Networked Markets and Simple Relational Contracts

Empirical studies of commercial relationships between firms reveal that (i) suppliers encounter situations in which they can gain in the short run by acting opportunistically and (ii) good conduct is sustained not exclusively by formal contracts but through informal relationships and the expectation of future business. In such relationships, the need to offer each supplier a large enough share of future business to deter cheating limits the number of supply relationships each buyer can sustain. The market thus becomes networked, with trade restricted to durable relationships. This article proposes a dynamic model to examine the structure of such simple overlapping relational contracts in equilibrium. These informal relational contracts are simple in the sense that they respect a set of realistic properties that can be easily understood and audited by both parties. Due to exogenous stochastic shocks, suppliers are nevertheless not always able to make good on their promises even if they wish to and thus relationships are constantly dissolving, leading to a destruction of social capital. New relationships are forming to take their place, but restoring social capital takes time due to search frictions. This creates a novel way for shocks to be persistent and also suggests new connections between the theory of relational contracting, on the one hand, and the macroeconomic analysis of recessions, on the other