D - Formalizing the Argument

Summary

This appendix presents a simple model that formalizes the key insights introduced in Chapter 2. Specifically, the model demonstrates that: (1) state legal capacity is necessary but frequently insufficient to induce firms’ use of legal strategies for securing property, and (2) firms frequently adopt legal strategies even without heightened state legal capacity, due to declining demand-side barriers or effectiveness of illegal strategies. The analysis also elucidates the mechanisms whereby coordination effects among firms create demand-side barriers to firms’ use of formal legal institutions and illustrates how these coordination effects interact with exogenous parameters of the model.

Model Setup

Consider a game in which a conflict arises between two firms drawn randomly from a large population of firms over an asset with value V. All firms are assumed to be identical. This assumption, while clearly unrealistic, facilitates analysis of the primary question of interest: How levels of state legal capacity, demand-side barriers to firms’ use of formal legal institutions, and the effectiveness of illegal strategies affect firms’ choices about how to secure property. Each firm i has a pure strategy space si = ﹛l, f﹜, where l represents legal strategies and f represents illegal strategies based on force and corruption. Legal strategies include turning to courts and law enforcement agencies. Illegal strategies include reliance on criminal protection rackets or informal ties with state bureaucrats and law enforcement personnel to resolve business conflicts. An endogenous proportion λ_l of firms rely on legal strategies, while a proportion 1 − λ_l rely on illegal strategies. More realistically, but with the same implications for the model, λ_l can be interpreted as the proportion of each firm's portfolio of property security strategies based on law, and 1 − λ_l as the proportion of each firm's portfolio of property security strategies based on force and corruption.

When the conflict begins, the two firms choose their strategies simultaneously, representing firms’ inability to observe the preferred strategies of other individual firms. After both firms choose a strategy, payoffs are realized, and the game ends.

Payoffs

The payoffs to a conflict reflect the three variables in the framework developed in Chapter 2 – state legal capacity, demand-side barriers, and the effectiveness of illegal strategies – and depend on the profile of strategies chosen by the two firms.