Legal competition, political process and irreversible investment decisions Bruno Deffains a,b, ⁎, Dominique Demougin c a University Paris 10 Nanterre and CNRS, EconomiX, Bâtiment Max Weber, 200 Avenue de la République, 92001 Nanterre Cedex, France b European Business School, Wiesbaden, Germany c European Business School, Department of Law, Economics and Governance, 65201 Wiesbaden, Germany article info abstract Article history: Received 16 May 2007 Received in revised form 6 May 2008 Accepted 7 May 2008 Available online 15 May 2008 We compare the effects of competition for the design of labor laws in an environment characterized by irreversible investments in human and physical capital. We compare autarky with two-country cases, assuming that capital is mobile and labor immobile. We distinguish two cases. In the first, the political system is free from capture, while in the second, we examine the case where labor captures the institutional design problem. We find that in the former case legal competition reduces welfare while in the latter it improves the overall outcome. © 2008 Elsevier B.V. All rights reserved. JEL classification: K4 Keywords: Legal competition Bargaining power Political process Irreversible investment 1. Introduction The last decade has been characterized by great efforts in the analysis of legal institutions to explain the economic performance of nations. For instance, La Porta, Lopez-de-Silanes, Shleifer and Vishny (hereafter LLSV) have produced empirical papers analyzing the importance of legal origin (LLSV,1998) and its implication on corporate governance (LaPorta, 2000, 2002) to justify international differences in financial development. These papers show that the Anglo-Saxon, French, German or Scandinavian legal origin to which a country belongs, the contents of laws and the quality of law enforcement influence not only the degree of investors' protection, but also the performance of capital markets. Their empirical studies depict a situation in which common law countries provide stronger protection for investors compared to civil law countries. This feature may help explain why common law countries have more developed financial markets, more concentrated ownership and higher equity returns than civil law countries. Levine (2004) extends the analysis to the banking system, noting that countries with more stringent enforcement of contracts and closer creditor protection are also those with more developed banking systems and higher economic growth rates. Rajan and Zingales (1998) employ a cross-country statistical approach and show a positive correlation between the legal tradition and the growth of firms dependent on external financing. One might derive that these studies converge with Posner's hypothesis that common law evolves towards efficiency. Implicitly, these results also contribute to the idea that civil law might be less efficient. 1 Beside academics, there is also wide consensus among politicians and members of international organizations concerning the determinant role of legal institutions for the wealth of nations. For example, the Doing Business Report (World Bank, 2006) states that “although the importance of macro-economic policies cannot be denied, there is an ever-widening consensus today European Journal of Political Economy 24 (2008) 615–627 ⁎ Corresponding author. University Paris10 Nanterre and CNRS, EconomiX, Bâtiment Max Weber, 200 Avenue de la République, 92001 Nanterre Cedex, France. Tel.: +33 1 40 97 77 86. E-mail address: bdeffains@u-paris10.fr (B. Deffains). 1 Posner uses the Kaldor–Hicks criterium for efficiency, so he also focuses on economic growth. 0176-2680/$ – see front matter © 2008 Elsevier B.V. All rights reserved. doi:10.1016/j.ejpoleco.2008.05.001 Contents lists available at ScienceDirect European Journal of Political Economy journal homepage: www.elsevier.com/locate/ejpe