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Contracting when enforcement is weak: evidence from an audit study

Author

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  • Rajkamal Iyer
  • Antoinette Schoar

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 premiums to mitigate risks arising from relationship-specific investments. Upfront payments for printed pens cover only 40 percent 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.

Suggested Citation

  • Rajkamal Iyer & Antoinette Schoar, 2024. "Contracting when enforcement is weak: evidence from an audit study," Review of Finance, European Finance Association, vol. 28(5), pages 1513-1536.
    • Handle: RePEc:oup:revfin:v:28:y:2024:i:5:p:1513-1536.
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    File URL: http://hdl.handle.net/10.1093/rof/rfae019
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    More about this item

    Keywords

    Incomplete Contracting; Contract Enforcement; Audit Study;
    All these keywords.

    JEL classification:

    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law

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