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

Turning now to distributional issues, note that hypothesis 2 predicts that, in a concentrated market, buyers obtain all surplus while sellers earn reservation payoffs. Figure 3 illustrates how the ratio of the sellers' surplus to total surplus evolves across periods. In both C and RC2, sellers consistently captured less than 50% of total surplus; in fact, in round 15, sellers earned negative surplus (sellers earn less than reservation payment). At the other extreme, under RC1, sellers collectively never earned less than 50% of total surplus and, in some cases, earned more than 100%, especially in early and late rounds when relationships were being established or were ending.

[FIGURE 3 OMITTED]

One logical explanation for high seller surplus in RC1 is that Q is unenforceable; thus, the power to engage in opportunism belongs to sellers. Figure 4(a) illuminates this by contrasting the ratio of seller to total surplus under RC1 in private and public trading. Note that the ratio tends to be lower under private trading. Private trades indicate that relational trading is taking place, making it less likely that parties will renege on their agreements for fear of breaching self-enforcement constraints. If sellers or buyers shirk on their agreements for short-term gains, they risk being terminated by the other party and foregoing long-term relationship-specific gains. Nonetheless, one can see that even under private trading, the ratio increase dramatically in the final periods when relationships are about to end.

[FIGURE 4 OMITTED]

Figure 4 (b) provides the same analysis for treatment RC2. Note that unlike RC1, the ratio is higher under private trading. Intuitively, in RC2, buyers may also engage in opportunistic behavior so that private trading appears to discipline buyer opportunism thereby increasing sellers' surplus. Nonetheless, in the last few rounds, buyer opportunism increases so that sellers' surplus falls significantly, even under private trading.

So far, we have suggested that opportunistic behavior may explain some of the patterns observed in figures 3 and 4. To better understand the role of opportunism, turn to figure 5, which graphs sellers' propensity to renege on quality across periods in the incomplete contract treatments. Note that the percentage of trades in which sellers reneged was lowest under private RC2 trading and highest under public RC1 trading. It is particularly interesting that sellers reneged less often in private RC1 trading than in public RC1 trading, except in the early and late rounds. It appears that sellers were more likely to renege on quality before relationships were well established (in the early rounds) and when they were about to end (in the late rounds). However, in RC2 sellers renege less often in early and late rounds, presumably because buyers can still use discretionary price adjustments to discipline sellers even when relationships are fragile.

[FIGURE 5 OMITTED]

Rows 1 through 4 of table 3 report sellers' propensity to renege on quality after buyers retaliate; that is, after being terminated. One might anticipate that sellers would renege less often after being punished (terminated) but there was little evidence of this. Under RC1, sellers renege more if they were just terminated regardless of whether post-termination trade is public or private. This might be because terminated sellers have to switch to partners with whom they have no relationship-specific capital. The evidence is more mixed for RC2. Under private (public) trading, sellers renege more (less) if they have just been terminated.

Rows 5 to 8 compare sellers' promised profit, which is what they would earn if all parties honor the terms of the contract, to realized profits. On average, sellers earn more than promised in RC1 in both public and private trading, which is no surprise considering that sellers can engage in opportunistic behavior. In contrast, in RC2, sellers earn less profit than promised perhaps because buyers can behave opportunistically by making price deductions even when sellers meet obligations (recall that conditional on good performance, deducts were observed 55% of the time in public trades). This is consistent with claims made by some growers that they earn less than expected under contract production. For instance, Hamilton (2001) reports that, in a survey of broiler growers, 43% indicated that they earned less than they had anticipated under contract production.

Rows 9 and 10 reveal that in the C and RC1 treatments, sellers rarely earn profits below reservation levels so that, on average, sellers make good contract choices. However, in RC2, buyer opportunism results in sellers earning less than reservation payoffs, ex post, in 24% of public trades and in 7.9% of private trades. Thus, although sellers in RC2 accept the best contracts ex ante, in nearly one in four public trades, sellers end up with profits below reservation payoffs. This is mitigated by private trading but sellers still earn profits that fall below reservation payoffs in nearly 8% of trades.

We now turn to an econometric investigation of our data, which allows for a more complete analysis of surplus and profits. We estimate regressions where the dependent variables are surplus, buyer profit and seller profit. We are interested in the impact of RC1 and RC2 on each of the dependent variables so we include dummy variables for each regime as explanatory variables. Moreover, because our experiment is a repeated game where subjects can establish cooperative agreements by making the continuation equilibrium conditional on past play, the observations are history dependent. Thus, surplus/profits in a given period may depend on the underlying equilibrium, which in turn depends on past strategies and actions. We account for this dependence by including lagged quality chosen by sellers, lagged discretionary price deviations by buyers, and a measure of the length of private relationships. Additional control variables include demographic information and linear and quadratic time trends to capture learning and search. The "reservation" variable represents the seller's reservation payoff to account for the fact that reservation payoffs varied from 5 to 10 in some C sessions. Unobserved experiment-specific effects may cause the composite error term of observations within an experiment to be correlated. Thus, the robust standard errors were adjusted for clustering on experiments. (9)

While our main explanatory variables of interest are RC1 and RC2, we want to interact these treatment variables with a "private" dummy because it is likely that the incremental impact of RC1 and RC2 depends on whether trades are private or public. Because the decision to trade privately may be endogenous, a two-stage endogenous switching model is used. The first-stage probit model is used to predict the probability of private trading and then the inverse Mill's ratio calculated from this probit is included as a regressor in the second-stage regressions. In the second stage, the sample is split into public and private trades and the regression equation is estimated for each subsample. The exclusion restrictions used for the first-stage probit are lagged variables for "positive surprise" (Q > E(Q)) and "negative surprise" (Q < E(Q)), where E(Q) is the quality level the buyer expected to receive. In each round of RC1 and RC2 each buyer was asked to enter their quality expectation immediately after the seller accepted the offer (and prior to delivery). These variables are attractive exclusion restrictions because they should affect the probability that a buyer will continue to contract privately in the following period, but should have no direct impact on surplus and profits in a future period; that is, these variables should only affect future surplus and profits through the private variable.

Table 4 presents the results of the first-stage regression. (10) The regression reveals a strong, positive relationship between RC1 and the probability that private trading is used, which is consistent with figure 1. The previous length of a private relationship between a buyer and seller also significantly increases the probability of private trading. Thus, buyers/sellers locked in relationships are highly likely to use private trading.

Table 5(a) reports the second-stage regression explaining total surplus. The explanatory variables are the same as those used in the first-stage probit except for positive and negative surprise, which are excluded. A dummy variable for treatment C was omitted so that C represents the base treatment against which comparisons are made. The coefficient for RC1 is negative and significantly different from zero for both subsamples, suggesting that surplus under RC1 is lower than surplus under C whether trades were conducted publicly or privately. However, the difference in coefficients across the subsamples is estimated to be 26.48 and is significant at the 5% level according to a Chow test, suggesting that private trading reduces efficiency loss (relative to C) by an average of 77%. Turning to RC2, it is interesting that the coefficient for the private sample is not significantly different from zero--RC2 does not appear to reduce surplus relative to C, provided that subjects trade privately. This result is in stark contrast to RC1 and it suggests that relational contracting combined with a buyer's ability to make discretionary adjustments in price can provide informal enforcement that can nearly perfectly substitute for formal enforcement in producing social surplus.