Relational Contracts, Financing Constraints and Social Welfare
Abstract: This paper analyzes the interaction between relational contracting and the quality of financial markets. I study a simple model in which a downstream firm (the buyer) sources components from an upstream firm (the supplier). The parties interact without the benefit of a formal contract and, due to imperfections in financial markets, the supplier has limited access to credit. The buyer is then required to cover a fraction of the investment cost. I characterize the whole set of efficient self-enforcing contracts and analyze how they are affected by the magnitude of the financing friction. If the supplier has strong bargaining power, less efficient financial markets may be beneficial to social welfare. If the buyer has strong bargaining power, on the other hand, less efficient financial markets are always welfare-reducing. The model also predicts that the productivity of the partnership increases with the length of the relationship. After a finite number of periods, however, the relationship “matures” and every efficient self-enforcing contract converges to a stationary agreement that maximizes social welfare among the class of all self-enforcing contracts. During the “transition phase”, investment decisions are distorted, resulting in either under- or over-investment. Over time, the inefficiencies decrease and investment monotonically approaches its first-best level.
