Roses, ice, anchovies, and commuter minibuses

How informal agreements support markets in developing countries

Developing countries are known for having weak institutions. It thus comes as no surprise that relational contracts serve as the basis for significant economic activity. Understanding these relationships can help design policies that leverage these mechanisms, rather than replacing them with formal institutions that may not function as effectively. In practice, most research on such informal contracts focus on the dynamics between buyers and sellers.

Definition:
a relational contract is an informal agreement based on trust and reputation

For instance, a study of the Kenyan rose export industry reveals that trade volume is constrained by buyers’ perceptions of sellers’ reliability, and highly correlated with the age of their trading relationship. In the event of a supply chain disruption, however, firms do not prioritize deliveries to their youngest or oldest relationships, but rather to those in the middle. This illustrates how sellers depend on the expected gains from long-term relationships to offset short-term losses. In such settings, formal contracts may be beneficial in reducing risk across firms.

Likewise, a study in Sierra Leone observes that relational contracts between ice sellers and fishermen supported repeated trade. Here, ice retailers prioritize new buyers perceived as loyal. So, when a new manufacturer enters the market, the frequency of late deliveries among existing retailers drops significantly. Such entry further benefits buyers in the form of higher quantities and reduced prices of ice and the fish caught with it. This highlights a less commonly discussed mechanism through which market competition can benefit economic development in low- and middle-income countries.

Similarly, a study of the Peruvian anchovy industry demonstrates that relational contracts facilitate trade in the presence of volatile supply conditions. These informal agreements even have positive spillover effects for individuals operating without them. The author estimates that a one standard deviation increase in the share of sellers with such relationships would increase industry revenues by $208,000 annually.

Meanwhile, another study in Kenya assesses the relational contracts between owners and drivers of commuter buses. Here, researchers track real-time driving behavior and productivity, and randomize which drivers have access to this monitoring data. Six months into the intervention, “treated” drivers’ effort increased by almost 10 percent. These drivers also took substantially fewer risks, effectively cutting daily repair costs by half. Consequently, firm profits increased by 12 percent. These results highlight the efficiency of monitoring devices in boosting productivity in small and medium-enterprises in developing countries.

Understanding relational contracts may not seem conducive to economic development at first glance. However, research demonstrates that these contracts enable trade and investment where formal institutions are lacking. Further, relational contracts are apt at adapting to dynamic economic conditions in low- and middle-income countries. By providing a glimpse into the mechanisms peddling billions of transactions, the study of relational contracts proves extremely informative to cost-effective evidence-based policymaking.

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