Contracting when enforcement is weak: evidence from an audit study

Abstract

How are contracts structured in the presence of relationship-specific investments when legal enforcement is weak? Using a new audit methodology, we show that simple financial contracts in combination with social norms and reputation concerns can sustain relationship-specific transactions. Wholesalers in the market for pens in India use upfront payments rather than increased risk premia to mitigate risks arising from relationship-specific investments. Upfront payments for printed pens cover only 40% of the production costs, highlighting the importance of upfront payments as a screening device. Ex-post, renegotiation is more likely for printed pens, but in a substantial fraction of cases renegotiation fails.