RelImprecision · Behaviour, perceptions, cognition, knowledge, organizations. Relational contracting approach to design of contractual forms when information is imprecise.

Behaviour, perceptions, cognition, knowledge, organizations. Relational contracting approach to design of contractual forms when information is imprecise.

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.

Data: CORDIS, © European Union