UC Davis

Relational contracting (RC) is an important special case of vertical coordination that provides more stability than spot market transactions and more flexibility than vertical integration. Unlike formal contracts that are third-party enforceable, relational contracts are self-enforcing agreements governed by the trading parties' valuations of a potential long-lived economic interaction, and are particularly prominent in countries where institutions for enforcing formal contracts are incomplete. Despite the growing awareness of RC's importance and prevalence, little is known about its value as markets develop, as informal relationships are generally studied in contexts with salient market imperfections.

By analyzing the transactions of a large wholesale fresh produce market in China, this dissertation presents evidence of relational contracting inside a well-functioning market. The market exhibits two stylized facts, namely persistent price dispersion across and within individual sellers, and repeated trade between a significant number of bilateral buyer-seller pairs. Motivated by the stylized facts, the conceptual foundations for the economic relationships formed by buyers and sellers via repeated trade are set forth, and testable hypotheses regarding the characteristics of the informal agreements (relational contracts) embedded in these relationships are developed. First, buyers under RC pay a premium to sellers relative to spot market prices. Second, RC price varies with spot market prices; it rises if the market price increases and falls as the market price drops. Third, the RC premium is suppressed under a negative supply shock and is enlarged under a positive supply shock. Fourth, buyers enjoy greater assurance in supply through RC. Last, the value of a relationship is higher as it ages.

The empirical analysis provides evidence supporting the hypotheses under a set of definitions of RC and supply shocks. A price premium is found to be charged to RC buyers when compared to their nomad counterparts. In return, RC buyers enjoy a more reliable supply: they are rationed less frequently and less severely than buyers not in an RC. In this regard, the premium that RC buyers pay is essentially a premium for quantity insurance. RC traders adjust RC price as well as RC premium to sustain the relationship under supply shocks on the spot market. As a result, variation in prices is smaller in relational transactions than in that in spot exchanges. Further, the RC premium increases as the relationship accumulates number of transactions, indicating an increase in RC value over time.

Together, these findings highlight the value of RC in a well-functioning market by showing that it functions as an informal insurance contract to mitigate quantity and price risks under stochastic supply and volatile prices in the market. The potential of RC as a promising vertical coordination mechanism, even when markets develop and become more efficient, is thus highlighted.