In Discussion Paper No. 1506, Stephan Haggard, John McMillan and Christopher Woodruff examine the problems that private firms face in economies undergoing transition to the market. From a survey of 149 Vietnamese firms, they try to understand how firms cope with a poorly developed legal system and inadequate market information. Despite the absence of formal financial markets, proper transportation, reliable government administration and legally enforceable property rights, Vietnam’s private factories seem to be thriving, accounting for 29% of industrial output. How do these firms overcome the high costs of searching for trading partners and the lack of a legal system?

The authors find that firms employ a variety of practical, informal mechanisms for contract enforcement, which rely heavily on reputational mechanisms. They discover that the market ‘frictions’ actually offset each other, in that poor market information, and the consequent difficulty of locating trading partners, can help make self-enforcing contracts workable. Firms that have nowhere else to go will refrain from breaking their agreements. But the obstacles are not completely overcome: although high search costs permit the reputational mechanism to work, they simultaneously limit its effectiveness. Given that modernizing legal systems takes a long time, it is important – especially at the early stages of reform – to support market and social institutions that facilitate exchange and dissemination of information and thereby the means for informal contract enforcement.

Trust and Search in Vietnam’s Emerging Private Sector
Stephan Haggard, John McMillan and Christopher Woodruff