How Firms Overcome Weak International Contract Enforcement: Repeated Interaction, Collective Punishment and Trade Finance

83 Pages Posted: 17 Feb 2013 Last revised: 3 Nov 2016

Date Written: September 22, 2016

Abstract

How do parties engaged in international trade ensure adherence to contracts when contract enforcement is weak? In a dynamic general equilibrium model of matching and repeated interaction, I argue that reputational concern can provide a substitute for formal contract enforcement if the threat of exclusion by the current and potential future partners is effective. However, if trade is infrequent or information of past behavior disseminates poorly trade is constrained. Policy makers can manipulate the matching process by imposing tariffs or restricting the entry of firms and new sources of gains from trade arise. Further, when trade is constrained a bank can provide guarantees - letters of credit - for multiple importers. The bank’s additional credibility is endogenously derived from increasing returns to credibility in size.

Keywords: Trade Finance, Letters of Credit, Repeated Interaction, Business Networks, Contract Enforcement, Reputation

JEL Classification: C73, D83, F12, G21, L11, L14

Suggested Citation

Olsen, Morten, How Firms Overcome Weak International Contract Enforcement: Repeated Interaction, Collective Punishment and Trade Finance (September 22, 2016). IESE Business School Working Paper No. WP-1111-E, Available at SSRN: https://ssrn.com/abstract=2219243 or http://dx.doi.org/10.2139/ssrn.2219243

Morten Olsen (Contact Author)

University of Copenhagen ( email )

Copenhagen
Copenhagen
Denmark

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