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

Table 5(b and c) report results for the second stage regressions for buyer and seller profit. In table 5(b), the coefficient for RC1 is negative and significantly different from zero for both subsamples, meaning that buyers clearly profit less under RC1 than C. The same coefficients in table 5(c) are positive, though only the private subsample coefficient is significant. Thus, sellers may benefit from RC1 (relative to C) under private trading. While this appears to contradict figure 4(a), which shows that sellers earn a larger fraction of surplus under RC1 in public trading, recall from figure 2(a and b) that surplus is much higher under private trading; thus, a higher fraction of surplus may not necessarily mean higher absolute profits.

Our results indicate that, on average, the impact of RC1 under public trading is to reduce buyer profit by 45.18 compared to profit under C; seller profits are the same. Under private trading, both buyers and sellers benefit compared to public trading as buyer losses drop from 45.18 to 16.20, while seller profits are 7.97 higher than they are under C. Hence, under private trading, RC1 reduces buyer profit and increases seller profit, which contradicts hypothesis 2. In contrast, RC2 has very different effects on buyers and sellers. None of the coefficients for RC2 in table 5(b or c) are significantly different from zero. The only significant finding regarding RC2 is that buyers profit more under RC2 when engaged in private trades, though this result is significant at only the 10% level.

Overall, the results suggest that neither social efficiency nor profits will change in the absence of formal enforcement of contracts provided that the trading parties have a sufficient range of informal enforcement mechanisms available. If the number of informal instruments is limited (e.g., RC1) so that buyers are constrained in their ability to use informal mechanisms to enforce quality, then significant surplus losses can occur.

Conclusion and Implications

We report the results of an experiment that investigates contracting relationships in an environment that features buyer concentration and different degrees of formal contract enforcement. Because market concentration and constraints to third-party contract enforcement are common features of agricultural contracting, we believe that our results provide insights into the basic microeconomic forces that shape contracting relationships between processors and growers. Moreover, by exogenously varying enforcement regimes, we provide experimental counterfactuals that can help economists and policy makers understand how government involvement in contracting markets affect social efficiency and the distribution of surplus.

We find that full formal enforcement of contracts promotes social efficiency. We also find, however, that if formal enforcement is missing (i.e., the government is hands off or performance is not verifiable by a third party due to lack of information or institutions), trading parties can use discretionary adjustments to contract terms combined with contract renewal to create a level of social surplus and profits that nearly matches the level obtained under full formal enforcement. This finding is consistent with the claims of Telser (1980) and Klein (1996) who suggest that the ability of trading partners to self enforce contracts can enhance economic productivity. However, our experiments show that if formal enforcement is one-sided or incomplete, this can constrain the range of informal incentive mechanisms leading to significant losses in social efficiency. This finding is consistent with the theoretical work of Bernheim and Whinston (1998) who show that, given limits to third-party enforcement, it may be optimal to increase the level of incompleteness of a contract. The policy implication is that if the government chooses to monitor and enforce contracts more vigorously, doing so in a one-sided or ad hoc manner can crowd out informal incentives and introduce inefficiencies. Government attempts to enforce contracts should not ignore informal mechanisms that are already in place.

With regard to distribution, a very complex pattern emerges under our three enforcement regimes. On the surface, it would be reasonable to assume that, due to buyer concentration, most of the gains from trade would be captured by buyers. We find that this is generally true under the extreme cases of full formal enforcement and no formal enforcement. However, in the intermediate case, when there is only partial or one-sided enforcement--where buyers' contractual obligations are rigorously enforced but sellers' obligations are not--sellers can capture a significant share of social surplus and may earn more in absolute profits, so long as surplus is not reduced significantly. The practical implication of this result is that, while government enforcement of processor obligations might help growers, it may have significant costs in terms of social efficiency.

We close our article with a caveat. While efficient trading can still occur under a hands-off policy of no third-party enforcement, there was evidence of opportunistic behavior on the part of buyers. Specifically, while buyers' ability to make discretionary adjustments in price ex post can provide informal incentives to discipline sellers, a non-trivial fraction of trades also exposed sellers to discretionary downward adjustments even when they met or exceeded contract requirements. Because of this opportunistic behavior, sellers, on average, earned less than they were promised in their contracts and a non-trivial fraction of sellers even earned profits that fell below their reservation profits. However, it is not clear whether this opportunism depends solely on the enforcement regime. For example, if the market were concentrated in favor of sellers, would such opportunism exist? If processors were forced to use discretionary bonuses rather than deducts, would this limit opportunism? If sellers can bargain collectively, how might this affect efficiency and opportunism? It would be interesting to tackle these questions in future research.

The authors thank three anonymous reviewers, who provided a number of helpful comments; seminar participants at North Carolina State University; and Myoungki Lee, Michael Brady, and Jack Schieffer for excellent research assistance. Abdoul Sam provided helpful suggestions and discussions. Any remaining errors are the authors'.

[Received August 2005; accepted July 2006.]

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