A Transaction Cost Theory of Business Formalization

Abstract: Business formalization has been argued to be a mere rent-seeking process, what has encouraged simplification policies that aim to abate the initial costs of formalization without paying attention to its value. This paper presents an alternative theory, which contemplates business formalization as a necessary ex ante intervention, by which some of the voluntary contracts creating the firm are made public. This allows judges to apply liability rules instead of property rules when adjudicating disputes. As liability rules protect innocent third parties, these are consequently unaffected by the information disadvantage they suffer when contracting with the firm. This enhances impersonal trade, but dilutes property rights. Therefore, legal systems can apply the liability rule only when the owner has consented to it in a judicially verifiable manner. For company transactions, judicial verification requires formal mechanisms that provide independent control, such as company registers. These mainly prevent owners who contract with third parties under a liability rule to opportunistically deny later that such rule should be applied. The theory is tested in a sample of 160,291 corporate transactions by showing that the extent of control in formalization is related to the complexity of the transaction.