Recent controversies surrounding contract production in agriculture
have raised concerns among policy makers that vertically coordinated
industries might favor large agribusiness at the expense of growers.
Among the issues that have received attention include the apparent lack
of bargaining power possessed by growers when negotiating and performing
under contracts, and the lack of transparency concerning how performance
and payments are determined (Pierce and Stewart 1997). As an example of
the latter, Schrader and Wilson (2001) analyze data from a survey of
broiler growers and suggest that many growers were concerned about the
quality of inputs they received from contractors and the timeliness and
accuracy of bird weighing. Because both input quality and the accuracy
of weighing can affect performance outcomes, which in turn, determine
compensation, there might be a lack of transparency in the determination
of pay. (1) Along similar lines, Hamilton (2001) points out that many
broiler contracts contain a provision that allows a contractor to
unilaterally change payment methods or rates, which provides integrators
with the option of making discretionary ex post adjustments in pay. The
lack of transparency can make it difficult for third parties, such as
courts or regulators, to enforce contracts. This means contracts may be
rendered incomplete by limits to enforcement.
While enforcement problems appear to be key issues for policy
makers, there have been few efforts to clarify the consequences of
contractual enforcement on efficiency and distribution. Textbook
principal-agent models are inadequate for studying enforcement problems
because an assumption of these models is that third-party enforcement of
contracts is perfect. Thus, law and economics scholars focus on
contracting environments where there are limits to third-party
enforcement so that contracts are incomplete.
An analysis of the impact of third-party contract enforcement is
complicated by the fact that traders can devise informal enforcement
mechanisms to self enforce contracts. Incomplete contracts combined with
the possibility of repeated trading, which is common in some
agricultural subsectors, (2) enable private parties to devise informal
enforcement mechanisms (i.e., form relational contracts) to mitigate
hold-ups and other distortions (Telser 1980; Klein 1996; Macleod and
Malcomson 1989; Levin 2003). Relational contracts fit many of the
stylized facts of agricultural contracting because even if explicit
contracts exist, some dimensions of performance (e.g., quantity
commitments, timing of deliveries, contract renewal) are frequently
omitted from explicit agricultural contracts, opening the door for
informal incentives.
Apart from theoretical issues, there is a paucity of data for
studying policy issues in vertically coordinated industries. Explicit
terms in contracts are often buttressed by unwritten rules, informal
incentives, and tacit expectations so that it is difficult to find
observational data that captures every important aspect of the
contracting environment. There is also a lack of historic precedent for
many of the contracting issues that have emerged recently in U.S.
agriculture. Thus, there is little data available for assessing the
impact of alternative enforcement regimes on trading outcomes.
Given the lack of theoretical and empirical research, it is not
surprising that economists and policy makers hold numerous opinions
about how government regulations of agricultural contracts would affect
efficiency and distribution. Some economists suggest that too much
regulation spurs unintended consequences that, for example, may cause
livestock industries to leave states in which regulations are binding
(Boehlje et al. 2001). Others suggest that regulations and enforcement
are necessary to enhance both fairness and competitiveness in contract
agriculture (Harl et al. 2001; Taylor 2002).
This study uses experimental economics to investigate the effects
of third-party enforcement on contractually based markets with buyer
concentration. Our experimental setup is based on the design of Brown,
Falk, and Fehr (2004); two treatments are identical to theirs while a
third treatment unique to our study facilitates examination of issues
pertinent to agricultural contracting. An experimental approach allows
for exogenous variation in enforcement regimes, which facilitates
estimation of causal relationships. We view this study as an initial
step in understanding the microeconomic forces that shape trading
patterns in a contractually based economy where buyers have bargaining
power and third-party contractual enforcement might be imperfect. The
insights generated in this study can shed light on how policies that
increase transparency and/or third-party enforcement of contracts can
affect efficiency and the distribution of rents.
Noussair and Plott (1995) argue that experiments need not replicate
field situations and all institutional details to retain relevance for
policy analysis. Instead, experiments are valuable in that they allow
economists to examine general theories that should apply more broadly.
If a theory does not apply in simple, controlled environments, one must
question whether the theory is appropriate for explaining behavior or
predicting responses in more complex environments. Moreover, abstracting
from reality is not unique to experiments; indeed, most economic studies
incorporate simplifying assumptions and abstractions.
One main finding is that perfect third-party enforcement promotes
social efficiency. However, we also find that a regime devoid of
third-party enforcement can generate comparable social efficiency. In
such regimes, many subjects use contractual renewal and discretionary
adjustments in contract terms to provide informal enforcement that can
be nearly perfectly substitutable with formal enforcement in terms of
generating social surplus. This finding is consistent with the case
studies provided by Anderson (1999) and Gow, Streeter, and Swinnen
(2000), which show that self-enforcing agreements can substitute for
inefficient third-party enforcement. However, we find that a nontrivial
fraction of trades resulted in sellers (i.e., growers) making ex post
profits that fell below reservation payoffs due to opportunistic buyer
behavior. Another interesting result is that one-sided formal
enforcement (buyers' obligations only) constrains subjects'
ability to use informal enforcement, which resulted in significant
efficiency losses.
Experimental Design
Motivation
Agricultural contracts facilitate vertical coordination because
processors can provide incentives for performance factors that enhance
profits. In a typical contract, a grower agrees to produce crops or
animals in a manner consistent with conditions in a written or verbal
agreement. (3) Growers are then paid according to a price established in
the agreement.
In practice, a processor may care about a range of performance
factors, including quality, on-time delivery, product consistency, and
efficient input use. While there is considerable heterogeneity in
performance factors across contracts, the key point is that contracts
are essentially incentive devices for increasing productivity and the
value of trade. Thus, in designing our experiments, we were primarily
interested in a design that would allow us to assess the incentive
effects of contracts.
In complete contracting environments, where third-party enforcement
is assumed perfect, the crucial question is how variations in explicit
incentive structures affect productivity. However, if there are
impediments to complete contracting, such as limits to enforcement, then
parties may be constrained in their ability to structure explicit
incentives and must also rely on implicit or informal incentives. In
practice, contractors use discretionary adjustments in pay and contract
termination policies. Such discretionary ex post adjustments in contract
terms can affect future trading equilibria.
Given that there often are barriers to third-party enforcement of
agricultural contracts, implicit incentives cannot be ignored. Moreover,
even if explicit incentives exist in an incomplete contract, informal
incentives will still supplement explicit incentives in motivating
performance. For example, although broiler contracts contain explicit
incentives for efficient input use, processors may supplement these
incentives with discretionary adjustments in pay and/or the number and
frequency of flock placements, which affect future pay. Some have
suggested that when there are limits to enforcement, it may be optimal
to omit explicit incentives entirely even if some dimensions of
performance are enforceable (Bernheim and Whinston 1998). Thus, the
focus of our study is on informal incentives and how interventions
(e.g., new policies or institutions) that impact third-party enforcement
will affect trading outcomes.
Details of the Design
We follow the basic design of Brown, Falk, and Fehr (BFF) and two
of our treatments are identical to theirs. In addition, we add a third
treatment, which is unique to our study. In this treatment, we let
buyers make discretionary ex post adjustments in compensation. Hamilton
(2001) points out that some contractors can make unilateral adjustments
in payments ex post, so this allowance is consistent with agricultural
contracting. Further, parties can track the reputations of past trading
partners and have discretion to renew or dissolve existing relationships
based on past performance. This creates the possibility of relational
contracting where the promise of future relationship-specific gains from
trade can be used to provide informal incentives to discipline current
behavior.
In each experiment subjects are partitioned into two groups: buyers
and sellers. (4) All trading takes place on networked computers enclosed
in cubicles to eliminate between-subject visual contact. Moreover,
anonymity is preserved by assigning all subjects identification (ID)
numbers. Each experiment has two trading sessions featuring distinct
contract enforcement regimes. Each session has 17 trading rounds--two
practice rounds and 15 "live" rounds that may determine
eventual cash payment. ID numbers are fixed across rounds, which allows
subjects to develop and track reputations.
Within each trading round, buyers offer contracts to sellers
specifying a price--quality combination for a unit of an abstract good,
where quality can be thought to embody all costly performance factors.
Sellers can only accept or reject offers. A buyer can make as many
offers as desired in each round, but once one offer is accepted, all
other offers are withdrawn and no additional offers can be made.
Similarly, once a seller accepts an offer, no other offers can be
entertained. In short, each buyer and seller can conclude at most one
trade per round. No buyers (sellers) are obligated to make (accept)
offers in any round.
Buyers can extend two types of offers: public and private. Public
offers are displayed on the computer screens of all sellers and buyers;
any seller can accept any public offer. Private offers are extended by
entering a specific seller's ID number into the computer. Only the
seller identified sees the offer and only he can choose to accept it.
Private offers enable long-term relationships, which lie at the core of
relational contracting theory. For example, if a buyer predicts benefits
from contracting with a specific seller (i.e., can earn
relationship-specific rents) and wants to establish a long-term
relationship, the buyer can make a single, private offer to that seller
in each round rather than venturing into the open market and hoping that
that seller is the first to accept the offer. (5) Had we not
incorporated private trading, it would have been difficult for parties
to establish relational agreements that persisted over time as buyers
would have had to hope that their targeted sellers accepted their public
contracts before any other sellers did so.
Every round features the same five buyers and seven sellers. Fewer
buyers than sellers create buyer concentration because at least two
sellers do not trade in each round. This forces sellers to compete for a
limited number of contracts, which tilts bargaining power in favor of
buyers. (6) Excess demand for contracts is consistent with stylized
facts in some sectors. For example, according to Mitchell (2004), most
chicken processors have waiting lists for those who want to become
growers and some existing growers want to add capacity to expand
contract production. Our subjects maintained the same role (e.g., buyer)
during both sessions in an experiment and no subject participated in
more than one experiment (two sessions).
In order to test the impact of third-party enforcement on
efficiency and surplus, we examine three enforcement regimes. First, in
the "complete contract" (C) treatment, the computer fully and
perfectly enforces all contractual components. That is, sellers must
supply the quality stipulated in the contract, and buyers must pay the
agreed upon price. In the second treatment, called "Relational
Contract 1" (RC1), the computer only enforces contractual price, so
that discretionary price adjustments are made illegal. Quality is
unenforceable, that is, sellers can supply quality that differs from
contractual specifications. This treatment mimics situations where
neither input quality nor output measurement (e.g., weighing of birds)
is verifiable by a third-party. In this case, measured performance is
unenforceable by a third-party because when quality is low, both parties
can blame each other (e.g., growers can claim poor quality inputs and
processors can claim grower torpor) and verifiability is costly. Our C
and RC1 treatments are identical to BFF's. The third treatment,
called "Relational Contract 2" (RC2), is unique to our study.
This treatment is similar to RC1 except that the buyer can make expost
adjustments to the promised price; that is, after observing the
seller's delivered quality, the buyer can choose a price that
deviates from contract specifications. Our RC2 treatment allows for the
examination of a broader range of informal incentive mechanisms used to
regulate trading. We show that our RC2 treatment can provide significant
new insights into the nature of relational contracting relative to the
findings of BFF.
Round specific payouts are determined for buyers as follows:
(1) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII],
where [[pi].sub.b] is the buyer's profit, Q is the actual
quality chosen by the seller, and P is the actual price received by the
seller. All payments are given in experimental points where subjects
earn 1 dollar for 70 points.
The seller's profit is
(2) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII],
where r is a reservation payoff in the absence of trade (5 or 10
depending on the session). We impose positive reservation payoffs for
sellers to ensure that they earn some money during the experiment.
Varying reservation payoffs should only induce buyers to change their
price offers to ensure that sellers' reservation payoffs are
covered, but efficiency should not be affected. During the experiment, Q
is an integer in the set {1, 2, ...,10} and P is an integer in the set
{0, 1, ..., 100}. The cost function, c(Q), is fully represented by the
following schedule of quality-cost combinations: {1, 0}, {2, 1}, {3, 2},
{4, 4}, {5, 6}, {6, 8}, {7, 10}, {8, 12}, {9,15}, {10, 18} so that c(Q)
is increasing and convex. Note that marginal cost never exceeds 3 and
that a buyer's marginal benefit always exceeds 3 so that first best
is achieved if the seller delivers maximum quality. At the end of each
round, each subject is informed of her own payoff and her trading
partner's payoff.
We conducted thirteen experiments. Each experiment included two of
the treatments (C, RC1, or RC2). Each subject participated in both
treatment sessions during an experiment, which means that order effects
might arise. Hence, the design counterbalances the order of appearance
for each of the three enforcement regime sessions. (7) Before subjects
were paid, they provided demographic information. (8) There were a total
of 156 subjects in twenty-six sessions (two in each of the thirteen
experiments) where thirteen were C treatments, seven were RC1
treatments, and six were RC2 treatments. Subjects made 1,903 out of a
total of 1,950 possible trades across all sessions. Table 1 provides a
summary of treatments, sessions, participants, rounds, and trades. The
experimental economy was programmed using Z-TREE software (Fischbacher
1999). For five C treatments, r = 10, and for the others, r = 5; r = 5
for all RC1 and RC2 sessions. See Wu and Roe (2006) for additional
details of the experiment, including subject instructions.
Predictions
In this section, we provide theoretical predictions for each
treatment. Like BFF, we use the theory of repeated games to generate
predictions. We focus on the case where the seller's reservation
payoff is set at r = 5, but the case where r = 10 is analyzed similarly.
In treatment C, the sequence of events within a round is as
follows. First the buyer offers a contract, which specifies the desired
P and Q. If a seller accepts, payoffs are determined and the round ends.
Note that Q and P specified in an agreement are third- party enforced,
that is, neither party can deviate from contracted Q and P. Thus, the
buyer's profit-maximizing contract choice is determined by solving
the problem
(3) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII].
Substituting the binding constraint into the objective function
yields
(4) [MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII]
which gives the first-order condition
(5) 10 - c'(Q) = 0.
As noted above, marginal cost never exceeds 3 so the buyer should
implement maximum quality, [Q.sup.*] = 10. With [Q.sup.*] in hand, it is
easy to solve for [P.sup.*] = 23 from the participation constraint to
ensure that the seller will accept. Because both parties can earn at
least as much when trading, we predict that all five buyers will make
offers and that five sellers will accept them. Hence, in equilibrium,
five trades occur in the round and joint surplus is given by
(6) [S.sup.C] = [[pi].sub.b] + [[pi].sub.s] - r = 77.
Due to perfect third-party enforcement, sellers and buyers have no
incentive to deviate from this prediction in any round of the session.
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]
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.
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
losse