The need for strong contract enforcement
Mains Paper 4: Economy
Prelims level: E-commerce
Mains level: Indian Economy and issues relating to planning, mobilization of
resources, growth, development and employment. Inclusive growth and issues
arising from it
According to Milton Friedman, the three primary
functions of the government are defence, law and order, and contract
Unlike the former two, the latter has not received
adequate importance in India.
An efficient contract enforcement mechanism not only
provides remedies to aggrieved parties, but also dissuades violation of the
contractual obligations because of the fear of legal fees and court fines.
Thus, an effective contract enforcement mechanism can in
reality reduce flouting of laws and contracts, reducing the need to approach
A sound contract enforcement mechanism is essential for
maintaining business confidence, reducing uncertainty and promoting fair play in
This is the reason for its inclusion as a criteria in
World Bank’s Doing Business (DB) report.
India’s position on e-commerce
India’s overall ranking in the report this year
improved from 100 to 77, when it comes to the contract enforcement metric,
it lags behind at 163 out of 190 nations.
There has been no improvement in absolute terms here
either, as the contract enforcement DB score has remained fixed at 41.19.
A business must try to maximize its expected returns.
At the same time, healthy risk-taking behaviour in the
economy is necessary to ensure growth, rather than just relying on low-return
The poor contract enforcement tends to increase the risk
and reduce the returns (increased legal costs), thus affecting the overall risk
to return ratio.
As a result, businesses don’t engage in economically and
socially beneficially activity such as innovation. Similarly, the failure of
legal mechanisms in guaranteeing loan repayment has resulted in banks bearing
The outcome is that interest rates are higher and banks
are reluctant to lend to socially beneficial sectors such as agriculture and
Poor contract enforcement tends to increase the risk and reduce the returns
The poor legal frameworks tend to promote excessive
vertical integration of companies.
According to Nobel Laureate Oliver Hart, when contracts
are ineffective, businesses prefer to eliminate the need to deal with other
companies by resorting to acquisitions and mergers.
A power plant that requires high quality coal but can’t
ensure its quality from the coal mine would find it profitable to acquire the
The success of an e-commerce company depends on its
ability to retain consumers’ trust.
This trust has been waning because of frequent reports of
fake and poor quality products sold on their websites.
A poor contract enforcement system further prevented them
from ensuring good quality products from their suppliers.
On the other hand, Flipkart and Amazon through their
hybrid model have been able to maintain the quality of their own products.
To compete with these products, other sellers have also
had to improve the quality of their products.
Thus, the latter two have succeeded while the others have
not been able to.
Another effect of a poor contract enforcement mechanisms
is the spurt of informal and often illegal channels of dispute resolution.
These make use of local leaders and under-the-table
dealings to help settle disputes.
Keeping aside the issue of biased and poor quality
decisions, this also brings undue power into the hands of middlemen and
This, in turn, creates problems such as increased
corruption and the undermining of the rule of law.
These direct and indirect problems and the market
inefficiency associated with them underline the need to reform the legal
Though some measures have recently been undertaken, they
fail to address the deeper issue of an overburdened and understaffed judiciary.
As highlighted by the Economic Survey, addressing such
deep-rooted problems will only be possible through extensive cooperation between
the organs of the government “cooperative separation of powers”.
Q.1) What is a blockchain?
A. A distributed ledger on a peer to peer network
B. A type of cryptocurrency
C. An exchange
D. A centralized ledger
Q.1) It is essential for maintaining business confidence, reducing uncertainty
and promoting fair play in the economy. Critically examine the statement.
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