The legal environment, specialized investments, incomplete contracts, and labor productivity

Abstract

This paper provides a framework for analyzing the interactions among legal environments, incomplete contracts and specialized investments. It is well known that providers of specialized investments may be taken advantage when the contract is incomplete, thus an improvement in legal environments may be able to better protect those specialized asset investors and provide them with stronger incentive for specialized investments hence promote the overall level of specialization of the economy and enhance labor productivity. (1) We use the data set from IEDB(Industrial Enterprises Data Bank) of China to capture this effect. It is found that legal environment improvement does enhance the labor productivity through encouragement of specialization. This effect is robust under different settings in assumptions of endogeneity, heterogeneity and measurements of productivity index. (2) Heterogeneity analysis shows that a bigger market scale does encourage deeper specialization, more specialized investments, and thus improving the labor productivity. (3) The above conclusion holds up not only at the micro (firm) level but also at the macro level of the economy. The labor productivity increase happens with the growth of an industry along with deeper specialization and better legal environments.