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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.

Adverse Selection --- Asymmetric Information --- Business Environment --- Competitiveness and Competition Policy --- Consumers --- Cred Economic Performance --- Debt Markets --- E-Business --- Economic Theory and Research --- Emerging Markets --- Equilibrium --- Expected Utility --- Finance and Financial Sector Development --- Financial Literacy --- Fixed Costs --- Incentives --- Influence --- Insurance and Risk Mitigation --- Investment --- Labor Policies --- Macroeconomics and Economic Growth --- Marginal Costs --- Microfinance --- Moral Hazard --- Prices --- Private Sector Development --- Production --- Productivity --- Property Rights --- Public Sector Development --- Social Protections and Labor --- Theory --- Trade --- Utility

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November 1999 - Social capital raises productivity and falls with labor mobility. Because labor mobility generates a negative externality, integration of labor markets results in too much mobility, too low a level of social capital, and an ambiguous effect on welfare. Trade liberalization is superior to labor market integration because it reduces mobility and the negative externality associated with it. Labor market integration is typically assumed to improve welfare in the absence of distortions, because it allows labor to move to where returns are highest. Schiff examines this result in a simple general equilibrium model in the presence of a common property resource: social capital. Drawing on evidence that social capital raises productivity and falls with labor mobility, Schiff's main findings are that: Labor market integration imposes a negative externality and need not raise welfare; The welfare impact is more beneficial (or less harmful) the greater the difference in endowments is between the integrating regions; Whether positive or negative, the welfare impact is larger the more similar the levels of social capital of the integrating regions are and the lower the migration costs are; Trade liberalization generates an additional benefit-over and above the standard gains from trade - by reducing labor mobility and the negative externality associated with it. Trade liberalization is superior to labor market integration; The creation of new private or public institutions in response to labor market integration may reduce welfare. Schiff shows that the welfare implications depend on two parameters of the model, the curvature of the utility function and the cost of private migration. This paper - a product of Trade, Development Research Group - is part of a larger effort in the group to understand the link between market performance and welfare. The author may be contacted at mschiff@worldbank.org.

Bonds --- Capital --- Cred Economic Performance --- Debt Markets --- Economic Theory and Research --- Emerging Markets --- Equilibrium --- Finance and Financial Sector Development --- Financial Literacy --- Free Trade --- Goods --- Health, Nutrition and Population --- Human Capital --- Labor Markets --- Labor Policies --- Liquidity --- Macroeconomics and Economic Growth --- Markets and Market Access --- Negative Externalities --- Population Policies --- Private Sector Development --- Production Function --- Production Functions --- Public Good --- Social Capital --- Social Development --- Social Protections and Labor --- Trade Barriers --- Transactions Costs --- Transport --- Transport Economics, Policy and Planning --- Unemployment --- Utility --- Utility Function --- Voters --- Welfare