Endogenous Enforcement Institutions

We model the State as a self-enforcing agreement over the use of force. A principal contracts with an agent, and a powerful ruler enforces their contracts through a mix of monetary fines and coercion. If the ruler fails to enforce, or if he uses his power to expropriate, all parties revert to low production forever after. Our model has two important implications. First, a better coercion technology moves the optimal system from private ordering, where contracts are enforced by the threat of termination, to the State, where they are enforced by the threat of coercion. This is consistent with the historical correlation between improvements in coercion and the transition from the Law Merchant enforcement system to the State. Second, contract enforcement and non-expropriation are complementary inputs in the State, in the sense that improvements in the enforcement technology increase the agents effort only if the ruler has limited expropriation power, so that the rulers incentive constraint on contractual enforcement is binding. This result relates to the Acemoglu and Johnson (2005) finding that constraints on rulers have affected the development of nations more than improvements in contractual enforcement. Using their data we find that, consistent with our model, contractual enforcement does affect development, but only when the rulers expropriation power is sufficiently constrained.