Formal and informal institutions in developing economies with limited contract enforcement

Developing countries often have weak formal institutions for the enforcement of contractual commitments. Different informal institutions typically fill this gap in varying degrees, creating scope for beneficial policy interventions. This dissertation studies the role of formal and informal institutions and the interactions between them in three different contexts.; Many pairwise trading environments leave traders vulnerable to opportunistic exploitation. With weak enforcement institutions and non-verifiable hold-ups, cooperative arrangements are sustained by reputation for honesty and reliability. The first chapter explores the credibility and cost of reporting behavior forming the basis of reputations of individual traders. Unlike previous literature, this study endogenizes the reporting behavior and shows that the veracity of reported information is compatible with individual incentives. The analysis is extended to study the incentives to send and receive information when such activities are costly.; The second chapter studies training in an informal economy without credit markets and shows that some labor market frictions may be necessary for skill creation. An enforcement problem is created as trainers have to be compensated by ex post ‘indenture’ services. With a large supply of unskilled workers, enforcement constraints bind, leading to underinvestment in training. Comparative statics of such an underemployment equilibrium reveals that technological progress or positive demand shocks reduce training, contrary to the first-best world. The model is used to analyze historical apprenticeship institutions and to study human capital policy implications for developing countries.; The third chapter studies interactions between formal and informal lenders in rural credit markets to evaluate the impact and performance of government sponsored credit expansion policies. Informal lenders are assumed to have better information about borrower risk while formal lenders have lower opportunity cost of funds. When long-term contracts cannot be enforced, entry of formal lenders can cause all lending to cease, unless the informal lenders can themselves borrow from the formal sector. The study provides an explanation of why policies designed to eradicate informal lenders have failed in many developing countries and why informal lenders are major recipients of formal loans.