A Contract

1. Introduction. – Access to information and transactional reliability work in tandem. With better information, business executives are more likely to trade with a counter-party who is well matched. They are better prepared to meet any stress that the relationship might encounter. Knowing that the other party has access to information about his own behavior, the counter-party is himself less likely to try to defraud.

What is more, when a transaction is more reliable, the contracting parties are more willing to invest in relationship-specific assets and skills; earning a return from those assets and skills, they will be less likely to find termination profitable. Providing information to one’s counter-party constitutes exactly such a relationship-specific investment: The contracting parties are incurring a cost to exchange information that they each will find valuable only in the context of their relationship.

Hence the conclusion: Legal institutions that enforce the terms of an agreement increase both transactional reliability and the amount of information that the contracting parties will find it profitable to exchange.

2. Transactional reliability. – Modern formal legal institutions serve at least two key functions relevant here. First, they potentially extend the range of parties with whom a business executive can profitably trade. The point follows from jurisdictional reach. Formal institutions can enforce compliance from those counter-parties who are subject to the jurisdiction of the court. For most modern societies, this jurisdiction will extend at least to the boundaries of the nation state (and sometimes even beyond). By contrast, informal institutions exert power only within a party’s social network. They induce compliance only from those parties subject to the social sanctions of the group.

As a result, rational wealth-maximizing parties to a contract can use the courts as a way to expand their set of potential contract partners beyond those amenable to informal social sanctions. For any business executive, some potential business partners will lie beyond the range of their informal networks. In such situations, court-enforceable legal sanctions potentially extend the bounds of profitable contracting. As Richard Epstein (Reference Epstein2008, 279–80) put it:

Second, the formal legal system will potentially set the contours of the terms by which the parties settle disputes out of court. In cases involving contracts, modern legal systems generally provide a non-breaching party with expectation damages: The profit he could reasonably expect to earn had the counter-party not breached. Given that both parties can generally settle a dispute out of court more cheaply than through trial, rational parties will settle most disputes informally.

When parties to a contract do settle out of court, the legal system potentially sets the contours of their informal settlement. When rational wealth-maximizing parties decide to terminate a relationship, they negotiate – in the famous words of Robert Mnookin and Lewis Kornhauser (Reference Mnookin and Kornhauser1979) – “in the shadow of the law.” As scholars in law and economics have shown in detail, they settle their endgame disputes within a “settlement window” determined by their respective estimates of the probable litigated outcome, their costs of litigation, and their costs of settlement. In Lisa Bernstein’s words (2015, 569):

Crucially, the expected legal outcome sets the contours of the out-of-court settlement only when the parties have decided to terminate their relationship. Firms (or Midwestern business executives, observes Bernstein) draft contract terms in order to structure the dissolution of a relationship if and when they decide it no longer works. They do not intend the terms to bind them while the relationship remains viable. So long as they find the relationship profitable, they routinely adjust and change their course of dealing to keep it mutually advantageous.

Faced with a contract breach, explains Bernstein (Reference Bernstein1996, Reference Bernstein1999), firms distinguish between those relations they want to keep and those they want to terminate. The former, they work to preserve, and in doing so may ignore completely the terms that a court would impose in court. The latter, they terminate and do so in Mnookin and Kornhauser’s shadow of the law. The terms they apply to the relations they want to preserve can – and often do – differ dramatically “from the terms of transactors’ written contracts, which contain the norms that transactors would want a third-party neutral to apply in a situation where they were unable to cooperatively resolve a dispute and viewed their relationship as being at an end-game” (Bernstein Reference Bernstein1996, 1796).

3. The effect of price. – When transacting across the market, a firm can increase the incentive of its contracting partner to keep its word by increasing the price it pays. Obviously, firms do not generally increase profitability by raising the prices they pay. They raise profitability through higher prices only if those prices induce a contracting partner to so increase its reliability that the firm can produce in a way otherwise not possible.

At stake are the rents that a contracting party can expect to earn from the relationship. If the rents are sufficiently high, the party will find it profitable to pay more to insure that the relationship continues. If information disclosure will increase the viability of the contractual relationship, rational parties will each disclose additional information. They will continue to invest in the relationship-specific attributes (like information) until they have reduced the return on the contract to market levels.

More generally, consider this the contractual analogue to the concept of “efficiency wages.” Sometimes, an employer can raise profitability by raising wages. It can do so when those higher wages raise productivity by an amount that more than offsets the higher wage costs. The classic example is Henry Ford. He had conceived a new manufacturing technique: the assembly line. To make the technique work, he needed workers who would stay on the job. He needed workers who would accumulate experience and then draw on that experience to engineer the hundreds of changes necessary to make the assembly line work. As long as he paid the going rate in Detroit – $2.50 per day – workers quit as they pleased. Ford doubled the pay to $5.00, and workers now stayed on the job. They studied the assembly line and made it work.Footnote ²

B Vertical Integration

If one plausible way that formal legal procedures can increase access to information and contractual reliability is through contract law, another is through merger. On the one hand, two contracting parties can use the formal contract apparatus to buy and sell their goods and services to each other. On the other, they can use the merger apparatus to work together within a single firm.

In the classic language of economics workshops, the parties can either “make or buy.” If “to buy” is to contract through formal legal mechanisms, “to make” is to use those same legal institutions to merge. As early as 1937, Ronald Coase explained the choice – like so much else – through transactions costs. Rational parties will place the two counter-parties within a single firm when the transactions costs of contracting across the market exceed the transactions costs of administering a transaction within the firm. They will contract across the market when the transactions costs of internal organization exceed the costs of market contracting.

In the 1980s and 1990s, scholars tried to explain mergers through the extent that the firms relied on assets whose value was specific to the transaction. Such a transaction-specific investment would generate “quasi rents,” they explained. Should the two parties try to contract for the assets across the market, those rents would create incentives for them to try to “hold up” each other (e.g., Klein, Crawford & Alchian Reference Klein, Crawford and Alchian1978; Williamson Reference Williamson1985). The point is obviously true. Unfortunately, as an explanation for actual mergers, the concept lacked much empirical currency. Scholars had initially focused primarily on one historical example (the GM-Fisher Body merger). That example, however, turned on factors later shown to be entirely orthogonal to the “transaction-specific asset” hypothesis (Casadesus-Masanell & Spulber Reference Casadesus-Masanell and Spulber2000; Coase Reference Coase2000). When scholars did find other applications, many of them involved clearly non-standard venues like government procurement (e.g., Masten, Meehan & Snyder Reference Masten, Meehan and Snyder1991).

In his own theory of the firm, Oliver Hart (Grossman & Hart Reference Grossman and Hart1986; Hart & Moore Reference Hart and Moore1990) instead suggests that the question of whether to merge or contract turns on whose involvement is most important to the value of the key assets. Assets, he reasons, should be owned by the firm whose involvement raises the value of those assets to its highest use. As Halonen-Akatwijuka (Reference Halonen-Akatwijuka2019) summarized the argument:

If the land is most valuable when used for the production of sake, for example, it should be owned by the entity whose role is most important in producing that sake (see Chapter 2).

Crucial to our discussion here, formal merger (or vertical integration) does not solve the problem of either information acquisition or transactional reliability. Coase’s point – as important now as in 1937 – is that a merger will change the nature of the transactions costs involved. Sometimes a merger will reduce the level of transactions costs – and when it does, rational parties will tend to merge. Sometimes it will increase the level of the transactions costs – and when it does, rational parties will contract across the market. But in either case, some transactions costs will remain.

Posit two contracting parties, A and B. When they contract as independent parties across the market, they bring interests that sometimes diverge. Because they are each residual claimants to their separate businesses, they each have an interest in diverting as much of the residual revenue stream as possible to themselves. Toward that end, they may find it advantageous to renege on their bargains (hence the problem of transactional reliability). Given that risk of opportunism, they may hesitate to disclose much information to each other (hence the problem of information acquisition).

Now suppose that A buys B’s business. B (or someone else named by A as B’s replacement) will continue to operate the assets and people that constituted B’s business, but now under A’s ownership. In effect, B (or his replacement) now works as a paid agent of A. Given that A has a claim to the entire residual revenue stream from the combined A-B business, he no longer needs to worry about how B splits the stream. After all, no one splits the stream at all.

Instead, however, A does now need to worry about B diverting the firm’s revenue stream to himself as hidden compensation. He can take money from customers under the table. He can steal assets from the firm. He can steal the most profitable business opportunities for himself. If not pecuniarily inclined, he can simply stop working hard. A no longer worries about splitting the residual income stream with B; instead, A now worries that B will divert revenue before it ever reaches that residual level.

Hence the importance of Coase: When (a) the potential loss from divergent interests in the residual revenue stream exceeds (b) the potential loss from the efforts of an in-house agent to increase his pecuniary or non-pecuniary compensation, the parties will tend to join together in a single firm. When the latter exceeds the former, they will tend to contract across the market. Call it “transactions costs” if you will – but vertical integration does not eliminate informational and reliability problems. It may reduce those problems, but never to zero. It may eliminate the problem that arises from having two independent claimants to a business’s residual revenue stream. But in eliminating that problem, it simultaneously compounds the problem that arises from employing an agent with his own selfish interests.

A Introduction

No one relies exclusively on formal legal institutions, of course. No one ever did. Legal scholars traditionally focused on those institutions, and many scholars in economics have done the same. Yet in both fields, over the course of the last century, scholars have increasingly also studied the way that people integrate their formal legal tools into the social world within which they live and work (Section B). Simultaneously, sociologists and political scientists have used a different set of terms to explore a largely overlapping phenomenon (Section C).

B The Classic Examples

Scholars examining the relationships among formal legal institutions and social context focus on several closely observed studies. In all of these classic studies, the authors examined a relatively small and insular community. Throughout – whether explicitly or implicitly – they focused on the way that the parties involved increased the reliability of their transactions and the information to which they had access.

1. Macaulay. – The modern literature begins with Stewart Macaulay (Reference Macaulay1963). As described above, Macaulay’s Wisconsin businessmen transacted with people they knew. They transacted with them because they knew them (had better information) and could trust them (could more reliably predict transactional performance). “At all levels of the two business units personal relationships … exert pressures for conformity to expectations,” wrote Macaulay (Reference Macaulay1963, 63). “The top executives of the two firms may know each other. They may sit together on government or trade committees. They may know each other socially and even belong to the same country club.”

Macaulay’s businessmen knew each other from a variety of fora. They could use those fora to obtain information. And they could rely on those fora to induce the other to perform.

2. Landa. – If Macaulay saw himself as a sociologist, Janet Landa (Reference Landa1981) tied her studies to modern economics. Landa examined Chinese middlemen in the Southeast Asian rubber market. There, she (1981, 350) found trade dominated by several clans bound together through “a tightly knit kinship structure” and “linked together in complex networks of particularistic exchange relations.” An “ethnically homogenous middlemen group,” she called them. The clan functioned as “a low-cost club-like institutional arrangement,” she (1981, 350) explained, “an alternative to contract law and the vertically integrated firm.”

These Chinese middlemen traded, Landa and Robert Cooter (1984, 15–16) continued, within “a repository of trust that reduces the probability of breach on a contract between insiders.” Through their personal ties, they were able “to rely upon informal means of enforcement of contracts.” As Richard Epstein (Reference Epstein2008, 280) explained Landa’s work, “the group members tend to cooperate with each other because they have common ties of kinship that antedate their business relationship.” They understand that “to treat someone badly on the job is to risk social censure and ostracism, which in turn makes breach more costly than would otherwise be the case.”

3. Ellickson. – Robert Ellickson (Reference Ellickson1986, Reference Ellickson1991) identified much the same apparent irrelevance to the formal legal system among the farmers and cattle ranchers of Shasta County, California. As the cattle roamed, they damaged fences and ate crops. For the most part, found Ellickson, the residents settled their resulting disputes without going to court, and without even following the rules a court would enforce.

Ellickson’s rangers interacted with each other regularly, and across a wide range of issues – and could expect to continue to interact indefinitely into the future. Because they thought their norms better suited to their micro-economy than California property or tort law, they “discourage[d] members from taking intermember disputes into the legal system” (Ellickson Reference Ellickson1991, 250). Despite the logic of law and economics scholarship, claimed Ellickson (Reference Ellickson1986, 672), Shasta county rangers did not resolve their conflicts “in the shadow of the law.” Instead, they settled them “beyond that shadow” (Ellickson Reference Ellickson1986, 672; ital. orig.).

4. Bernstein. – Lisa Bernstein (Reference Bernstein1992) studied the New York diamond market. There, she (1992, 140) observed that “the diamond industry has long been dominated by Orthodox Jews.” She found that the merchants deliberately shifted their highest stake transactions outside the ambit of the US legal system (Bernstein Reference Bernstein1992, 133). Within “the diamond industry, extralegal contracts are the dominant contractual paradigm,” wrote Bernstein. Rather than turn to the courts, merchants construct a market where “enforcement depends on social ostracism or reputational damage” (133).

Their religious ties, Bernstein posited, gave the Jewish merchants both access to relatively high levels of information about their contracting partners and an ability to punish those who reneged on their promises. The Orthodox community provided, she (1992, 140) explained, “geographical concentration, ethnic homogeneity, and repeat dealing.” Within this world, traders organized their industry “to minimize the cost of obtaining information about dealers’ reputations” (133).

5. Greif. – Finally, Avner Greif (Reference Greif1993) examined long-distance commerce among eleventh-century Maghribi Jewish traders in the Muslim Mediterranean world. Greif did formally what Bernstein and Ellickson did informally: He modeled the ties among traders and agents as an indefinitely repeated game. He then examined the historical record and found that the members of the community did indeed share information with each other and enforce honesty by punishing violators mutually and multilaterally.

These traders “deterred opportunism in bilateral agency relations [through] a credible threat of losing future profitable relations in the traders’ broader community,” wrote Greif (Reference Greif2012, 445). The traders could rely on this informal punishment strategy because they traded through “coalitions,” Greif contended; Bernstein (Reference Bernstein2019) more plausibly argues that they could punish opportunism because they traded within “small-world networks.”

6. “Law and social norms.” – Parallel to these studies, several legal scholars in the 1990s developed a corpus of largely non-empirical scholarship on “social norms” (see the synthesis by E. Posner Reference Posner1998, Reference Posner2002). They focused – at the obvious risk of over-simplification – on several points: on the importance of information, on the gains from repeated trades, and on the cost of ostracism.

First, the scholars focused on the informational advance that norms and rules could provide. “Norms and rules, whether publicly or privately created, embody and convey information,” explained Avery Katz (Reference Katz1996, 1749):

The more people gossip, the more information they collect. The better their information, the more they know about their neighbors. And the more closely they follow what their neighbors do, the more secure their collective norms.

Second, the scholars concluded that people follow communal norms in order to retain the chance to trade. They earn returns from their trades that they do not want to jeopardize. Those future gains from trades, in essence, become a hostage that they sacrifice should they renege from the communal standards of behavior.

Last, should anyone try to deviate from communal norms, others enforce the norms by boycotting him. That boycott – ostracism – was in most cases the ultimate sanction. The parties enforced expected behavior, wrote Richard Posner (1991, 366), by tying behavioral norms to an “implicit threat of ostracism, that is, of refusal of advantageous transactions.”Footnote ³

C Social Capital

1. The concept. – As economists and law professors studied social norms and private legal systems over the course of the last several decades, several political scientists and sociologists pursued a parallel project. During the same period, they studied the way people invest in their relational networks. Through these networks, people gather information about each other and develop the mechanisms by which to induce each other to comply with broadly shared communal norms.

The scholars called it “social capital.” More than anyone else, it was political scientist Robert Putnam (Reference Putnam1995, Reference Putnam2000) who popularized the concept in academic circles. Putnam hit a chord (and sold books) when he suggested two decades ago that the modern American malaise might stem from a decline in “social capital.” Sociologists replied by noting antecedents in their own discipline. They pointed to the concept in Durkheim and Marx (Portes Reference Portes1998, 2). They cited more recent discussions by James Coleman (Reference Coleman1988, Reference Coleman1990).

But it was Putnam who brought the theme home. It was he who introduced it to political science, to economics, and to the chattering classes more generally. As Putnam articulated the idea, people invest in social capital within their communities by building, maintaining, and strengthening their ties with each other. They help the PTA. They join the Rotary Club. They coach soccer leagues. They attend churches and synagogues.

In the course of doing all this, Putnam’s citizens created social capital: the byzantine network of reciprocal favors and obligations that let them overcome the collective action problems that would otherwise plague their communities. With social capital intact, they volunteer. They deter petty crime. And together, in the words of Blanche Dubois, they come to depend on the kindness of strangers.

Build ties, and people behave. Integrate them into dense and crosscutting networks of social connections, as Saegert and Winkel (Reference Saegert and Winkel2004, 220) put it, and they come to “share a sense of mutual obligation, shared norms, and trustworthiness.” Make friends, and “[i]nformation flows freely and from multiple channels.” Convey that information, and people know what they need to know to punish those who misbehave: “norms of behavior are reinforced in many settings and sanctions for violating these norms can be effectively brought to bear.”

Coleman (Reference Coleman1988, Reference Coleman1990; see Burt Reference Burt2000, 351) gave the classic statement of social capital. As he articulated the concept, residents enforce their communal norms best if they keep a network of overlapping ties dense enough to create “closure” (Coleman Reference Coleman1988, S105):

Posit two societies, explained Coleman (1998, S105–S107). In one, members maintain ties with other members that do not intertwine. A knows B and C, but B and C do not know each other and neither do they know anyone else in common. Without such mutual connections, they find it harder to punish people who violate important norms:

If members do maintain intertwined ties, the society is “closed.” Should anyone deviate from the norms, many in the network will know, and many can punish (Coleman 1998, S105–S107). “In a structure with closure,” Coleman continued, “B and C can combine to provide a collective sanction, or either can reward the other for sanctioning A.” As Ronald S. Burt (Reference Burt2000, 351) put it, “network closure facilitates sanctions that make it less risky for people in the network to trust one another.” It “enables local monitoring,” write Hillmann and Aven (Reference Hillmann and Aven2011, 486). It helps “ensure that members know how their exchange partners behaved in the past, whether the behavior complied with community norms or not, and if these partners should be trusted in future transactions.”

2. Variation. – Social capital is, as Saegert and Winkel (Reference Saegert and Winkel2004, 220) put it, “a property of groups.” To be sure, it “can derive from a variety of individual actions, motivations, and expectations and can be used for individual as well as collective benefit” (Saegert & Winkel Reference Saegert and Winkel2004, 220). But at root it is a group attribute. Stolle and Rochon (Reference Stolle and Rochon1998, 50) probably overstate their case in describing a reference “to an individual’s social capital” as “a category mistake.” But as Burt (Reference Burt1997, 339; see 2000, 346) explains, if human capital describes the abilities that an individual develops, “social capital is the contextual complement to [that] human capital.”

Putnam compared the social capital in the US across time. He saw in the modern US a fall in social capital and lamented the decline. Social capital mattered to Putnam, because he thought the capital key to democratic governance. In Northern Italy, he noted, residents maintained a more vibrant democratic order than in the south. They maintained it through (Putnam’s first canonical example) the vast number of choral societies they joined. In the 1950s, US residents maintained their democratic order through (his second canonical example) the bowling leagues they joined. Unfortunately, claimed Putnam, in the twenty-first century, they bowl alone.

Charles Murray (Reference Murray2012) compared the social capital in the US across regions. He contests any notion that American social capital has declined across the board. It remains intact in professional communities, he argued, even as it has vanished from among the working class. He calls the former “Belmont,” after the affluent Boston suburb, and the latter “Fishtown,” after the blue-collar Philadelphia neighborhood of that name. In America’s Belmonts, social capital remains high – and people read the newspaper, vote, attend churches or synagogues, volunteer at schools, marry, bear children within marriage, and stay married. In its Fishtowns, social capital has disappeared. With social capital high, in Belmont people keep their promises; with that capital gone, in Fishtown they rely on neighbors at their peril. In Belmont, people trust; in Fishtown, they cheat.

3. Positive and negative groups. – This is all a bit ingenuous, of course. Communities enforce a wide variety of norms, and not all of them promote democracy. Much less do communities necessarily confront poverty, shield the vulnerable, or exploit new opportunities. In the 1930s, choral-society-rich Northern Italy turned fascist (Riley Reference Riley2005). When the Soviet empire collapsed, Serbs embedded in dense networks of social ties massacred their Bosnian Croat and Muslim neighbors (Chambers & Kopstein Reference Chambers and Kopstein2001, 842).

By far the most telling example, however, involves the Nazis. Through historical narrative, Berman (Reference Berman1997, 402) shows “how a robust civil society actually helped scuttle the twentieth century’s most critical democratic experiment, Weimar Germany.” The “high levels of association,” explains she (402), “served to fragment rather than unite German society.”

Satyanath, Voiglaender, and Voth (Reference Satyanath, Voiglaender and Voth2017) make the same point econometrically. From city directories, they calculate the density of civil associations (not just political associations, but “sports clubs, choirs, animal breeding associations, or gymnastics clubs”; 2017, 491) in Weimar Germany. With that density, they then predict the speed at which the Nazi Party grew. The denser the associational networks, the faster the spread of Nazism. Conclude Satyanath, Voiglaender, and Voth (Reference Satyanath, Voiglaender and Voth2017, 520), “where there were more grass-roots social and civil organizations, the Nazi Party grew markedly faster.”

A Introduction

The Omi merchants hired their agents and branch managers from within the Omi world. They did so deliberately because of the contractual advantage that the policy presented. More generally, they did not just contract within a social context; they deliberately manipulated that social context to contract to their private advantage. They chose people about whom they had relatively full information and obtained that information through their social connections. They chose to deal with people whom they could monitor, who would be subject to informal social sanctions, and who would jeopardize future profits should they renege – all factors correlated with their places within that social context.

Further, Omi merchants required their agents and branch managers to invest in their ties within the Omi world. Successful merchants and industrialists did not take their social context as exogenous. Instead, they self-consciously created and shaped the social context within which they did business. They invested in their friendships, ties, and connections. They encouraged the people with whom they dealt to learn to know each other. If social context could facilitate the acquisition of information about potential partners, they invested in that social structure. If it could increase their ability to monitor their contractual partners, if it could increase their ability to learn what their rivals might be doing, and if it raised the odds that their contractual partners would perform as promised – if social context could do any of this (and often it can do all of this), they deliberately invested in that structure.

What one can say about the Omi merchants, one can say – and Macaulay, Landa, Ellickson, Bernstein, and Greif did say – about merchants elsewhere. They deliberately structure their transactions within social networks that enable them to elicit information and to increase transactional reliability (Section B). And they deliberately structure those networks to strengthen their transactions in turn (Section C).

B Exploiting Social Capital

The relevance of this social capital to business contracts stems from two characteristics: First, within a world with high levels of social capital, information travels. Potential contracting parties have better information about each other; once they enter into a contract, they can more readily monitor each other’s behavior; they can more accurately gauge the state of the market and the actions of their competitors.

Second, within a world of “closed” (Coleman’s term) social capital, contracting parties can more effectively draw on informal social sanctions to induce their partner to perform his part of the bargain. Because the community at large can observe contractual performance, contracting parties effectively post a larger share of their future profits as a bond. The bond both helps assure a partner’s contractual performance ex post and increases the credibility of his promises ex ante.

Put in those terms, these observations confirm the logic behind the classic studies by Landa, Bernstein, and Greif. These writers studied communities bound together through high levels of social capital. Landa described the expatriate Chinese merchant community in Southeast Asia. Bernstein described the Orthodox Jewish community in New York. And Greif described the Maghribi traders in North Africa. These were small and distinctive ethnic groups. They were groups shunned by the surrounding society. And they were groups that had cultivated within their insular community dense and interlocking networks of personal and social ties.

Restated, although Landa, Bernstein, and Grief did not use the term “social capital,” the groups they studied were indeed groups with high levels of closed social capital. Through the dense networks of interlocking ties, group members obtained information about potential trading partners. They monitored their trading partners. And they manipulated the mechanism of social exclusion to induce their trading partners to keep their word. Within these densely intertwined communities, information about contractual trustworthiness traveled. And precisely because it traveled, contractual partners could trade on their partners’ reputation for probity and post their own profits from future transactions as a bond for their own performance.

C Building Social Capital

Shrewd contracting parties do not just exploit social capital; often, they also create it. In fact, often they actively structure their contracts to promote the network of relationships that together constitute social capital. Lisa Bernstein (Reference Bernstein2015), for example, recently turned to heavy industry manufacturers in the Midwest and explicitly draws on the social capital literature. “The governance frameworks created by the [contracts used by these manufacturers] promote the growth of trust-based relationship-specific social capital,” she explains (2015, 589). They “create conditions that support the emergence of repeat dealing relationships which in turn grow relational capital that is valuable to firms.” And they create the “frameworks [that] facilitate the types of investments, norms, and interactions that are commonly associated with the emergence of trust. …”

Through their contracts, the manufacturers deliberately build, maintain, and extend the social networks that together constitute social capital. Bernstein (Reference Bernstein2015, 599) uses the term “structural social capital” to refer to “the positions of a firm and its contracting partner in a relevant network of firms.” In turn, she (2015, 599) continues, a “network is simply a set of connections between individuals or between organizations (here, firms).” Crucially, firms do not take these connections as given. Instead, the “connections can arise from prior deals between firms or prior social and business connections between their employees.” They can and do actively promote the connections.

“These links enable firms in the network to convey ‘privileged information about one another to other network members’,” continues Bernstein (Reference Bernstein2015, 599). Recall Coleman’s discussion of informational consequences to network “closure.” The links, Bernstein (Reference Bernstein2015, 599) writes, affect:

Social context, in other words, is not exogenous. Contracting parties need not – and do not – take that context as a given. Rather, they can create among the people with whom they contract a network. They can maintain that network, nourish the network, and grow the network. In the process, they increase their ability to obtain the information they need to choose contracting partners, to monitor their existing partners, and to scrutinize their potential rivals. In the process, they also increase their ability to harness informal pressures against partners who would consider reneging on their deals.

* * *

Businessmen and businesswomen – whether producers, merchants, or anyone else – need information: They need to know what their suppliers can provide, what their customers want, what their rivals offer, and what, more generally, will happen tomorrow. Businessmen and businesswomen also plan ahead by entering into agreements with other men and women. In doing so, they hope their counter-parties will keep their word. Toward that end, they do what they can to increase the reliability of their agreements.

In most modern, wealthy societies, businessmen and businesswomen exploit the advantages that the formal legal process can afford. When transacting across the market, they draft contracts that detail contingencies and specify terms that courts will enforce. When cross-market transactions grow too expensive, they integrate vertically. Using the formal legal process, they combine the contracting parties into one unit.

Yet even in modern, wealthy societies, businessmen and businesswomen do not rely solely on the formal process. They do not even rely mostly on the formal process. Instead, they contract within networks of social contacts that enable them both to gather information and to encourage contractual compliance. They do this deliberately. They search for counter-parties who live and operate within their own social networks, and they deliberately construct such networks around their transactions.

In the book that follows, I illustrate these observations through five sets of real-world business arrangements in twentieth- and twenty-first-century Japan.

Chapter 2: Contracting for Terroir in Sake. Over the course of the last century, Japanese consumers have gradually lost their taste for sake. A few producers in Kobe have dominated the mass market through economies of scale. Smaller regional brewers have steadily gone out of business. In this environment, a small cohort of ambitious (and perhaps desperate) brewers have tried radically to shift direction. Rather than continue as is, they have moved to create a market for unambiguously delicate and subtle high-end sake that showcases the environmental variation French chateau call “terroir.”

To create their new terroir sake, these brewers must convince local farmers to grow the high-risk and high-cost varieties of rice optimized for premium sake. The necessary arrangements involve extraordinarily complex incentive and informational requirements. Yet the parties almost never draft elaborate contracts with verifiable terms and rarely vertically integrate. Instead, they try to encircle their transactions with dense networks of social capital and then use terminable short-term contracts and high prices to give them the flexibility they need.

Rather than pursue either elaborate contracts or vertical integration, in other words, brewers (i) deliberately cultivate a dense network of social capital around themselves and their contracting farmers. They then combine (ii) short-term renewable (and conversely, terminable) contracts, (iii) “efficiency wage” level payments, (iv) close monitoring, and (v) free intervention. Ultimately, this combination generally gives the brewers all the control over the farming process that they need.

Chapter 3: Contracting for Quality in Fish. Japanese fishermen traditionally fished individually. Through their hamlet, they held a collective property right in the coastal waters. But though they policed the waters together, they fished the waters by themselves.

Given the returns to modern equipment, fishermen now face economies of scale that reward capital investments. Because of those scale economies, the traditional small family firms find it hard to compete against their larger rivals. To survive in this environment, some entrepreneurial fishermen are moving deliberately upscale. Rather than try to sell on the mass market, they create and service a niche market for premium, high-quality fish. They have talent and are willing to invest time and effort, they reason. They will target the niche that rewards that deliberate care.

To compete in this market, the entrepreneurial fishermen have purposely raised the stakes: They try to post their broader reputations as bonds in ways that make them as vulnerable as possible. Many of these fishermen then sell directly to customers over the Internet. The resulting human contact and potential for repeated transactions enhance promissory credibility and encourage trust. Sometimes, they work together through their local fishing union. The union fosters trust by monitoring and certifying the quality of the members. The union places the community’s collective reputation at stake. The union monitors its members to prevent free-riding.

By posting their reputations widely, the fishermen increase their vulnerability to a dissatisfied customer. That such a customer can communicate with other customers on the web dramatically raises the stake to the fisherman. And that is why the strategy works. In effect, the fisherman uses his contracts to create among his customers the (Internet-based) overlapping ties that constitute social capital. When selling publicly on the Internet, the fishermen enable their buyers to contact each other; in the process, they build a network that lets them more credibly promise high quality, precisely because their buyers can contact each other, learn how they have behaved in the past, and punish them if they renege.

Chapter 4: Contracting for Geothermal in Hot Springs. Although Japan holds the third largest geothermal energy potential in the world, it has kept it largely undeveloped. The problem: The largest geothermal deposits lie in vacation centers with a thriving industry of hot springs hotels and inns. The hotel owners worry that new geothermal wells will run their wells dry. The geothermal developers argue that this cannot happen and can point to some solid science behind their claims. By Japanese property law, however, in many communities the hot springs owners hold the potential right to veto a geothermal plant.

Suppose geothermal energy generates larger returns than the risk it poses to hot springs. Logically, the two groups ought to be able to negotiate prices and terms that let the developers proceed. Yet except in a few areas, they have not done so.

Two reciprocal contracting problems have stymied the industry. First, geothermal developers cannot credibly promise incumbent hot springs owners that they (the incumbent owners) can collect expectation damages in case the geothermal wells do damage the hot springs. The hot springs industry is over-developed in Japan, and existing wells randomly go dry on a regular basis. Owners know that if a geothermal developer were to harm a well, they may not be able to prove causation in court – there are simply too many other possible explanations. In effect, the developers find it hard credibly to commit to compensating them in full ex post.

Second, the developers must negotiate with the hot springs hotel owners seriatim, and no one hotel owner can credibly promise that all subsequent owners will also negotiate in good faith. In many communities, Japanese hot springs owners potentially hold a customary right to protect their steam and hot water through injunctions ex ante. Because each owner may have (not “certainly have,” but may have) a right to hold up the entire geothermal project, the geothermal developer faces sequential negotiations, each of them a bilateral monopoly, and each of them a possible holdup.

The few geothermal plants in operation disproportionately involve cases where the developer and the hotel owners were able to solve these twin contractual problems and make the necessary credible commitments. Sometimes, in the case of the smallest geothermal plants, the parties solved the problem through vertical integration: The hotel owners build the geothermal plants themselves. Sometimes, the geothermal developer made the promise of ex post compensation credible through technology: He pipes hot water to the springs directly from the geothermal plant. Unfortunately, many (if not most) geothermal projects lack enough hot water to cut this deal.

And sometimes, the hotels solved their offsetting collective action problem by negotiating through their trade association or town government. They harness the networks of local social capital, in other words, to control would-be deviants through threats of social ostracism. Necessarily, however, this requires levels of cohesion and social capital that many villages (especially those in the steadily deteriorating rural countryside) no longer have.

Chapter 5: Contracting for Credit in Agriculture. In describing the land reform program in 1947–50 Japan, scholars routinely claim that it raised productivity. In fact, it did nothing of the sort. Land reform in Japan slowed rather than hastened the growth in productivity.

Scholars miss the effect of the land reform because they miss the constraints on agricultural credit contracts in developing societies. Farmers in pre-war Japan faced two potential sources of funds: local elites and banks. Of these, the local elites had both the informational and the informal enforcement advantage. They lived and worked within the local social capital network: They knew the potential borrowers, the land, the various local micro-climates, and the agricultural technology. Members of the community itself, they could readily harness the social sanctions necessary to compel performance informally.

Should local elites try to advance money directly as a loan, however, they needed to create a security interest in the land that the farmer bought with it. Literate and numerate as these investors assuredly were, most lacked the university education necessary to manipulate the legal procedures involved in creating security interests. Banks had the university-trained officers who could create the security interests, but they were not local. As outsiders, they lacked the informational edge in the local credit market that the village elites enjoyed.

Leases gave local investors a simple but effective way to protect their funds. Rather than lend farmers the money directly, they bought land with the funds and leased it. If a farmer began to act strategically, the local investors could begin to activate the social sanctions by which to discourage the farmer from defaulting on the rent. If a farmer did default, they simply evicted him and moved on. The process was easy to understand and simple to enforce. Through it, the funds moved to the farmers who presented the best projects, and farmers and investors jointly economized on the transaction costs inherent in credit market arrangements anywhere.

The post-war land reform program reduced agricultural growth rates by interfering with the allocation of credit. A tenancy contract is a lease, and a lease is a capital market transaction. By precluding the use of leases, land reform effectively increased the cost of capital, reduced the amount of credit, and reduced the accuracy with which investors could target that credit.

Post-reform, farmers owned almost all the land, but many of them lost their access to the most efficient source of capital: The local elites tied into the networks of community social capital. Post-reform, farmers were richer, but no longer had the most efficient access to the extra funds they needed to repair dikes, to fix sluices, and to experiment with alternative equipment, fertilizers, and pesticides. Cited regularly by development economists and World Bank and UN officials as an example of the way redistribution can increase the rate of productivity growth, the Japanese land reform program did nothing of the sort. Instead, it slashed it.

Chapter 6: Contracting for Mercy in Buddhism. In the 1960s, Japanese women began asking temples to perform commemorative ceremonies for the fetuses or children (the term is obviously loaded) they had aborted. They still do. Physicians have been able to perform abortions legally since 1952, and many women have had them. The ceremonies do not fit within the classic rituals offered by the temples, but many Japanese women find them helpful. They ask for the services. The temples respond.

Increasingly, in other words, temples offer memorial services for children (as the temples discreetly put it) who “were not able to be born.” Many women ignore all this: They have their abortions and move on. Some, however, have found the experience more troubling and turn to the temples for comfort. In both Japan and the West, scholars feigned outrage at this “commercialization” within the religious community.

Yet the temples do not have much choice. As a church rather than sect (as Weber and Troelsch called it) – or a low-tension rather than high-tension religious group (as Rodney Stark put it) – Japanese Buddhism has not demanded much of its parishioners. Instead, priests have stood ready to offer counseling and ritual as needed during the existentially troubling passages in life. In exchange, local communities effectively kept the temple on retainer. The temples cannot rely on their parishioners to give voluntarily; low-tension groups never can. Instead, they counted on their local parishioners to enforce a donative obligation on each other through the elaborate networks of community social capital – through the tightly intertwined social ties in the traditional neighborhoods, towns, and villages.

Traditional temples broadly supplied two types of services: those they could price and sell on the market (if they had to do so) and those they could not. On the one hand, they supplied rituals associated with funerals. If necessary, they could have priced these services. On the other hand, traditional temples also offered more generalized support during difficult phases of life: compassion, comfort, and guidance from (in the best of all worlds) a priest who has known a parishioner and his or her family for years. These latter services complement the formal rituals, but cannot readily be priced. Obviously, they are not impossible to price. Hypothetically, village priests could charge by the hour like a Freudian analyst. But they rarely do, and even in the West Christian priests and ministers and Jewish rabbis hesitate to sell their support by the hour.

In the traditional closed village, none of this mattered, because the members of the community (through their tight networks of social capital) enforced on each other an obligation to support the temple as necessary. In the modern urban environment, people no longer provide that generalized support. As a result, the temples exist in an inherently non-viable situation: They provide two sets of complementary services, but face market competition for the priceable services and no way readily to charge for the non-priceable services.

The memorial service for the aborted children developed in part as a priceable ritual that could substitute for what in another era might have been informal compassion, comfort, and guidance. With sufficient generalized revenue support enforceable through a tight network of community social capital, a priest might have offered a troubled woman that compassion directly. With no source of support except in the highly competitive and anonymous market for fee-for-service transactions, modern priests find that support hard to fund.

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It should go without saying, but I say it anyway: for the sources of information about the contracting practices involved, see the various materials cited, either in footnotes or in parenthetical form. Many of the contracts involved are oral, and I rely on secondary materials about the contracts.

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Such is the gist of what follows. I take five sets of negotiations. I examine the way people have tried to obtain information they needed and to protect themselves from adverse consequences. I discuss the ways they tried to structure their contracts to avoid having to involve the courts in resolving any disputes that might arise. I explore the ways that they tried to make credible their commitments to cooperate. And I study the way they have tried to create, maintain, strengthen, and leverage the social networks within which they negotiated, policed, and performed the agreements they made.