Institutions in society provide the rules of the game that determine the incentives for individuals to engage in growth-enhancing or redistributive activities. Institutions are both formal and informal. Formal institutions consist of the laws and regulations of a society. Informal institutions are the norms and customs of a society. Both impose constraints on behavior. The question addressed by Andrew Stone, Brian Levy, and Ricardo Paredes in the following essay is: To what extent do laws and regulations that ostensibly increase transaction costs in fact affect the costs of doing business? Or, put another way, in the presence of high formal transaction costs do businesses adopt informal institutions to lessen the burden of regulations? The work is innovative both theoretically and empirically. Theoretically, the authors recognize the interconnection and potential substitutability between formal and informal institutions. Empirically, they measure the effect of formal regulations by conducting field surveys in the garment industry in Brazil, a country noted for its regulations, and Chile, a country that has recently deregulated to a large extent.

The degree to which formal rules constrain behavior depends on enforcement. Enforcement is effected by the coercive power of the state or by the norms of society. Coercion and norms are substitutes. If the members of a society generally agree that something is not appropriate behavior – for example, littering – society must expend fewer resources in enforcing laws against littering.