Relationships and Growth: On the Dynamic Interplay between Relational Contracts and Competitive Markets in Economic Development

Abstract

This paper presents a dynamic general equilibrium model to investigate how different contracting modes based on formal and relational enforcements emerge endogenously and are linked dynamically with the process of economic development. Formal contracts are enforced by third-party institutions (courts), whereas relational contracts are self-enforcing agreements without third-party involvement. The novel feature of our model is that it demonstrates the co-evolution of these different enforcement modes and market equilibrium conditions, all of which are jointly determined. We then characterise the equilibrium paths of such dynamic processes and show the time structure of relational contracting in the process of development. In particular, we show that relational contracting fosters the emergence of a market-based economy in the growth phase of development; however, its role declines as the economy enters a mature phase.