Putting the Relationship First: Relational Contracts and Market Structure

I examine relational contracts and investment in a market for intermediate goods using a tractable game of imperfect private monitoring. A downstream firm requires one of several products in each period from a market of suppliers. If output is not contractible, I show that the downstream firm relies on a small network of suppliers relative to first-best. These upstream firms choose to “put the relationship first.” By investing to produce many of the products that may be required by the downstream firm, they lock themselves into the relationship, thereby increasing effort provision. Using this framework, I consider why suppliers might resist socially efficient legal reform and discuss implications for employment and ex ante human capital investments.