Network Effects and Private Legal Systems
[The text below
includes excepts from Regulation by Networks, 2003 BYU L. Rev. 1179
(2003)]
A significant body of legal literature (which is often referred to as ‘private ordering’) examines connectivity regulation by parties other than government: rules, norms and institutions that are self-imposed by private parties to govern their behavior and transactions. Stuart Macaulay’s seminal work in this field observed that few contractual disputes are litigated, and most are settled without resorting to government-enforced laws [Stuart Macaulay, Non-Contractual Relations in Business: A Preliminary Study, 28 Am. Soc. Rev. 55 (1963)].
Much of the research following Macauley’s observation on opting out of the governmental legal system examined bilateral, relationship-based transacting, in which reputational investments in the relationship serve as collateral against opportunism: Clifford Geertz noted that buyers and sellers in Bazaars tend to pair off in recurrent transactions [Clifford Geertz, The Bazaar Economy: Information and Search in Peasant Marketing, 68 Am. Econ. Rev. 28 (1978). For similar observations also see: Cyril Belshaw, Traditional Exchanges and Modern Markets (1965) (Noting that traders in traditional markets tend to personalize their exchange relations to mitigate contractual uncertainty (i.e., opportunism))]. Richard Posner pointed to a similar pattern of “barter friendships” within primitive societies, which oblige the parties to similar standards of loyalty as they owe their kinsmen [Richard A. Posner, A Theory of Primitive Society, with Special Reference to Law, 23 J. Law & Econ. 1 (1980)]. Such a status and its attached obligations serve to mitigate opportunism despite the absence of public enforcement [Id., at p. 26]. Janet Landa expanded Geertz’s and Posner’s observations by considering a wider, network relationship, which she identified as an “ethnically homogenous middleman group” [Janet T. Landa, A Theory of The Ethnically Homogenous Middleman Group: An Institutional Alternative to Contract Law, 10 J. Leg. Stud. 349 (1981)]. This group facilitates exchanges where government enforcement of law is deficient (and therefore the certainty of abiding to contracts is lacking), by taking advantage of the high barriers to entry into an ethnic social group (and therefore the need to stay on good terms with one’s existing ethnic group). Landa follows the method of analysis used earlier by George Akerlof to explain the caste system in India: an ethnic group can impose an efficient code of behavior through the threat of exclusion, and it can provide low-cost, accurate information on the trustworthiness of its members by economizing on information-collection [George Akerlof, The Economics of Caste and of the Rat Race and Other Woeful Tales, 90 Q. J. Econ. 599, 608-611 (1977)]. Landa’s focus, therefore, is on networks’ mitigation of informational asymmetries.
A few scholars examined the effects networks have in coordinating punishment against opportunists. Avner Grief modeled a “Multilateral Punishment Strategy” patterned after the Maghribi merchant coalitions [Avner Greif, Contract Enforceability and Economic Institutions in Early Trade: The Maghribi Traders' Coalition, 83 Am. Econ. Rev. 525 (1993)]. His model considered what is effectively a decentralized network, in which the decisions (mainly, whether to punish or exclude opportunists) are made by each member separately, and the network facilitates the exchange of information that identifies a member as an opportunist (therefore, it is an extension of the reputation element). Karen Clay modified this model, patterned after merchant coalitions in early 19th Century Mexican California, to incorporate different strategies of specific merchants regarding dealing with people whom other members of the network tagged as ‘dishonest’ [Karen Clay, Trade Without Law: Private-Order Institutions in Mexican California, 13 J.L. Econ. & Org. 202 (1997)]. John McMillan and Christopher Woodruff pointed to the role of private-order organizations in coordinating responses to opportunism (in addition to collecting information to detect such opportunism) [John McMillan & Christopher Woodruff, Private Order Under Dysfunctional Public Order, 98 Mich. L. Rev. 2421, 2430-2435 (2000)]. Lisa Bernstein examined mechanisms (such as arbitration and the maintenance of a common culture) by which trade associations, diamond exchanges, and other trading networks enforce their private legal systems [See, e.g., Lisa Bernstein, Opting Out of the Legal System: Extralegal Contractual Relations in the Diamond Industry, 21 J. Legal Stud. 115 (1992); Lisa Bernstein, Private Commercial Law in the Cotton Industry: Creating Cooperation Through Rules, Norms, and Institutions, 99 Mich. L. Rev. 1724 (2001)]. Many of these mechanisms take achieve their effectiveness through utilization of network effects.
Amitai Aviram categorized the mechanisms used by networks to mitigate opportunistic behavior in four groups: switching mechanisms (efficient replacement of failed transactions with alternative ones); exclusion mechanisms (depriving a member of access to the network); control mechanisms (centralized control of transacting facilities and other members’ assets); and information mechanisms (collection and dissemination of information on the credibility of firms, in order to facilitate independent decisions on the feasibility of transacting) [Amitai Aviram, Regulation by Networks, 2003 BYU L. Rev. 1179 (2003)]. These mechanisms are not equally effective in all circumstances. Certain types of opportunism are more resistant to certain mechanisms than to others. Also, in certain market structures these mechanisms are less effective than in other market structures. Learning more about the strengths and weaknesses of the various types of opportunistic behavior and those of the various mechanisms to combat them will enable us to better assess the circumstances in which self-regulation is a viable, and even preferable alternative to government regulation.
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