From families to formal contracts: An approach to development

This paper develops a theory in which individuals can use one of two types of human/social capital to enforce contracts: “Local capital” relies on families and other personal networks; “market capital” relies on impersonal market institutions such as auditors and courts. Local capital is efficient when most trading is local, but only market capital can support trading between strangers that allows extensive division of labor and industrialization. We show that economies with a low cost of accumulating local capital (say, because people live close together) are richer than economies with a high cost of accumulation when long distance trade is difficult, but are slower to transition to impersonal market exchange (industrialize) when long distance trade becomes feasible. The model provides one way to understand why the wealthiest economies in 1600 AD, China, India, and the Islamic Middle East, industrialized more slowly than the West. We report an array of historical evidence documenting the pre-industrial importance of family and kinship networks in China, India, and the Islamic world compared to Europe, and the modernization problems linked to local capital.