Competition and Relational Contracts: Evidence from Rwanda's Coffee Mills

Business transactions often occur in the absence of enforceable contracts. To sustain trade in such cases, parties rely on relational contracts (RC). Introducing competition might change exit options, thus undermining the ability to sustain RC. To examine the impact of competition in procurement of inputs, we exploit the prevalence of RC between processing mills and farmers in Rwanda's coffee sector. We implement a census of all mills and farmers to capture the features of the RC binding them. We then develop a RC model to capture the incentive problems between mills and farmers. The model is used to predict how competition affects RC, the mill's performance, and farmer outcomes. Since the location of mills is endogenous, an engineering model is estimated for the optimal placement of mills to instrument for competition in each locality. We find that competition between mills undermines RC by increasing the mill's processing costs, lowering the mill's capacity utilization and reducing the quality of coffee cherries received by the mill. Competition constraints the farmer's credit and input choices and reduces farmer's wellbeing. The findings highlight that in weak contracting settings, the value RC generates can be hampered by competition. The evidence provides a rationale for policies commonly observed historically across developing countries, such as zoning regulations and monopsony licensing, and emphasizes the importance of promoting contractual enforcement in agricultural value chains in order to reap the benefits of competition.