The economy of relationships as opposed to the economy of contracts

Business Standard, 13 July 2020

A sophisticated economy is one in which business relationships are defined by formal legal contracts. When extreme events -- such as Covid-19 -- impact upon such an economy, there is a greater disruption. In India, a large part of the economy is held aloft by family relationships or friendship, and the good behaviour of a repeated game. The residual states of the incomplete contract are dealt with through pragmatic renegotiation. In such an environment, the extreme events are handled in a more sensible fashion. This will help the non-modern part of the Indian economy come back better from the Covid-19 shock.

Landlords and tenants

Consider the relationship between a landlord and a tenant. In developed countries, the landlord is a company. Rent is expected on the clock every month. When the payment is delayed, there is a junior official in the company who worries about the metrics that shape her bonus. The junior official tends to be trigger happy, to send out an eviction notice. The courts work well, and the rights of the landlord are protected well.

In normal times, this is a great system. But it's hard to avoid the sense that when facing this pandemic, if a third of the renters in the US are facing difficulties with making rent payments on time, it would be a poor outcome if many evictions took place. And yet, in the way that system is organised, it is hard to avoid this outcome.

In India, we have traditionally bemoaned the extent to which landlords lack protection of their property rights. Evicting a tenant takes two years and large payments to lawyers. Under normal circumstances, there is no question that these features hamper the capabilities and productivity of the economy. But, when faced with this once-in-a-century shock, the informal Indian arrangement has its advantages. The landlord is generally the principal (the owner) and not an agent (the employee of a rental company). This encourages the landlord to think about what makes the most sense. Landlords value good tenants and tenants value good landlords, and there is a greater possibility of negotiating a better solution when faced with Covid-19.

The ecosystem of large firms

A similar story is playing out in a large number of contracts, in the world of business. No firm is an island; every large firm is the centre of an ecosystem containing ancillary producers, distributors, retail outlets, etc. Covid-19 is a disruption that was not envisaged in the legal contracting. There are now all kinds of contract violations that have taken place. The ancillary producer has failed to supply parts on time as there was a lockdown, the mothership has failed to make payments on time, and so on. In a world of formal contracts, all the firms would be lawyering up, and slugging it out in court.

Ordinarily, in India, we bemoan the extent to which contract enforcement through the courts works poorly. But this problem has been with us for a long time, and has exerted a profound influence upon the nature of business. Because contract enforcement is weak, the arrangement of business is not primarily underpinned by contracts. Every large firm has a vested interest in the survival of its ecosystem. For the mothership to fare well in the future, it needs the smaller firms to do well. The smaller firms are often friends and family. These long standing relationships are vital to the possibility of success of the large firm. Everyone is held together in a repeated game. The role of lawyers and enforcement in court, in resolving difficulties, is low. Indeed, when the business community sees a firm that is prone to litigate, it tends to steer clear of the firm.

When faced with Covid-19, then, there is a greater possibility of conversations between principals (and not lawyers), through which negotiations take place about the best way forward. Indeed, many large firms who have access to ample equity and debt capital, in the wholesale financial markets, are explicitly or implicitly becoming financiers of their ecosystem. Instead of the world of contracts and courts -- where various elements of the ecosystem would be in court slugging it out -- we have a world where the large firm is often turning into a financier, to help tide over these bad times.

Households after demonetisation

We saw similar phenomena in the economic stress after demonetisation also, where the economy of relationships dealt with problems in a way that an economy of contracts might not have. Chakraborty and Sane, 2019 find that about one in ten households resorted to borrowing from shops, between 2016 and 2018. This outcome would not arise in a formal economy: customers of Amazon or DMart cannot expect such behaviour from their shop. But in traditional India, the shop and the household know each other, they are in a repeated game, the shop owner is the principal and not an employee, and has the ability to see the macro shock and embark on such accommodation that helps tide over the bad times.


This is not to take away the importance of enforceable contracts and the rule of law. Private negotiations which generate outcomes that are tied down in enforceable legal contracts are central to creating the complex edifice of advanced capitalism and prosperity. For India to become a mature market economy, we have to undertake the changes to the justice system so that such complex edifices can be constructed here. Those complex edifices are required for organising modern high productivity firms. When firms do not have to limit their search to friends and family, there is a greater chance of finding high productivity business partners, and competition in all markets goes up. The limited point here is that the complex edifice of a contracts-based capitalism handles a novel shock like Covid-19 poorly. In contrast, there is greater room for negotiation and accommodation in the Indian arrangements of contracting with friends and family. Hence, the difficulties induced in India by such a storm are smaller.

Back up to Ajay Shah's 2020 media page
Back up to Ajay Shah's home page