The role of formal contracts with weak legal enforcement: A study in the Chinese context

Abstract

This article explores in depth the mechanisms through which formal contracts and relational governance complement each other, focusing on the role played by formal contracts in transitional economies characterized by weak legal enforcement and a culture oriented around informal ties. The findings, drawn from case studies conducted at five firms across China, suggest that formal contracts are used even when they are not legally enforceable because by defining the rights and obligations in an exchange, contracts reinforce reciprocity in long-term exchange relationships. Although this role of contracts has not previously been clarified in the literature, it is particularly important in China because its cultural traditions prioritize reciprocity. The findings have implications for developing a theory of inter-firm relationship governance and optimal contracting, particularly in transitional economies.