The Effects of Governance on Relational and Formal Contracts: Theory and Evidence from Groundwater Irrigation Markets
Abstract: This paper examines evidence on the role different types of governance plays in the adoption of relational or formal contracts. We conduct our empirical analysis using a unique data set on contracts for groundwater irrigation in Bangladesh. In this market, households seeking to secure groundwater irrigation can either exploit high-quality inside information to design contracts or rely on low-quality but third-party verifiable information. A distinguishing feature of this market is the existence of a variety of different village-level institutions for the enforcement of contracts. This allows us to examine both the determinants of contract choice under a specific governance regime and how differences in governance affect contract choice. We adapt existing models of relational contracts to integrate stylized observations from the field and derive empirical tests based on comparative static predictions. We find that households adopt formal contracts when the quality of third-party verifiable information is good and when the punishment for contract violation is severe. We also find that in villages which provide no third-party enforcement the issue of who retains ex post discretion is particularly important. Contracting parties attempt to balance counter party risk by using bargaining power to force adoption of contracts in which they retain ex post discretion.
