Relational Contracts and the Nature of Market Interactions

Abstract

We provide evidence that long-term relationships between trading parties emerge endogenously in the absence of third party enforcement of contracts and are associated with a fundamental change in the nature of market interactions. Without third party enforcement, the vast majority of trades are initiated with private offers and the parties share the gains from trade equally. Low effort or bad quality is penalized by the termination of the relationship, wielding a powerful effect on contract enforcement. Successful long-term relations exhibit generous rent sharing and high effort (quality) from the very beginning of the relationship. In the absence of third-party enforcement, markets resemble a collection of bilateral trading islands rather than a competitive market. If contracts are third party enforceable, rent sharing and long-term relations are absent and the vast majority of trades are initiated with public offers. Most trades take place in one-shot transactions and the contracting parties are indifferent with regard to the identity of their trading partner. Copyright The Econometric Society 2004.

On The Economics and Biology of Trust

“…Brown, Falk, and Fehr (2004) show that these behaviors arise from an interaction between fairness preferences and reputation incentives. Note that because it is common knowledge that the experiment lasts 15 periods, backward induction rules out the possibility of reputation formation if all subjects are purely selfish.…”

“…I will deal with this question in the next section. In this section I demonstrate the endogeneity of trust with the help of the experiments that examined the impact of reputation formation opportunities on markets with moral hazard problems (Brown, Falk, and Fehr 2004). 10 Subjects in these experiments are randomly allocated to two treatments: a oneshot gift exchange treatment and a gift exchange treatment with an opportunity for reputation formation.…”

“…One can thus measure the extent to which behavioral trust differs by observing wage levels across treatments. In addition, because Brown, Falk, and Fehr (2004) elicited employers' beliefs about the effort level they expect, we have a separate measure of beliefs in workers' trustworthiness. Finally, we also have a measure of the workers' actual level of trustworthiness because we can observe the actual effort level.…”

Profit Sharing and Reciprocity: Theory and Survey Evidence

“…The contexts are numerous including positive effort responses to high wages in contracts that cannot be enforced (Brown et al 2004), the rewarding of trust (Berg et al 1995;Altman et al 2007) and the willingness to punish those who violate norms of cooperation (Fehr and Gachter 2000;Carpenter and Seki 2005). In these contexts and others, reciprocity tends to be confirmed even as the evidence for pure altruism and commitment is absent (Croson 2006).…”

Producer Protection Legislation and Termination Damages in the Presence of Contracting Frictions

“…(1989) suggest that "...implicit limits on bonding and upfront payments reflects society's unwillingness to enforce bonding contracts." Brown, Falk and Fehr (2004) show that even in experimental settings, subjects rarely use entry fees. Now that the optimal choice of I has been determined, the processor and grower's expected profit can be specified to determine distribution under each policy regime.…”