On Corruption and Institutions in Decentralized Economies

This paper studies opportunistic behaviour in a model of decentralized economic exchange and inadequate institutional framework of formal contract enforcement. It is shown that (i) when the number of cheating traders is sufficiently large, inadequate institutions (e.g. due to insufficient legal provisions and/or ineffective enforcement of existing laws) result in a loss of decentralized trading contracts which suggests yet another explanation of the output fall puzzle of the recent transition experience; (ii) while being necessary for the attainment of a Pareto optimal outcome, an adequate institutional framework may not be sufficient if traders perceive it as inadequate; and (iii) in the presence of adequate institutional framework, even if enforcers are corrupt contractual breach is deterred when enforcers enjoy strong bargaining power. The results suggest that institutions of formal contract enforcement have a first order effect on the success of liberalization in the economy with a high level of corruption.