Markets for specific services in specific places from specific individuals do not exist and the
price is sometimes a matter of extended negotiation – often continuing beyond an initial
agreement – because the threat of exploitation is high and the basis for evaluation lacking.
The mutual selection of partners is fraught with danger because potential and actual partners
may misrepresent their capabilities and their intentions. Ensuring compliance with
agreements among partners is often difficult because although both parties can, at least in
principle, benefit from such exchanges (they are voluntary exchanges with voluntarily and
mutually chosen partners that are undertaken for gain), one partner may be further
advantaged if he or she renegotiates the exchange agreement after the other party has
invested some resources in the exchange by performing some tasks. Moreover, exchange is
subject to risks, such as the possibility of supply and demand changes or of uncertain
property rights, that transcend individual transactions and particular relationships. Each
consideration introduces a large amount of uncertainty into such exchanges and thereby
decreases the attractiveness of exchange, possibly decreasing the amount of economic
activity to far below that possible.
Embedding the economic exchanges in a formal legally-recognized institution such as
a regulatory state can reduce such uncertainty and increase economic activity (North 1990).
There are extensive laws governing commercial transactions and labor relations, protecting
both parties from risks. Yet, common observation suggests that across societies, despite the
size of the legal profession, firms and individuals are reluctant to resort to the legal system to
enforce agreements (Macauley 1963; Ellickson 1991). Moreover, it does not often seem to
be the case that “the authority of law is always perfectly sufficient to protect the meanest man
in the state (Smith 1976, p. 223).” The relevant state bureaus themselves are the indirect
outcomes of sustained successful exchange. In many developing and transitional economies,