Lack of institutional cooperation between individuals in a marketplace reduces efficiency and prevents potentially beneficial contracts from being cemented. The reason behind this lack of trust is the fact that the government cannot be counted on to uphold contracts, property rights and the like. Without this legal guarantee, people are hesitant to do business with people they don’t know, or who are from different backgrounds, thus preventing business relationships from being established.

Feder and Feeny identify three categories of institutions: constitutional order, institutional arrangements and normative behavioral codes. The constitution describes the fundamental rules for society, the guidelines for making laws. For example, the First Amendment in the US Constitution prohibits the government from obstructing some individual freedoms such as freedom of speech and freedom of religion.

Institutional arrangements refer to laws, contracts, regulations and other legal instruments designed to maintain order and stimulate growth. A lease is a basic example of an institutional arrangement.

Finally, normative behavioral codes refer to the norms followed by a culture. In the developed world, the norm is for most marketplace activity to take place within the formal sector, where government institutions protect buyers and sellers and maintain competitiveness and fairness. Conversely, in many developing countries, the informal – or unregulated – sector is where most market activity occurs, resulting in diminished trust between buyers and sellers.

For example, land may be transferred according to a government regulation yet the transfer of this land to a certain ethnic group or tribe may be forbidden according to a normative behavioral code. Additionally, poor institutional arrangements such as lack of enforcement or registration procedures could be the issue.

In developed countries, these three institutions generally all follow and reinforce each other, but in developing countries one institution may be followed more by some and another more by others, creating different, opposing “laws” in the same place.

In many developing countries, where tribes and family lineages play a large role in social group formation, the lack of collaboration between unfamiliar groups leads to economic inefficiencies. More specifically, a culture that prefers to do business within the confines of family lineage only, will see less division of labor and a consequent lower degree of specialization as per Adam Smith’s theories. For example, Annen cites Rabellotti and Schmitz who suggest an interesting reason for Brazil’s superior performance to Mexico in the footwear manufacturing space. The authors note that social capital in the Sinos Valley manufacturing area in Brazil is created in local, open social networks supported by business associations that serve the entire district. In contrast, Mexican footwear manufacturers in Gaudalajara and Leon cooperate based on strong family ties, destroying the benefits of trading and collaborating based on normal economic incentives (Annen, 2001).

This leads to the important distinction between inclusive and exclusive social capital. Exclusive social capital describes the value created by collaborating within closed social networks, where entry is difficult and requires bribery, paying a fee or spending time getting acquainted and proving yourself to the exclusive social group. On the other hand, inclusive social groups have low entry costs and exist to further the interests of a broader community.

Aside from less division of labor, there are two other downsides to exclusive social capital: lack of innovation and rent-seeking activities. In industries with a high degree of technological change, the closed nature of these groups impedes potential efficiency innovations that come about from the diffusion of ideas. Granovetter also made a similar point in saying that few “strong ties” are a lot less beneficial than many “weak ties” (1973). It’s important to note however that the negative effects of exclusive social capital on innovation depend on how much dynamism is required in the industry in question. To illustrate, consider the software industry versus the precious gems industry. The former requires firms to constantly innovate and collaborate to stay competitive, however, given the relatively simplistic nature of the precious gems industry, a mine owner doesn’t need to collaborate or innovate as he or she is simply taking materials out of the earth and selling them to processors and retailers.

Lastly, exclusive social capital leads to rent-seeking activities, which get in the way of real economic incentives. When the likelihood of entry into a market is determined by the level of a firm’s influence vis-à-vis other firms, potential entrants tend to spend more on trying to obtain an item than it is actually worth to them (Davis and Reilly, 1998). Therefore we have inefficiencies taking place as firms waste resources on simply trying to get their foot in the door instead of investing all resources into the wellbeing of their business.

Although inclusive social networks result in higher economic efficiency than exclusive networks, there is major issue that arises and challenges the integrity of inclusive networks as they grow. Since inclusive networks rely on members having good reputations, cooperation within groups can only take place if every member is aware of other members’ past actions. With small networks, this is easy to manage but as the membership and heterogeneity of an inclusive network increase, it becomes more difficult to inform every member of every other member’s past behavior. This means that a network works best when it’s size is not allowed to grow to infinity, but rather to point where information sharing is manageable (Annen, 2001).

References:

Annen, Kurt. “Inclusive and exclusive social capital in the small-firm sector in developing countries.” Journal of Institutional and Theoretical Economics JITE157.2 (2001): 319-330.

Davis, Douglas D., and Robert J. Reilly. “Do too many cooks always spoil the stew? An experimental analysis of rent-seeking and the role of a strategic buyer.” Public Choice 95.1-2 (1998): 89-115.

Feder, Gershon, and David Feeny. “Land tenure and property rights: Theory and implications for development policy.” The World Bank Economic Review5.1 (1991): 135-153.

Granovetter, Mark S. “The strength of weak ties.” American journal of sociology(1973): 1360-1380.