Self-Enforcing Agreements and Relational Contracting: Evidence from California Highway Procurement

Abstract

We empirically examine the impact of relationships between contractors and subcontractors on firm pricing and entry decisions in the California highway procurement market using data from auctions conducted by the California Department of Transportation. Relationships in this market are valuable if they mitigate potential hold-up problems and incentives for ex post renegotiation arising from contractual incompleteness. An important characteristic of informal contracts is that they must be self-enforcing, so the value of relationships between firms and suppliers depend on the extent of possibilities for future interaction. We construct measures of the stock of contractors' prior interactions with relevant subcontractors and, most importantly, an exogenous instrument to measure the future value of ongoing relationships that is orthogonal to contractor--subcontractor match-specific productivity. We find that a larger stock of relationships leads to a greater likelihood of entry and to lower bids. Importantly, this relationship does not hold in periods of time and areas with little future contract volume, suggesting that the value of the future is crucial in providing value for informal contracts. The Author 2012. Published by Oxford University Press on behalf of Yale University. All rights reserved. For Permissions, please email: journals.permissions@oup.com, Oxford University Press.