The Incentive Complementarity Between Formal and Informal Enforcement

Abstract

We introduce a model in which people exchange some goods and services informally in their community and others formally on a market. We show that enforcement by informal communities and a formal market are complements: if communities ostracize individuals who are caught cheating on the market, this bolsters incentives to comply with exchanges in both settings. Although transactions within a community generate lower gains from trade than those on the wider market, the enhanced incentives from simultaneously transacting in communities and on the overall market can be welfare-enhancing compared to either extreme. We discuss the implications of informal community exchanges in a country’s development as well as how moral or religious beliefs enhance the complementarity between community and formal enforcement.