By Raja Kali

Business networks are a feature of the organizational landscape of many countries, though they vary in magnitude. This paper develops a theory of business networks where they are endogenous to the reliability of the legal system. Networks are a substitute for reliable institutional support that guarantees written contracts. The existence of networks exerts a negative effect on the functioning of the anonymous market. This is because the network absorbs honest individuals, raising the density of dishonest individuals engaged in anonymous market exchange. Since this lowers the payoff from market exchange, larger networks may be easier to enforce. We find that networks are economically inefficient unless they are relatively large. This is consistent with the view that informal contract enforcement institutions may be inefficient in general equilibrium even though they enhance efficiency in partial equilibrium.