Optimal cash-in-advance contracts under weak third-party enforcement

Abstract

We explore the implications of North’s weak third-party enforcement (TPE) on the structure of the ex ante incentives-compatible contracts that require an advance payment by the principal to the agent. This generates appropriable quasi-rent, which the agent can appropriate. To deal with this, we introduce a stronger constraint, the augmented participation constraint, reflecting the quality of tpe that prompts a distinction between insider reservation and outsider reservation utility. We show that a falling TPE raises the agent’s insider reservation utility, reducing the principal’s profit and his willingness to contract. When the cash-in-advance commitment is endogenous, its optimal level falls as TPE falls. tpe erosion thus leads to either the nonexistence of or the flight from more productive contracts and exchange, leading to North’s observation of poorer economic performance.

JEL classification: O22, O26, 611