NCPA - National Center for Policy Analysis

Examining How Contracts Work

October 10, 2002

Traditional economics focuses on supply and demand. But the new institutional economics studies how people arrange their affairs; how they create institutions -- including legal sanctions, social norms and organizational structures -- to govern their relationships; how those institutions spur or hinder economic growth; and how those institutions improve through trial and error.

Central to this new discipline is an understanding of contracts -- how they developed and how they work.

How is it, for example, that people can lend money to complete strangers far away and be certain they will eventually get their money back?

  • Initially, in the Middle Ages, enforcement of such contracts was through the community responsibility system -- in which every member of a community was liable for every other member's debts.
  • This system was eventually abandoned in favor of another which rested on creditors evaluating borrowers by using indicators of their individual merits.
  • New research focuses on how traffickers finance long-term, long-distance moves by poor illegal immigrants from, say, China to the U.S. or Europe -- and how the trafficker is repaid, even though such contracts are no longer enforceable.
  • The illegal status of the new arrivals actually helps to enforce the contract to repay -- since they don't want to be found out and deported.

This example illustrates that when the rule of law is absent or imperfect, people find other ways to make contracts workable.

Source: Virginia Postrel, "Economic Scene: Even Without Law, Contracts Have a Way of Being Enforced," New York Times, October 10, 2002.


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