If formal institutions of contract governance are absent or ineffective, traders try to substitute relational governance based on norms and sanctions. However, these alternatives need good information and communication concerning members’ actions; that works well only in relatively small communities. If there are fixed costs, the market has too few firms for perfect competition. The optimum must be a second best, balancing the effectiveness of contract governance and dead-weight loss of monopoly. This chapter explores this idea using a spatial model with monopolistic competition. It is found that relational governance constrains the size of firms and can cause inefficiently excessive entry, beyond the excess that already occurs in a spatial model without governance problems. Effects of alternative methods of improving governance to ameliorate this inefficiency are explored.
Revisiting the Marriage of Monopolistic Competition and Factor Proportions Theories