Relational Contracts and the Nature of Market Interactions

Abstract

We provide evidence that long-term relationships between trading parties emergeendogenously in the absence of third party enforcement of contracts and are associated witha 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 fromtrade 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 exhibitgenerous rent sharing and high effort (quality) from the very beginning of the relationship. Inthe absence of third-party enforcement, markets resemble a collection of bilateral tradingislands rather than a competitive market. If contracts are third party enforceable, rent sharingand long-term relations are absent and the vast majority of trades are initiated with publicoffers. Most trades take place in one-shot transactions and the contracting parties areindifferent with regard to the identity of their trading partner.

Keywords: fairness preferences, repeated transaction, involuntary unemployment, market interaction, implicit contracts, relational contracts

JEL Classification: D2, D4, C7, C9