Contract enforcement, social efficiency, and distribution: some experimental evidence.

Under RC1, the sequence of events within a round are the same as under C except that after a seller accepts, Q is unenforceable by a third party so the seller can deviate from the quality specified in the contract. After Q is chosen by the seller, payoffs are determined and the round ends. To determine what Q the seller will choose and what contract the buyer will offer, note that it is common knowledge that each live session ends after fifteen rounds. Thus, we must use backward induction and begin analysis in round 15 of the finitely repeated game. Within a round, the seller is the last mover. Therefore, consider what the seller should do given that she has accepted a contract and is guaranteed a payment P. Note from her objective function (2) that profit is maximized when Q = 1 so that production cost is zero. Hence, equilibrium quality is [Q.sup.RC1] = 1. The buyer anticipates that the seller will deliver the lowest quality and offers just enough to ensure participation ([p.sup.RC1] = 5). Again, both parties earn at least as much under trade. Thus, in equilibrium, five trades occur during the round and joint surplus is given by [S.sup.RC1] = 5. Unenforceable quality leads to substantially lower joint surplus and quality, which, via backward induction, will obtain in all previous rounds.

In RC2, the sequence of events within a round is the same as RC1 except that after the seller chooses quality, the buyer chooses a payment that can differ from the price in the contract. To determine equilibrium in RC2, first consider how the buyer, who is the last mover, will respond to a given quality, [Q.sup.0] chosen by the seller. The buyer's payoff is [[pi].sub.b] = 10[Q.sup.0] - P, which is maximized by setting [p.sup.RC2] = 0. The seller, anticipating that the buyer will renege on any contracting agreement with positive payment, will expect to earn [[pi].sub.s] = [p.sup.RC2] - c([Q.sup.0]) = 0 - c([Q.sup.0]) < 5 from the contract, which is lower than reservation earnings. Thus, the seller accepts no contract. In equilibrium, no trade takes place and no surplus is earned in round 15. A similar logic follows for all earlier rounds. With two-sided discretion, the contracting market is completely destroyed by opportunism.

The above analysis provides us with several hypotheses:

HYPOTHESIS 1: When Q is unenforceable by a third party (RC1 or RC2), total surplus will be lower than the case when quality is enforceable (C).

HYPOTHESIS 2: Whether quality is enforceable or not by a third party, all surplus goes to the buyer and trading sellers earn reservation payoffs.

HYPOTHESIS 3: If both quality and payment are unenforceable by a third party (RC2), the contracting market collapses and no trade occurs in equilibrium.

Certain aspects of Hypotheses 1 and 2 are similar to the equilibrium predictions of BFF in that only minimal quality trading is anticipated in RC1 and all surplus goes to buyers. Our prediction about RC2 is even more stark-the market collapses. However, these predictions rely on strong assumptions about the self-interested motivations of all subjects. When these assumptions are violated, such as when a subset of subjects has social preferences (Fehr and Gachter 2000; Charness and Rabin 2002; Engelmann and Strobel 2004, among others), then different outcomes may emerge. BFF show that when enough subjects place a value on fairness, there is a perfect Bayesian equilibrium in which trade and high-quality levels emerge, even in a finitely repeated game. The key mechanism supporting this "cooperative" equilibrium is that subjects who care about equity will choose strategies that are "fair" and support high relationship-specific rents, even in the final period. The existence of these rents in the final period will incentivize even selfish subjects to cooperate in earlier periods so that the perfect Bayesian equilibrium outcomes may resemble what might occur in an infinitely repeated game with strictly selfish types. Moreover, multiple equilibria are possible depending on subjects' beliefs and the nature of subjects' social preferences. Given that multiple equilibria are possible and the potential for equity-minded subjects, it becomes even more important to study subjects' actual behavior in an experimental setting, rather than to rely purely on theory. Nonetheless, our theoretical predictions provide a useful organizing framework.

Results

Trading

We now provide an overview of trading outcomes from each treatment. Focusing on rows 8 and 9 of table 1, a first notable result is that, under RC2, subjects executed 449 out of the 450 possible trades, which contrasts the dire prediction from hypothesis 3 that the market will collapse. Of the three treatments, RC2 may most resemble agricultural markets given barriers to third-party enforcement and the ability of processors to make ex post adjustments in contract terms. One can see that such markets can remain active as subjects can use informal enforcement mechanisms to replace third-party enforcement.

One informal enforcement mechanism is private trading. Figure 1 graphs the evolution of private trading across periods. The share of private trades under RC1 increases over time before settling between 60% and 70% by the ninth round. The share of private trades under C is significantly lower than under RC1 and never exceeds 30%. These patterns are similar to BFF's results, which corroborate our experimental procedures and results. Under RC2, the share of private trades is significantly lower than under RC1 but consistently higher than under C. Kruskal-Wallis (KW) tests indicate significant differences in private trading between RC1 and RC2 (p = 0.0001), C and RC2 (p = 0.004), and C and RC1 (p = 0.0001). Our results suggest that buyers rely more on private trading when other enforcement instruments are missing.

[FIGURE 1 OMITTED]

Because buyers in RC2 resort to private trading less than they do in RC1, presumably due to the availability of discretionary ex post adjustments in price as a second informal enforcement mechanism, we examine this second instrument further. While the latitude to make ex post adjustments in payment terms is a controversial aspect of agricultural contracts as it can increase the probability of opportunistic behavior by buyers, our results suggest that these adjustments also provide incentives. That is, if sellers anticipate that buyers will reward (deduct) for high (poor) performance, then sellers may increase quality. Such price adjustments are consistent with discretionary bonuses of the sort discussed by Levin (2003), which can be used to provide incentives in relational contracts. If buyers are indeed making discretionary adjustments to incentivize sellers, then we ought to observe some correlation between performance and price adjustments.

Table 2 reports price adjustments made by buyers cross tabulated against performance for all RC2 trades. Buyers do seem to make adjustments contingent on performance. Conditional on good performance (Q > [Q.sup.*]), rewards are used 33% (2%/6% [approximately equal to] 33%) of the time under public trading and 67% (4.4%/6.6% [approximately equal to] 67%) under private trading whereas conditional on poor performance, sellers are rewarded only 1.1% (0.4%/35.2%) of the time under public trading and 2.5% (0.2%/8%) under private trading. Conditional on good performance, deducts are observed 55% and 19.6% of the time under public and private trading respectively, but these shoot up to 83.5% and 66.3% conditional on bad performance. Moreover, when sellers deliver quality that equals agreed upon quality, no price adjustment is most frequently observed. These patterns suggest that (1) discretionary price adjustments do appear to be contingent on quality, which is consistent with incentive provision, and (2) opportunistic behavior, independent of incentive provision, still occurs; that is, some buyers impose price deductions in trades where sellers meet or exceed performance obligations. This opportunistic behavior is more common in public trading. For example, when sellers meet performance obligations, buyers make downward adjustments in 41% (11.4%/27.6%) of public trades and in only 9.6% of private trades.

Surplus and Profits

We now discuss efficiency and the distribution of profits that result for each treatment. Hypothesis 1 predicts that total surplus under imperfect third-party enforcement will be lower than under perfect third-party enforcement. Figure 2(a and b) provides views of total surplus in each treatment under private and public trading. Under private trading, surplus under RC1 is consistently lower than under the other two treatments. In contrast, surplus under RC2 appears similar to surplus under C; we show formally in subsequent econometric analysis that there is no statistically significant difference. The combination of private trading combined with ex post price adjustments appears to provide powerful incentives, even in the absence of third-party enforcement. In contrast, under public trading, surplus under RC2 appears consistently lower than under C.

[FIGURE 2 OMITTED]