Competition on Agricultural Markets and Quality of Smallholder Supply: The Role of Relational Contracting and Input Provision by Traders

Abstract

We analyze how market power by traders on local agricultural spot markets affects investment in crop quality by smallholders in a context with “imperfect institutions”—without third-party contract enforcement and with incomplete input markets. Farmers and traders can engage in relational contracting where the promise of future rents supports current cooperation. We analyze informal contracting under the shadow of side selling by the farmer and ask how changes in the competitiveness of local markets affect flows of inputs in relational contracts. When local markets become more competitive, fewer farmers are included in relational contracting with traders, and farmers who remain in such relationships receive less support from traders. We document empirical evidence from local wheat markets in Ethiopia that is consistent with the theory.