Brown, Martin; Falk, Armin; Fehr, Ernst
Working Paper
Relational Contracts and the Nature of Market
Interactions
IZA Discussion Papers, No. 897
Provided in Cooperation with:
IZA – Institute of Labor Economics
Suggested Citation: Brown, Martin; Falk, Armin; Fehr, Ernst (2003) : Relational Contracts and
the Nature of Market Interactions, IZA Discussion Papers, No. 897, Institute for the Study of
Labor (IZA), Bonn
This Version is available at:
http://hdl.handle.net/10419/20136
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IZA DP No. 897
Relational Contracts and the
Nature of Market Interactions
Martin Brown
Armin Falk
Ernst Fehr
DISCUSSION PAPER SERIES
Forschungsinstitut
zur Zukunft der Arbeit
Institute for the Study
of Labor
October 2003
Relational Contracts and the Nature of
Market Interactions
Martin Brown
University of Zurich
Armin Falk
University of Zurich and IZA Bonn
Ernst Fehr
University of Zurich and IZA Bonn
Discussion Paper No. 897
October 2003
IZA
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IZA Discussion Paper No. 897
October 2003
ABSTRACT
Relational Contracts and the Nature of Market Interactions
We provide evidence that long-term relationships between trading parties emerge
endogenously in the absence of third party enforcement of contracts and are associated with
a 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 from
trade 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 exhibit
generous rent sharing and high effort (quality) from the very beginning of the relationship. In
the absence of third-party enforcement, markets resemble a collection of bilateral trading
islands rather than a competitive market. If contracts are third party enforceable, rent sharing
and long-term relations are absent and the vast majority of trades are initiated with public
offers. Most trades take place in one-shot transactions and the contracting parties are
indifferent with regard to the identity of their trading partner.
JEL Classification: D2, D4, C7, C9
Keywords: relational contracts, implicit contracts, market interaction, involuntary
unemployment, repeated transaction, fairness preferences
Corresponding author:
Armin Falk
IZA Bonn
P.O. Box 7240
53072 Bonn
Germany
Tel.: +49 228 3894 112
Email: falk@iza.org
2
1. INTRODUCTION
1
In many markets, contracts specify traders’ obligations imprecisely and trading relations are
riddled with informal agreements and unwritten codes of conduct. Neutral third parties often
cannot enforce such relational or implicit “contracts” because, typically, outsiders are unable to
verify whether contractual obligations have been met. Therefore, the trading parties face
important incentive problems (Chevalier and Ellison (1997, 1999), McMillan and Woodruff
(1999), Banerjee and Duflo (2000), Hong, Kubik and Solomon (2000)). There has been
considerable progress in the theoretical analysis of markets with enforcement problems in the
past two decades, with a strong focus on repeated interactions (Gintis (1976), Klein and Leffler
(1981), Shapiro and Stiglitz (1984), Bowles (1985), Bull (1987), Hart and Holmström (1987),
MacLeod and Malcomson (1989, 1993, 1998), Baker, Gibbons and Murphy (1994), Dixit
(2003), Levin (2003)). However, empirical evidence has been limited in contrast to the progress
of theory. While lack of empirical knowledge is always undesirable, it becomes an even more
serious problem in our context because there is generally a plethora of equilibria in the presence
of repeated interactions (see e.g., Fudenberg and Maskin (1986)). For this reason, theory alone
gives us little guidance regarding the likely consequences of enforcement problems for the
functioning of markets.
In this paper, we show experimentally that the absence of third party enforcement of contracts
causes fundamental changes in the nature of market interactions. Traders are very much
concerned about the identity of their trading partners if third party enforcement is ruled out. They
prefer to trade exclusively with the same partner for many periods with the consequence that,
over time, bilateral relationships thoroughly dominate the market. Efficiency wages (rents)
combined with the threat of firing discipline the workers (sellers) in this market. Moreover,
competition seems to have little impact on contract terms because the gains from trade are shared
equally among the parties and long-term relations are much more profitable than are short-term
