickly. Weak enforcement power and long-term incentives of the alternative mechanisms are complemented by effective reputation mechanisms as long as there are long-term profits to be made and shared by economic agents.

The interaction between legal and alternative mechanisms is another reason why alternative mechanisms can improve social welfare. Since most of the laws are adopted from ‘best practice,’ having a viable system of alternatives can thus improve the efficiency of legal institutions, especially in dynamic environments. Competition among formal and alternative mechanisms can also ensure that the best mechanism will be eventually adopted in the entire economy, and this is especially important in environments where special interest groups can easily capture the legal system. A fair and functional legal system can also improve the effectiveness of alternative mechanisms by adopting the best rules and enforcing the changes in the entire economy and by instilling stability amid frequent changes.


III.2 Policy Implications

It is not our intention to downplay the importance of the role of the law and legal system in commerce. Our ultimate goal is to help design the optimal combination of formal and alternative institutions that best suit a country’s needs. To this end we have compared the advantages and disadvantages of legal institutions versus alternative mechanisms. We conclude that legal mechanisms are an important part of developed economies’ institutions, providing stability and strong long-term incentives. This conclusion is based on the premises that there are infrequent shocks to the economy that cause fundamental changes in ways of how business is done, that the legal system allows full access by all and promises fair resolution of disputes and enforces the rules uniformly.

Unfortunately, these assumptions making the legal institutions the optimal system in developed countries are likely to hold in most emerging economies. A fast-growing economy, such as China and India and a growth phrase that most developing countries will go through, is often characterized by frequent changes to the fundamentals of the economy, making frequent changes to how business is done a requirement, not a choice. Given that it typically takes years to build a well-functioning legal system and other formal institutions, the fixed costs of using the legal system can be quite high in a dynamic economy, even if the system provides fair and expertise in dealing with changes. A perhaps much more severe problem with the legal system is the political economy factors. It would be much easier for interest groups to capture the legal system and government in a country with underdeveloped institutions than in a country with developed institutions. As a result, an economy relying on the law and legal institutions as the sole basis for commerce may end up being the barrier for changes and innovations.

Therefore, we argue that alternative mechanisms play a much more prominent role in emerging economies, and can actually be superior to legal mechanisms in supporting business transactions in certain industries or entire economies. Our main policy implication is that in emerging economies alternative dispute resolution and contract enforcement mechanisms should be encouraged and developed alongside the development of legal and other formal institutions. In particular, measures that help foster competition and reduce entry barriers are welfare enhancing. The coexistence of and competition between alternative and legal mechanisms can also exert positive impact on the development of legal institutions, so that they are less likely to be captured by interest groups and become more efficient in adapting to changes. Whether and how a transition from a system dominated by alternative mechanisms to one using the law and legal institutions as the focal point depends on the country’s economic history and growth potentials, as well as the workings of many other social and cultural factors that help build the social norms in the society and business communities.



IV. Summary and Concluding Remarks

In our view China and India’s economic success contains important lessons. While using the law in finance and commerce has become a widely accepted idea, it is based on the history of institutional development in the West. We have argued that it can be optimal in static environments with infrequent changes. In dynamic environments such as China and India it may be better to use other mechanisms that do not rely on the law because this reduces the inefficiencies associated with political economy factors. Designing economic institutions that minimize political economy problems by not relying on the legal system is one of the keys to fast economic growth.



References

  1. Acemoglu, Daron, and Simon Johnson, 2005. “Unbundling Institutions,” Journal of Political Economy, 113 (5), 949-995.

  2. Allen, Franklin, Jun Qian, and Meijun Qian, 2005. “Law, Finance, and Economic Growth in China,” Journal of Financial Economics 77 (1), 57-116.

  3. ____, ____, and ____, 2008. “China’s Financial System: Past, Present and Future,” Chapter 14, China’s Great Economic Transformation, eds. L. Brandt and T. Rawski, Cambridge University Press.

  4. ____, Rajesh Chakrabarti, Sankar De, Jun Qian, and Meijun Qian, 2008. “Financing Firms in India,” working paper, Wharton Financial Institutions Center.

  5. Bellis, Mary, The History of Antibiotics.

  6. Bernstein, Lisa, 1992. “Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry,” Journal of Legal Studies 21, 115-157.

  7. Bolt, Wilko, David Humphry, and Roland Uittenbogaard, 2005. “The Effects of Transaction Pricing on the Adotption of Electronic Payments: A Cross-country Comparison,” working paper, Federal Reserve Bank of Philadelphia.

  8. Djankov, Simeon, Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer, 2002. “The Regulation of Entry,” Quarterly Journal of Economics, 117 (1), 1-37.

  9. ____, ____, ____, and ____, 2003. “Courts,” Quarterly Journal of Economics, 118 (2), 453-517.

  10. ____, ____, ____, and ____, 2005. “The Law and Economics of Self-Dealing,” Working Paper, Harvard University.

  11. Demirgüç-Kunt, Asli, and Ross Levine, 2002. Financial Structure and Economic Growth: Cross-country Comparisons of Banks, Markets, and Development, MIT Press, Cambridge, Massachusetts.

  12. Dewatripont, Mathias, and Patrick Legros, 2007. “Essential Patents, FRAND Royalties and Technological Standards,” working paper, ECARES.

  13. Greif, Avner, 1989. “Reputation and Coalitions in Medieval Trade: Evidence on the Maghribi Traders,” Journal of Economic History 49, 857-882.

  14. ____, 1993. “Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders’ Coalition,” American Economic Review 83, 525-548.

  15. Heston, Alan, 2008. “The 2005 Global Report on PPPs: A Preliminary Review,” working paper, University of Pennsylvania.

  16. Humphrey, David, Lawrence Pulley, and Jukka Vesala, 1996. “Cash, Paper, and Electronic Payments: A Cross-country Analysis,” Journal of Money, Credit, and Banking 28, 914-939.

  17. Khan, Zorina, 2005. The Democratization of Invention: Patents and Copyrights in American Economic Development, 1790-1920, Cambridge University Press.

  18. Kirby, William, 1995. “China Unincorporated: Company Law and Business Enterprise in Twentieth-Century China,” Journal of Asian Studies 54, 43-63.

  19. Kondo, Jiro, 2007. “Self-Regulation and Enforcement: Evidence from Investor-Broker Disputes at NASD,” working paper, MIT.

  20. Kopf, Edwin, 1929. “Notes on the Origin and Development of Reinsurance,” Proceedings of the Casualty Actuarial Society, Vol. XVI, #33/34.

  21. La Porta, Rafael, Florencio Lopez-de-Silanes, Andrei Shleifer, and Robert Vishny, 1997. “Trust in Large Organizations,” American Economic Review (proceedings issue), 87 (2), 333-338.

  22. ____, ____, ____, and ____, 1998, “Law and Finance,” Journal of Political Economy, 106, 1113-55.

  23. ____, ____, ____, and ____, 1999, “The Quality of Government,” Journal of Law, Economics, and Organization, 15 (1), 222-279.

  24. Lee, Tahirih V., 1993. “Risky Business: Courts, Culture, and the Marketplace,” University of Miami Law Review 47, 1335-1414.

  25. Lerner, Josh, 2005. “150 Years of Patent Protection,” American Economic Review papers and proceedings.

  26. Oberholzer-Gee, Felix, and Koleman Strumpf, 2007. “The Effect of File Sharing on Record Sales: An Empirical Analysis,” Journal of Political Economy 115, 1-42.

  27. OECD, Directorate for Financial and Enterprise Affairs of the Competition Committee, 2004. “Intellectual Property Rights,” proceedings from Policy Roundtables on Intellectual Property Rights.

  28. Rajan, Raghuram, and Luigi Zingales, 2003a. “The Great Reversals: The Politics of Financial Development in the Twentieth Century,” Journal of Financial Economics 69, 5-50.

  29. _____, and _____, 2003b. Saving Capitalism from Capitalists: Unleashing the Power of Financial Markets to Create Wealth and Spread Opportunity, Random House, New York.

  30. Spagnolo, Giancarlo, 1999, “Social Relations and Cooperation in Organizations,” Journal of Economic Behavior and Organization 38, 1-25.

  31. Winn, Brian, 2004. “Arbitration of Reinsurance Disputes: Is There a Better Way?” Dispute Resolution Journal (by the American Arbitration Association).

Table 1 The Largest 20 Economies in the World: GDP and Growth


GDP in 2007 (simple

exchange rates)

GDP in 2007

(PPP)

GDP growth:

1990-2007

(constant prices)

Per capita GDP growth: 1990-2007* (constant prices)

Rank

Country

/Region


US$

billion





Country

/Region


Int’l $ billion




Country

/Region


Annual growth




Country

/Region


Annual growth

1

U. S.

13,794




U. S.

13,543




China

10.3%




China

9.3%

2

Japan

4,346




China

11,606




Vietnam

7.6%




Vietnam

6.0%

3

Germany

3,259




India

4,727




India

6.3%




Korea

4.7%

4

China

3,249




Japan

4,346




Malaysia

6.2%




Taiwan

4.5%

5

U. K.

2,756




Germany

2,714




Chile

5.6%




India

4.4%

6

France

2,515




U. K.

2,271




Korea

5.5%




Chile

4.2%

7

Italy

2,068




France

2,040




Taiwan

5.3%




Poland

3.9%

8

Spain

1,415




Brazil

2,014




Bangladesh

5.2%




Sri Lanka

3.8%

9

Canada

1,406




Russia

1,909




Sri Lanka

5.0%




Malaysia

3.7%

10

Brazil

1,295




Italy

1,888




Yemen, R.

5.0%




Thailand

3.6%

11

Russia

1,224




Spain

1,310




Thailand

4.6%




Bangladesh

3.1%

12

India

1,090




Korea

1,250




Pakistan

4.6%




Indonesia

3.0%

13

Korea

950




Mexico

1,250




Egypt

4.5%




Peru

2.9%

14

Australia

890




Canada

1,217




Iran

4.5%




Iran

2.9%

15

Mexico

886




Indonesia

1,054




Peru

4.4%




Argentina

2.8%

16

Netherlands

755




Taiwan

750




Indonesia

4.4%




Egypt

2.3%

17

Turkey

482




Australia

731




Turkey

4.0%




Turkey

2.3%

18

Belgium

443




Turkey

723




Argentina

4.0%




Pakistan

2.3%

19

Sweden

432




Argentina

691




Poland

3.9%




Spain

2.2%

20

Switzerland

414




S. Africa

664




Philippines

3.8%




Australia

2.2%
1   2   3   4


The database is protected by copyright ©essaydocs.org 2016
send message

    Main page