Periodic Reporting for period 2 - RelImprecision (Behaviour, perceptions, cognition, knowledge, organizations. Relational contracting approach to design of contractual forms when information is imprecise.)
Reporting period: 2021-10-01 to 2022-09-30
Contract enforcement and rule of law can be key in determining economic outcomes. The project aims to provide a new set of empirical results showing that cross country differences in contract enforceability can have important implications for aggregate TFP volatility, cross-sectional dispersion in firm-level TFP’s and wage inequality. These are important and relevant aspects for the evolution of society. Many studies support the notion that that income inequality - the gap between rich and poor - strongly influences people's health and wellbeing as well as human capital formation and social cohesion. Moreover, differences in aggregate TFP volatility can be detrimental for the well-being of nations. For example, economic studies have shown that the reason why poor and emerging countries suffer from more pronounced business cycle fluctuations is because of the volatility in their TFP process. As a result, the main aim of the project is to understand the determinants of aggregate TFP volatility.
To address this question, after presenting the empirical evidence that supported that rule of law matters for macroeconomic volatility the authors build a model that could rationalize their empirical findings. The authors use a game theoretical framework to build intuition upon the theoretical results. They build a model in which two entities, such as a firm and an employee, interact over time. The model includes two building blocks. The first is the concept that businesses are hit by shocks that make them more or less profitable. The second is that contracts are not perfectly enforceable, depending on the legal environment. This lack of contract enforcement can tempt a person to renege on a promise, and when it's the boss, there's a cost. The business relationship is damaged. The team compared two theoretical economic environments, one with strong rule of law, or contract enforcement, and the other marked by poor enforcement. Then they studied the effects of economy-wide and company-specific shocks. The researchers found a strong relationship between strength of rule of law and aggregate volatility. In countries with weaker legal systems, workers in less productive businesses are quicker to stop putting in effort during rocky economic times.
The findings have implications for relationships among employers and employees, businesses, and governments across the globe. Building trust is especially important for businesses in countries where the rule of law is weak and relational contracts are the norm. Organizations can work on building trust well before a major shock hits, and empowering employees to challenge broken promises can also help companies gain credibility. They conclude that the economic cycle could be smoother if there is a better rule of law. Such an understanding can help us build sustained policy that focuses on raising productivity in order to increase living standards, help rebuild fiscal buffers and make growth more inclusive.
To address this question, after presenting the empirical evidence that supported that rule of law matters for macroeconomic volatility the authors build a model that could rationalize their empirical findings. The authors use a game theoretical framework to build intuition upon the theoretical results. They build a model in which two entities, such as a firm and an employee, interact over time. The model includes two building blocks. The first is the concept that businesses are hit by shocks that make them more or less profitable. The second is that contracts are not perfectly enforceable, depending on the legal environment. This lack of contract enforcement can tempt a person to renege on a promise, and when it's the boss, there's a cost. The business relationship is damaged. The team compared two theoretical economic environments, one with strong rule of law, or contract enforcement, and the other marked by poor enforcement. Then they studied the effects of economy-wide and company-specific shocks. The researchers found a strong relationship between strength of rule of law and aggregate volatility. In countries with weaker legal systems, workers in less productive businesses are quicker to stop putting in effort during rocky economic times.
The findings have implications for relationships among employers and employees, businesses, and governments across the globe. Building trust is especially important for businesses in countries where the rule of law is weak and relational contracts are the norm. Organizations can work on building trust well before a major shock hits, and empowering employees to challenge broken promises can also help companies gain credibility. They conclude that the economic cycle could be smoother if there is a better rule of law. Such an understanding can help us build sustained policy that focuses on raising productivity in order to increase living standards, help rebuild fiscal buffers and make growth more inclusive.
The project developed a parsimonious model of relational contracts that help rationalize empirical evidence showing that countries with better rule of law – where courts are more easily enforce contracts—experience less economic volatility, have less productivity dispersion amongst its firms and lower wage inequality.
In the first part of the project, we collected data in order to establish the relationship between rule of law and economic volatility. Collecting data from the World Bank (in particular, World Bank’s World Development Indicators (WDI) database) for rule of law indicators we show a negative relationship between rule of law indicators and macroeconomic volatility. This is the case for countries like China, India, and Russia, which rely more on relational contracts based mostly on trust between two parties. Countries with better rule of law, however, like the U.S. the U.K. and Australia, see overall less economic volatility. We find that countries with better institutions that enforce rule of law experience smaller volatility in output. The second finding suggests that countries with weak institutions for rule of law can achieve a reduction in productivity dispersion if they improve the quality of their legal system. Finally, we also find a negative relationship between the rule of law measure and wage inequality. All three findings are consistent with our main theorem: countries with poor contractual environments experience greater aggregate volatility, productivity dispersion and wage inequality.
To rationalize these empirical relationships between the country’s quality of contract enforcement institutions and economic outcomes, in the second part of the project we offer a model of relational contracting. We show that a very tractable model of relational contracts can simultaneously explain both micro and macro phenomena. We compare two theoretical economic environments, one with good rule of law, or contract enforcement, and the other marked by poor enforcement. Our analysis shows that, when contract enforcement is poor, employee morale suffers, ultimately sparking more economic volatility and greater differences in productivity across companies. Our model features two main building blocks. The first assumption is that firms experience adverse shocks that make them less profitable. Importantly, these shocks are persistent. The second key ingredient is that when coping with uncertainty, contracts might not be perfectly enforceable, depending on the legal environment. This lack of contract enforcement can tempt an employer to renege on a promise. When an employer reneges, however, there is a cost: the business relationship is damaged.
In summary, our model highlights the role of persistence in productivity during bad times. When the current productivity is low, the future value from maintaining the relationship is low, and the firm cannot credibly promise to make bonus payments. Thus, in recessions, the firm experience difficulty in motivating the worker to exert high effort. Consistently with the empirical evidence, this “low morale effect” in turn amplifies the adverse effect of uncertainty in productivity. This amplification effect also sheds light on wage inequality in countries with limited legal enforcement.
The project has been published in the Journal of Monetary Economics in May 2022. It has been presented in various prestigious workshops and conferences (see the full list in the published paper).
In the first part of the project, we collected data in order to establish the relationship between rule of law and economic volatility. Collecting data from the World Bank (in particular, World Bank’s World Development Indicators (WDI) database) for rule of law indicators we show a negative relationship between rule of law indicators and macroeconomic volatility. This is the case for countries like China, India, and Russia, which rely more on relational contracts based mostly on trust between two parties. Countries with better rule of law, however, like the U.S. the U.K. and Australia, see overall less economic volatility. We find that countries with better institutions that enforce rule of law experience smaller volatility in output. The second finding suggests that countries with weak institutions for rule of law can achieve a reduction in productivity dispersion if they improve the quality of their legal system. Finally, we also find a negative relationship between the rule of law measure and wage inequality. All three findings are consistent with our main theorem: countries with poor contractual environments experience greater aggregate volatility, productivity dispersion and wage inequality.
To rationalize these empirical relationships between the country’s quality of contract enforcement institutions and economic outcomes, in the second part of the project we offer a model of relational contracting. We show that a very tractable model of relational contracts can simultaneously explain both micro and macro phenomena. We compare two theoretical economic environments, one with good rule of law, or contract enforcement, and the other marked by poor enforcement. Our analysis shows that, when contract enforcement is poor, employee morale suffers, ultimately sparking more economic volatility and greater differences in productivity across companies. Our model features two main building blocks. The first assumption is that firms experience adverse shocks that make them less profitable. Importantly, these shocks are persistent. The second key ingredient is that when coping with uncertainty, contracts might not be perfectly enforceable, depending on the legal environment. This lack of contract enforcement can tempt an employer to renege on a promise. When an employer reneges, however, there is a cost: the business relationship is damaged.
In summary, our model highlights the role of persistence in productivity during bad times. When the current productivity is low, the future value from maintaining the relationship is low, and the firm cannot credibly promise to make bonus payments. Thus, in recessions, the firm experience difficulty in motivating the worker to exert high effort. Consistently with the empirical evidence, this “low morale effect” in turn amplifies the adverse effect of uncertainty in productivity. This amplification effect also sheds light on wage inequality in countries with limited legal enforcement.
The project has been published in the Journal of Monetary Economics in May 2022. It has been presented in various prestigious workshops and conferences (see the full list in the published paper).
The findings of our study have implications not only for the employer-employee relationship, but also for relationships between two businesses, and for governments across the globe. The economic cycle could be smoother if countries had better rule of law.
For employers, the model confirms that in difficult economic times, it is tough to motivate workers, and companies risk a significant drop in productivity. But employee trust mitigates that drop. Building trust is even more important for businesses in countries where the rule of law is weak and relational contracts are the norm.
For employers, the model confirms that in difficult economic times, it is tough to motivate workers, and companies risk a significant drop in productivity. But employee trust mitigates that drop. Building trust is even more important for businesses in countries where the rule of law is weak and relational contracts are the norm.