The transaction cost economics (TCE) theory of trading favors

Trading favors is a pervasive business practice, especially in emerging economies. To date, a range of theories has been utilized to explore trading favors, but most extant studies focus especially on negative aspects of favors (e.g., corruption and bribery). We adopt transaction cost economics (TCE) to analyze systematically trading favors as an economizing practice serving efficiency purposes. From the TCE perspective, trading favors is a component of the relational contracting portion of transaction governance, and contributes to economizing on bounded rationality and bounded reliability. We hypothesize that trading favors will be more prevalent in (1) macro-contexts characterized by a vacuum of formal institutions as well as by excessive formal rules; (2) cultural contexts where in-group membership is highly valued; (3) high bounded rationality/low bounded reliability contexts where frequent opportunities exist for indirect reciprocity; and (4) cases whereby no asset-specific investment(s) in innovation need to be made by the supplier of the favor. Enforcement mechanisms such as in-group sanctions, access to formal contracting as a complement to favors, possibility of image scoring and incentive compatibility can function as critical components of the trading favors practice. We suggest a classification of favor trading practices based on their link to formal contracting and rate of recurrence, and describe a range of likely impacts.