THE LIMITS OF BARGAINING POWER WHEN CONTRACTS ARE INCOMPLETE: EVIDENCE FROM EXPERIMENTS 1. INTRODUCTION

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1 THE LIMITS OF BARGAINING POWER WHEN CONTRACTS ARE INCOMPLETE: EVIDENCE FROM EXPERIMENTS PAULA CORDERO SALAS ABSTRACT. This study uses economic experiments to investigate the impact of changes in bargaining power on efficiency and surplus distribution when buyers and sellers transact over an indefinite duration with incomplete contracts. When partial third-party enforcement exists, an enhanced seller bargaining power alters the surplus distribution in the sellers favor as theory predicts. In contrast, when formal enforcement is fully absent, an enhanced seller bargaining power does not translate into a change in the payoff distribution, though, notably, it does increase efficiency. We conclude that in markets having weak or informal institutions policies that seek to enhance bargaining power may have limited impact. Hence, enforcing minimum prices can support the effect of allocating bargaining power on contract rents distribution. Key words: bargaining, distribution, experiments, incomplete contracts, institutions. JEL Codes: C91, D86, K12, L14, O12, Q INTRODUCTION Contracts are used in many markets as a way of coordinating production in response to market changes and exigent consumer demands. Some examples are vertically coordinated contracts in agrifood systems, employment contracts in labor markets and production contracts in the software industry (Banerjee and Duflo, 2000; Blandon et al., 2009; Reardon and Barret, 2000). Such contracts are often implicit because explicit contracts that include all possible contingencies are costly to design and enforce. As obligations in implicit (relational) contracts are informal and imprecise, third-party enforcement is difficult because third-parties cannot verify if parties have met contract obligations (Brown et al., 2004); thus, parties may self-enforce the contracts by voluntarily complying with their obligations if they find sufficient long-term value of the contractual relationship. Acknowledgments: This project was supported by the National Research Initiative of the Cooperative State Research, Education and Extension Service, USDA, Grants # and # , and the Farm Income Enhancement Program at Ohio State University; and also by the OSU Graduate School s Alumni Grants for Graduate Research and Scholarship. Institutional Review Board (IRB) approval was obtained to perform this study. I thank Brian Roe, Steve Wu, Jack Schieffer, Paul J. Healy, Kevin Pflum, the Experimental Economics Workgroup and the participants at the Agricultural Economics seminar at Purdue University, the AAEA 2012 and SEA 2012 session participants and the economics seminar participants at University of Alabama for useful comments and discussion. University of Alabama Tel.: Fax.: address: pcordero@cba.ua.edu. Postal address: 361 Stadium Drive, 250 Alston Hall, Tuscaloosa, AL

2 Nevertheless, contracting has not been without controversy, as the existence of asymmetric bargaining power in increasingly concentrated markets have raised concerns among policy makers about how the terms of the contracts are established and how the contract benefits are distributed (Catelo and Costales, 2008; Hernandez et al., 2007; Lee, 2002; MacDonald et al., 2004; the Democratic Staff, 2004). As implicit contracts often include discretionary payments in order to incentivize performance, the use of those contracts has often generated a lack of transparency in how payments and performance are determined, causing the party with lower bargaining power such as employees and farmers to frequently complain about unfairness in the contractual relationships (Lee et al., 2008; Love and Burton, 1999; MacDonald et al., 2004; Wu, 2006). 1 To address these concerns, some governments have implemented policies with the objective of balancing bargaining power. Some examples are the National Labor Relations Act and the Producer Protection Act of 2000 in the U.S.; the Trade Practices Act in Australia, and the European Dairy Package. However, little is known about how policies designed to alter bargaining power affect economic outcomes when contracts are self-enforcing, particularly when the specified payment formula fully depends on the observed performance 2 and allows for unilateral payment adjustments through premiums and discounts after observing the outcome delivered (Hamilton, 2001). This paper uses experiments to investigate how the allocation of bargaining power affects relational contracts, efficiency and the distribution of profits. Although bargaining and relational contracts have been extensively studied (e.g., Bull (1987); Levin (2003); MacLeod and Malcomson (1989, 1998); Muthoo (1999); Rubinstein (1982)), researches have only recently examined the use of bargaining in a relational contracting environment (Cordero Salas, 2013; Halac, 2012; Miller and 1 For example, according to Barrett and Mutambatsere (2005) individual farmers have low bargaining power in negotiations with large firms and recent evidence shows that contracting with supermarket chains in developing countries has not improved the mean output price paid to farmers despite the use of stricter product quality standards (Hernandez et al., 2007; Michelson et al., 2011). In developed countries the story is similar. U.S. cattle producers have requested better regulation of meat packers procurement practices because they argue that the prices have been reduced through the use of forward contracts (Federal Register, 2010; FLAG, 2010)and in the European Union dairy farmers have complained about the lack of transparency in the prices they obtain from their buyers (Stocks, 2011).Other examples include concerns about contractors exploiting producers through the use of contract farming in developing countries (Grosh, 1994; Singh, 2002, 2005; Watts, 1994; White, 1997). 2 For example, forward marketing contracts used in grain production usually include a base price that may be adjusted depending on observed product qualities such as moisture or oil content (MacDonald et al., 2004). Other examples include extractable sugar contracts that pay according to the measured sugar content in the beet minus the percent loss of sugar due to impurities (Hueth and Melkonyan, 2004; MacDonald et al., 2004) and tomato contracts that include premiums and deductions from the base price depending on observed weight, sugar content, soft spots, and other characteristics (Hueth and Ligon, 2002). 2

3 Watson, 2010); the experimental literature has only studied relational contracts with one-sided bargaining power in finite games (e.g., Wu and Roe (2007a,b), Fehr et al. (1997), Brown et al. (2004, 2012), and Fehr et al. (2011)). In contrast, in this study we implement an infinite gift-exchange game where the bargaining power and the third-party enforceability of the contracts are adjusted, contributing to the literature in relational contracts and infinitely repeated games. The markets we envision are characterized by industry concentration and limited third-party contract enforcement. The experimental design is similar to that of Brown et al. (2004) and Wu and Roe (2007a,b) but it differs in that players interact indefinitely in a random one-to-one match and their bargaining power varies across treatments. Similar to Wu and Roe (2007a), we examine a scenario in which buyers and sellers employ contracts that are fully unenforceable by including a payment scheme that is completely discretionary. For example, many broiler contracts have provisions that allow integrators to make ex post discretionary adjustments to the payments or rates (Hamilton, 2001; Wu and Roe, 2007a). In addition, we exogenously vary the enforcement regime to examine contracts similar to those extensively studied in labor markets where third-party enforceable payments are adjusted upward through performance bonuses. This kind of contracts are also used in production; for instance, contracts for high-oil corn pay a base price plus a premium according to quality specifications (Hamilton, 2001). Besides the changes in enforcement, within the same market structure we exogenously vary the participants bargaining power by using two different ways to determine contract terms: through a buyer s take-it-or-leave-it offer or through an alternating offer game. While the former gives the sellers low bargaining power, the latter allows sellers to counteroffer giving them high bargaining power. Though, our control treatments features take-it-or-leave-it offers and fully and partial unenforceable contracts; and our main treatments combine the alternating offer game with the two enforcement regimes. This experimental design allows test predictions from a theoretical model in which the incompleteness of formal enforcement allows parties to alter their quality provision and payment while bargaining determines how the surplus is distributed (Cordero Salas, 2013). In contrast to Fehr et al. (1997), Brown et al. (2004, 2012), and Fehr et al. (2011), who explore other-regarding preferences as an explanation for cooperation in relational contracting, and similar 3

4 to Wu and Roe (2007a,b) and Brown and Serra-Garcia (2011), we assume that subjects act as rational money maximizers. Under this assumption, the model predicts that the constraints on formal enforcement limit the effect of bargaining on surplus distribution. Indeed, we find evidence that supports some of the model predictions. Enhancing the sellers bargaining power improves the distributional outcomes for the sellers only when contracts are partially enforceable. When third-party contract enforcement is absent, distributing the bargaining power increases the levels of cooperation and self-enforcement is more successful compared to when buyers have all bargaining power. Higher levels of efficiency are also achieved when formal enforcement is fully unavailable but the distribution of payoffs remains the same. The result suggests that enhancing the sellers bargaining power does not undermine the informal incentives that parties have to maintain long-term relationships. Furthermore, consistent with Telser (1980) and Klein (1996), self-enforcement further improves economic efficiency even when parties have the option to bargain over the terms of the contract through alternating offers. However, the sole existence of informal incentives is not enough to redistribute the gains from trade. In contrast, when third-party contract enforcement is partially available, distributing the bargaining power does not affect efficiency; however, it does alter the distribution of the payoffs. Distributing the bargaining power increases the sellers profits while decreasing the buyers profits without changing the social surplus. The allocation of bargaining power affects surplus distribution when the price is enforced because such price functions as a commitment device for the buyers and as an insurance policy agains opportunistic behavior for the sellers. This happens because the buyer s surplus share, and thus his value for the relationship, decreases with the enhanced seller s bargaining power given him incentives to act opportunistically and take short-term gains. The existence of the enforceable base payment reduces the buyer s short-term gains from deviation, therefore, he is better off by sharing more of the surplus with the seller and continue trading than taking small short-term gains with no future trading. This outcome implies that the existence of third-party enforcement is necessary if the allocation of bargaining power is to be used as a redistributive tool. The policy implication is clear: Governments must account for the institutional arrangements in which production and trading relationships develop before implementing policies that aim to increase the agents share of surplus through an increase in bargaining power. When contract enforcement is 4

5 imperfect, both distributing the bargaining power and the existence of enforcement have a positive effect on the sellers profits and share of the surplus; however, governments can only successfully achieve a redistribution of the contract benefits if part of the payment is third-party enforceable. The reminder of the paper is structured as follows. Section 2 presents the experimental design, the theoretical predictions, and the hypotheses. Section 3 presents the results and section 4 concludes. 2. EXPERIMENTAL DESIGN The experimental design aims to capture the characteristics of markets in which contracts are used to coordinate production, performance is difficult for a third-party to verify, and there exists asymmetric bargaining power in setting contract terms due to market concentration, e.g., agricultural products such as grain, poultry and cattle. The experimental design is a market experiment similar to that of Brown et al. (2004) and Wu and Roe (2007a,b) but it contrasts with those and other experiments in that players interact indefinitely and that the players bargaining power varies across treatments. The design allows us to test theoretical predictions of the effect of contract enforcement and bargaining on efficiency and surplus distribution as it captures the specific elements of a theoretical model where bargaining determines the contract terms in a relational contracting environment (Cordero Salas, 2013). To test the predictions for how bargaining power affects efficiency and surplus distribution derived from self-enforcing contracts, we implemented four treatment conditions: Contracting with no enforcement and low bargaining (NEL), contracting with no enforcement and high bargaining (NEH), contracting with partial enforcement and low bargaining (PEL), and contracting with partial enforcement and high bargaining (PEH). The no enforcement and partial enforcement conditions refer to the ability of a third-party to enforce the agreed contract terms. The no enforcement is the control condition that mimics markets in which payments fully depend on performance or product characteristics that are too costly for a third-party to verify, e.g., broiler contracts. The partial enforcement reflects the use a payment scheme in which there is a guarantee minimum payment and only part of the compensation depend on performance, e.g., labor and high-oil corn contracts. The low- and high-bargaining conditions refer to how contracts are established: take-it-or-leave-it offer or an alternating offer game. Take-it-or-leave-it offers effectively give the buyer most bargaining 5

6 power, i.e., the seller has low bargaining power, while the alternating offer game alters the parties bargaining power since the seller can counteroffer. Therefore, in the remainder of the paper we refer to low bargaining as the control condition in which the seller must accept the buyer s contract terms if she desires to trade because buyers hold most bargaining power. In contrast, we refer to high bargaining to the treatment condition where both parties can submit proposals and the amount of bargaining power is induced by varying the degree to which the players payoffs are discounted if they do not agree in the first round of the alternating offer game. Note that low bargaining is the control condition that mimics those concentrated markets where parties trade using informal incentives and the agents get very contract benefits; in contrast high bargaining is the treatment condition in which through an exogenous change of bargaining power the agents are able to influence the contract terms. 3 In all treatments subjects were randomly assigned to a fixed role of buyer or seller and were exogenously and randomly matched into pairs of one buyer and one seller. Each pair used contracts to establish the terms of trade for one unit of a good, i.e., quality and payments, and interacted anonymously through the computer network for an indefinite number of periods. 4 If the parties agreed on the terms of the contract, the pair moved to a trading phase in which they had to make decisions about quality and payments. After finishing decisions on quality and payments subjects received their payoffs (See appendix A for screen shots from the experiments). All treatments mimicked an infinite repeated game; therefore, each trading game was randomly terminated with a probability of 1/5. As a result, after each period players played with the same partner for an additional round with a probability of 4/5 and each pair expected to play together for 5 rounds. 5 All subjects in the same treatment faced the same parameters, payoff functions, and termination rule, and these were common knowledge. However, only the pair of traders involved in each transaction were informed about the actual decisions on payments and quality delivered. Parties then could 3 We implemented an alternating offer game instead of reversing the right to make a take-it-or-leave-it offer as we wanted to implement values for the bargaining power other than the extreme values; we also tried to implement more realistic conditions in which parties go back and forward in a negotiation process. We acknowledge that timing effects are introduced by using the alternate offers; nevertheless we control for this in our analysis. 4 The experiments were programmed using the Z-TREE software (Fischbacher, 1999). 5 The commonly known probability of continuation, the common discount factor, controlled for subjects belief about the possibility of future interaction. Each pair expected to play together for 5 periods because the expected number of periods of a game with a continuation probability of δ is equal to T = 1 1 δ. 6

7 build a relationship with the partner with whom they were trading through relational contracts. We next describe the treatment conditions in detail, which are also summarized in Figure I. FIGURE I. Summary of treatment conditions and predictions Treatments NEL Contracting with no enforcement and low bargaining NEH Contracting with no enforcement and high bargaining PEL Contracting with partial enforcement and low bargaining PEH Contracting with partial enforcement and high bargaining Terms of Contracting Buyers make take-it-or leave-it offers Sellers can counteroffer; alternating offer game with two offers Buyers make take-it-or leave-it offers Sellers can counteroffer; alternating offer game with two offers Exogenously enforced contract terms None None Price Price Predictions: rational money maximizer Marginal benefit Marginal cost Feasible quality Feasible price and bonus Termination rule implemented Self-enforcement and trade sustainable in every period Surplus=50 Profit buyer=45 Profit seller=5 Self-enforcement and trade sustainable in every period if sellers exercise lower bargaining power ( β = 0.6 ) p + b = 55;q =10. p + b = 80;q =10. Surplus=50 Profit buyer=20 Profit seller= q [1,10] p, b [0,100] Self-enforcement and trade sustainable in every period Surplus=50 Profit buyer=45 Profit seller=5 δ = 4 5 p [ 0,10];b [ 45, 55]. p + b = 55;q =10. Self-enforcement and trade sustainable in every period p [ 75, 95];b [ 0, 20]. p + b = 95;q =10. Surplus=50 Profit buyer=5 Profit seller= Contracting with no enforcement and low bargaining (NEL) In NEL contract enforcement is fully incomplete, that is, the contract terms are not binding, and only the buyer makes a take-it-or-leave-it quality-payment offer to the seller with whom he is matched. The seller accepts or rejects the offer. If the offer is rejected, the pair does not trade in that period, the seller receives 5 points and the buyer receives zero points. If the seller accepts the contract, she decides how much quality to provide and the buyer decides how much to pay after observing the quality provided by the seller. Reflecting the incompleteness of the contract, both parties have the latitude to adjust quality and payments to any feasible level irrespective of the contractually agreed upon level. This treatment reflects a concentrated market in which the buyer has 7

8 most bargaining power and all payments depend on performance, i.e., parties agree on a payment scheme that is not enforceable by a third-party. The buyer s and seller s payoffs in experimental points are respectively (1) (2) π bn = 10q P and π sn = P 5q where q is the delivered level of quality, P is the actual total payment, 10 is the benefit that the buyer gets for each unit of q, and 5 is the cost of each q that the seller supplies. Note that to keep consistency among enforcement treatment conditions, the payment is divided into a base price, p, and a bonus, b, (P = p + b). In the fully incomplete treatments, NEL and NEH, both the price and the bonus are not formally enforced such that the total payment, P, can be set to zero. The set of feasible qualities is [1, 10], and the base price and the bonus take any value in the set [0, 100] Contracting with no enforcement and high bargaining (NEH) In NEH the payoff functions, the feasible sets of qualities and payments, and the contract enforcement are identical to NEL. But NEH differs in that it features an alternating offer game with two offers for the determination of the contract terms. Whereas in NEL the buyers make take-it-orleave-it offers (first offer), in NEH sellers can bargain by submitting a counteroffer (second offer) after rejecting the buyer s offer. The buyer then gets to accept or reject the counteroffer. This treatment mimics the same market conditions as on NEL but through an exogenous change in the parties bargaining power sellers have high bargaining power as they are able to submit the last offer. If the players do not agree on a contract, payoffs are the same as in NEL when no trade occurs. If the seller accepts the buyer s offer that is, the contract is reached through a first offer the parties payoffs are also given by (1) and (2). If a seller rejects the first offer and the buyer accepts the counteroffer, a cost for delaying trade is imposed on both parties according to the alternating offer game with two offers. The seller s profit is discounted by β = 0.9, while the buyer s profit is discounted by 1 β = 0.1. Note that in the treatments with low bargaining (NEL and PEL), the parameter β takes the value of 0.1 given the parameters used (see Appendix B for more details); itherefore, the value 8

9 of β in the bargaining treatments is chosen to be consistent with the control treatments. In this case, the buyer s payoffs are πbn B = 0.1 π bn, while the seller s payoffs are πsn B = 0.9 π sn Contracting with partial enforcement and low bargaining (PEL) PEL is identical to NEL with the exception of the level of contract enforcement. The buyers make take-it-or-leave-it contract offers and sellers accept or reject. The sellers can also adjust the quality supplied to any feasible level, but contrary to NEL and NEH, the buyers can only adjust part of the payment. As the payment offered is divided into a base price, p, and a bonus, b, the price is exogenously enforced by the computer. If a seller rejects the offer, payoffs are the same as in NEL and NEH when no trade occurs. If the accepted contract includes a positive p, that price is a binding obligation and the buyer must pay it regardless of the level of quality the seller supplies. Still the buyer has the ability to adjust the bonus to any feasible level. This treatment reflects the same market conditions as NEL, but the partial enforcement of the contract (only the price is binding) mimics the existence of upfront payments or minimum prices that are guarantee regardless of performance and can be enforced by a third-party. 6 The buyer s and seller s payoffs are expressed respectively as (3) (4) π bp = 10q p + b and π sp = p + b 5q Contracting with partial enforcement and high bargaining (PEH) PEH is identical to NEH in the determination of the contract terms (that is, the sellers can counteroffer). But, as in PEL, the price is binding and exogenously enforced by the computer. Payoffs from no trade are the same as in the other treatments. If the contract is reached through a first offer, the payoff functions are also given by (3) and (4). If trade is reached through a counteroffer, the same cost for delaying trade as in NEH is applied to both parties payoff functions. The buyer s and seller s payoffs are πbp B = 0.1 π bp and πsp B = 0.9 π sp, respectively Procedures Seventeen experimental sessions were run using undergraduate students from a variety of majors recruited via . Upon arrival, participants were given a random ID number to preserve 6 Examples of this are minimum wages in the labor markets or minimum prices by bulk negotiated by cooperatives or farmer groups. 9

10 anonymity and were randomly assigned to a computer. There were 168 subjects across the sessions and each subject participated in only one session in which only one treatment was run. Written instructions were given to each subject and were read aloud for both buyers and sellers (a sample of the instructions can be found in the Appendix D). After reading the instructions, subjects answered a computerized control questionnaire formulated to test understanding of the treatment and participated in two practice rounds, in which subjects did not earn money and were not able to see actual choices or payments to avoid deception. Once the actual game started, each subject received a $5 balance in their account (250 experimental points). The implementation of the random-termination rule resulted in more than one game played in most of the experimental sessions. For each new game, subjects were matched with a different partner and no previous playing history was available for any of the players, avoiding any possibility of contagion effects across games. Subjects were aware of this. At the end of the experiment, subjects completed an exit survey and then were paid privately. Sessions lasted 1 hour and 45 minutes on average and subjects earned an average of $16.61, with a maximum of $32 and a minimum of $6 (including a $5 show-up fee and the additional earnings from the experiment). Table I provides a summary of the treatment details, offers, counteroffers, and executed trades. TABLE I. Summary of treatments, offers, counteroffers, and trades NEL NEH PEL PEH Third-party Enforcement? No No Only price Only price Option to bargain (counteroffer)? No Yes No Yes # of sessions # of games # of possible trades across sessions # of trades executed across sessions # of offers across sessions # of executed trades by offers # of counteroffers across sessions na 67 na 152 # of executed trades by counteroffers na 27 na Predictions Alternative predictions may exist based on theoretical models with distinct behavioral assumptions (i.e., money maximization, social preferences, etc). In this paper we focus on contrasting 10

11 the experimental results with the theoretical predictions for self-enforcement and cooperation, efficiency, and distributional outcomes from a simple model in which parties are money maximizers. Thus, the predictions are based on the introduction of bargaining in the relational contracting model (Cordero Salas, 2013) and the theory of repeated games (see the Appendix B for more details). Note that in all treatments the maximum quality, q = 10, is the socially efficient level because the marginal revenue, 10, is greater than the marginal cost, 5 for all quality levels. Therefore, the subjects trade q = 10 because it maximizes their gains through the maximization of the social surplus, S, and the net social surplus, S N, at 50 and 45 respectively (i.e., S = 10q 5q, benefits minus the cost, and S N = S 5, the surplus minus the parties payoffs if they do not trade). All participants know that the experiment ends after each trading period with a probability of 1/5. Assuming that subjects are money maximizers, the ongoing interaction sustains trade and the efficient outcome for the implemented parameters in the NEL, PEL, and PEH treatments. The intuition is that as long as the discount factor is high enough (0.8 in this case), the discounted payoff from honoring the contract (cooperation) for all players is more attractive than the payoffs from deviation. For example, in NEL the buyer offers a contract such as the gains for the seller equal her value of no trading, i.e., 5 points; though, the present value of the seller payoffs is 25 points. If instead the seller deviates in NEL, she does not get any payments in gets a long term payoff of 20 points (the cost of supplying the lowest level of quality, which is the most profitable deviation, plus the present value of the no trading value). In the same way, in PEL and PEH the long term value of cooperation is greater than the long term value of deviation (see the Appendix B for details). Therefore, cooperation is the dominant strategy in the NEL, PEL, and PEH treatments; self-enforcing contracts sustain the efficient outcome q = 10; and, trade is observed in every period. Furthermore, when partial enforcement exists, PEL and PEH, any distribution of surplus is possible as long as the discount factor is sufficiently high. In PEL, in each period the buyers take all the surplus and get 45 points while the sellers get the value of the reservation payoffs (5 points). In contrast, in PEH the sellers get all the surplus and obtain 45 points while the buyers get 5 points. When enforcement is completely absent, cooperation is also possible but there is a limit to how the surplus can be distributed. For the given continuation rule, the distribution of surplus is the same in NEL as it is for PEL. However, in NEH, self-enforcement limits the proportion of the surplus the 11

12 sellers can get from the contract (limits the sellers exercise of bargaining power) because if the sellers request too much surplus the buyers short-term gains from deviating become greater than the long-term gains from the contract. As the sellers bargaining power increases (going from NEL to NEH), the buyers share of the surplus shrinks accordingly. To compensate for the buyers loss, the minimum discount factor needed to sustain cooperation rises. Given the parameters of the experiment, the sellers bargaining power is so high that the buyers short term gains from deviation are greater than his value of the relationship (given the discount factor implemented). This happens because the buyer can withhold the total payment and thus his gains from deviation are greater than when the price is enforceable. In contrast, if the sellers take or accept lower payments, then the efficient outcome can be sustained by increasing the buyers stage payoff from cooperating. As a consequence, the set of contracts for which self-enforcement is the dominant strategy is smaller. This implies that to sustain long-term trade, in each period the sellers get less surplus than what they can extract by using the bargaining power in a one-shot game. The optimal contract includes P = 80 for the highest level of quality (q = 10), at which the buyers get a profit of 20, and the sellers get a profit of 30. Following these predictions we can test the next hypotheses. Hypothesis 1. High bargaining does not change trade and cooperation when enforcement is absent (NEH vs. NEL) while enforcement does not change the level of trade and cooperation either (PEL vs. NEL). Hypothesis 2. High bargaining does not decrease overall efficiency nor efficiency conditional on trade (NEH vs. NEL and PEH vs. PEL). Hypothesis 3. High bargaining increases sellers payoffs and surplus share (NEH vs. NEL and PEH vs. PEL). Enforcement supports higher sellers rents and surplus when bargaining is present (P EH > NEH > P EL NEL). Note the these hypotheses assume the players know how to play the game and employ the equilibrium strategies to reach the efficient outcomes. In the next section we report the results for each hypothesis. 12

13 3. RESULTS Table II provides an overview of the general results of altering bargaining power on trading outcomes, cooperation, efficiency, and the distribution of the surplus, while Figure II highlights the magnitude and distribution of surplus by treatment and type of offer. Scatter plots of surplus and distributional outcomes are presented in the Appendix C. These results are discussed in the following subsections. TABLE II. Summary statistics Means NEL NEH PEL PEH Overall trading rate 60% a 63% a 69% b 66% a,b % of offers accepted 60% a 53% b 69% c 53% b Counteroffer rate (% of rejected offers) na 50% a na 77% b % of counteroffers accepted na 40% a na 34% a Cooperation rate 36% a 49% b 41% a 38% a Quality unconditional on trade 3.87 a 4.72 b 4.40 b,c 3.96 a,c Quality conditional on trade 6.41 a 7.51 b 6.33 a 6.05 a Adjusted surplus (π b + π s ) a a a b Buyer s payoffs a a,b b 9.63 c Seller s payoffs a a,b,c c b Seller gross share 0.54 a 0.43 b 0.84 b 1.22 c Payoff spread 7.06 a 8.51 b 1.84 b c # Observations Treatment Effects Third-party Enforcement? No No Only price Only price Option to bargain? No Yes No Yes Notes: The overall trading rate is the number of executed trades over the total number of possible trades. The overall trading rate, the % of offers accepted, the counteroffer rate and % of counteroffers accepted include observations for incomplete and complete transactions. The number of observations were 413, 280, 406, and 350 in NEL, NEH, PEH, and PEL respectively. The rest of the variables include only observations for complete transactions. Different superscripts denote differences at a least 10% level following a Mann-Whitney Test. The unit of observation is buyer-seller pairs Results on trading and cooperation The experimental results suggest that distributing bargaining power does not have a negative impact on neither trading nor cooperation regardless of the enforcement level. However, enforcement has a positive effect on trading rates. To see this, first note that buyers proposed contracts to sellers in almost every trading opportunity (Table I). However, the number of executed trades is lower than the number of offers made, ranging from 60% in NEL to 69% in PEL (Table II). The low trading rate relative to the number of contracts offered indicates that the sellers rejected an important 13

14 number of offers. In fact, offers were accepted less often in the treatments in which sellers were able to counteroffer; a Mann-Whitney (MW) test shows a significant difference at 1% level when third-party enforcement was available but only significance at 10% level when contracts were fully unenforceable (PEH vs. PEL, p < ; NEH vs. NEL, p = ). When comparing in detail the terms of the offers which are accepted versus those that are rejected (Panel A in Table III), the accepted offers include significantly higher total payments and quality levels (MW test for equality in total payment, p = in NEL, p = in NEH, p = in PEL and p = in PEH; MW test for equality in quality, p = in NEL, p = in NEH, p = in PEL and p = in PEH). The accepted offers also provide better conditions for the sellers in terms of a significantly higher potential profit (with the exception of treatment NEL in which the potential profit is not different between accepted and rejected offers) and more certainty about the actual payment in the partial enforcement treatments as the accepted offers included a lower share of payment as bonus (significant at 1% level in both PEL ad PEH). The parametric results in Table IV provide additional evidence of the effect of distributing bargaining power on the acceptance of first offers. The first column presents the estimates from a probit regression where the dependent variable is an indicator for whether the seller accepts the buyer s offer. The baseline treatment is NEL, in which there is neither third-party enforcement nor the possibility of bargaining (i.e., counteroffer). Dummy variables for bargaining, enforcement, and the interaction of both are included as explanatory variables. The terms of the contract are also included because they influence the seller s acceptance choice. Because the experiment is a repeated game where subjects were matched into a pair for an indefinite number of rounds, in each period subjects made decisions that are history dependent; that is, this period s decision relates to what the decisions were in the previous period. Therefore, similar to Wu and Roe (2007a), lagged quality chosen by the sellers and the lagged payment deviations by the buyers are included to control for history dependence. In addition, subjects decisions from early periods can differ from the ones in later periods because subjects learn to play the game throughout the experiment. To control for this 14

15 period dummies are included. 7 Additional controls include subject personal characteristics, and the standard errors reported are robust and adjusted for clustering on buyer-seller pairs. 8 TABLE III. Contract terms Means Panel A: Offers NEL NEH PEL PEH Contracted Quality Total payment Share of payment as bonus (%) Seller s potential profit Rejected Quality Total payment Share of payment as bonus (%) Seller s potential profit Panel B: All rejected offers followed by counteroffers, all counteroffers and rejected offers followed by a contracted counteroffer All rejected offers: Quality Total payment Share of payment as bonus (%) Seller s potential profit All counteroffers: Quality Total payment Share of payment as bonus (%) Seller s potential profit Rejected offers followed by contracted counteroffers: Quality Total payment Share of payment as bonus (%) 42 Seller s potential profit Panel C: Counteroffers Contracted Total payment Quality Share of payment as bonus (%) Seller s potential profit Rejected Total payment Quality Share of payment as bonus (%) Seller s potential profit Notes: Offers include 413 observations for NEL, 280 for NEH, 350 for PEL and 407 for PEH, with exception of the share of payment as bonus for which 7 observations are missing, 2 in the PEL and 5 in PEH, due to subjects who did not submit a proposal. Counteroffers include 67 proposal in NEH and 152 in PEL. 7 In addition to the period dummies, we attempted to control for learning effects in a other ways. As subjects played more than one game in most experimental sessions given the random termination rule, we used game dummies to control for learning effects. We also created effective period dummies that include all periods played in all games within an experimental session and used them to control for subjects learning. These controls did not change the results and in fact, the specifications in the paper present more conservative results. 8 We cluster on buyer-seller pair because the correlation in pairs is more likely to be an issue than the correlation at session level. One buyer and one seller constitute a pair and they trade for several rounds within a session without interacting with other participants. Furthermore, the standard errors will be more conservative at the pair level. 15

16 TABLE IV. Determinants of offer acceptance, cooperation and counteroffer use Probability of Probability of Probability of Offer Acceptance Cooperation Counteroffer Constant (0.6394) (0.8150) (1.0677) Bargaining dummy (0.1631) (0.2326) Enforcement dummy (0.1639) (0.2527) (0.1881) Interaction barg X enforc dummy (0.2219) (0.3273) Contracted quality (0.0267) (0.0402) (0.0485) Contracted price (0.0042) (0.0053) (0.0069) Contracted bonus (0.0042) (0.0053) (0.0059) Lagged quality (0.0171) (0.0181) (0.0241) Lagged payment deviation (P c P ) (0.0023) (0.0065) (0.0033) Wald test joint significance Bargaining-Enforcement (0.322) (0.811) N Number of clusters Notes: Standard errors reported are robust and adjusted for clustering on buyer-seller pairs. Asterisks indicate the significance level of the estimate: * at 10% level, ** at 5% level, and *** at 1% level. Estimations are probit models with dependent variables that take a 1 if the contract was accepted, cooperation followed an accepted contract or the counteroffer was used respectively and a 0 otherwise. Additional controls are dummies for each period; history-dependence controls (lagged quality chosen by seller and lagged deviations in the price paid by buyers); and demographic variables, including gender, age, employment status, and GPA. The estimations in the first two columns only use data for offers made by buyers, which include whether an offer is followed by a counteroffer. The estimation for cooperation uses all data for complete trades. The data exclude observations for first-period interactions. In addition, estimation of the probability of counteroffers limits data to bargaining treatments. In contrast with the non-parametric analysis, the effect of bargaining on the probability of seller s acceptance is only significant when partial enforcement is in place (Wald test p=0.0001, joint effect of bargaining and bargaining-enforcement). The coefficient on enforcement suggests that the presence of third-party enforcement increases significantly the probability that a seller accepts a buyer s offer. But if counteroffers are also allowed, the probability that a buyer s offer is accepted does not differ from the NEL baseline (Wald test p=0.322). 16

17 Although distributing bargaining power affects the acceptance rate of buyers offers, the effect did not translate into a lower trading rate. After rejecting the buyer s offer the sellers submitted counteroffers more than 50% of the time in both of the bargaining treatments (Table II). Sellers proposed contracts with more favorable terms to them than the rejected buyers offers (Panel B in Table III); in fact, all counteroffers in PEH included the same level of quality but significantly higher payments and a significantly lower share of payment as bonus (MW test p = for quality, p = for total payment, p=0.000 for share of payment as bonus). Specifically, the accepted counteroffers (Panel C in Table III) reflect contracts with the same level of quality (MW p= for NEH and p= for PEH) but more favorable terms for sellers than the previously rejected offers (rejected offers followed by a contracted counteroffer in Panel B in Table III), including a significantly higher potential seller s profit in both treatments (MW p= for NEH and p= for PEH), and a significantly lower share of the payment as a bonus in PEH (MW p= for PEH). Thus, in general the sellers look for a different distribution of the same surplus through counteroffers and in the PEH treatment more certainty on payments with a lower share of the total payment as a bonus. Even though the acceptance rate for counteroffers is lower than for first offers (MW tests, 53% vs. 40% in NEH, p=0.0579; 53% vs. 34% in PEH, p=0.0001), the number of counteroffers accepted makes up for the rejection of the offers, resulting in no differences in the overall level of trading across bargaining regimes. This result partially supports hypothesis 1. Bargaining does not decrease overall trade (MW tests, p= for NEH vs. NEL and p= for PEH vs. PEL), but enforcement has a significant and positive effect on trading frequency (MW p= PEL vs. NEL). When we compare contract terms, those in the contracted offers in NEL are more favorable to sellers than those in offers in PEL (higher total payment, quality and sellers potential profit). As a consequence, sellers do not only care about the contract terms but also about the certainty on the contract returns. As buyers have the ability to adjust the total payment after observing the quality provided, the exogenously enforced price limits the adjustment the buyer can make. Thus, the enforced base price serves as an insurance policy for the sellers against buyers potential opportunistic behavior. Hence sellers were more comfortable trading when some third-party enforcement was in place even with lower potential contract returns. 17

18 When looking at cooperation, the results are similar. The previous analysis suggests that the willingness to trade given the contract terms is not affected by the distribution of bargaining power. However, enforcement does affect cooperation through the trading frequency. Subjects trade more when partial enforcement is in place. Therefore, third-party enforcement also has a positive effect on the level of cooperation. Once parties have decided to trade, the cooperation rate is defined as both parties complying with the terms agreed on the contract. Table II shows the cooperation rates for each treatment. In contrast with hypothesis 1, bargaining has a positive effect on cooperation when contract enforcement is absent (MW test p=0.0063, NEH vs. NEL). However, bargaining does not affect cooperation when partial enforcement exists (MW test p-value=0.5230, PEH vs. PEL). In the NEH treatment, cooperation is lower when contracts are accepted through counteroffers (MW test p=0.0081, offers vs. counteroffers in NEH) because buyers shirk more in this case (MW test p=0.0037, offers vs. counteroffers in NEH). In fact, the high rate of cooperation NEH is derived from contracts accepted through buyers offers for which both sellers and buyers shirk less. When partial enforcement exists cooperation is not different in offers and counteroffers. Therefore, cooperation seems to not be a result of having sellers committing to their own counteroffers but a result of informal incentives that emerge in the NEH treatment. The probit estimation in the second column of Table IV confirms these results. Bargaining has a positive and significant effect on cooperation when no enforcement is present, while enforcement does not have a significant effect (Wald test of joint effect bargaining and bargaining-enforcement, p-value=0.4711). These results are summarized next. Result 1. Bargaining decreases neither trade nor cooperation regardless of the third-party contract enforcement available. In fact, bargaining has a positive effect on the level of cooperation when enforcement is absent. In contrast, enforcement increases the number of trades but does not affect cooperation. Result 1 suggests that the availability of bargaining through offers and counteroffers gave subjects additional informal incentives to sustain cooperation and therefore self-enforcing contracts were more effective. Moreover, the existence of third-party enforcement provides a more appropriate environment for parties to engage in trading relationships, because of the existence of both formal and informal incentives to enforce the contracts. 18

19 3.2. Results on efficiency Maximum efficiency is achieved when trade occurs at q = 10; in the high bargaining treatments, the contract must be attained through ant offer rather than a counteroffer. However, in experimental settings subjects learn the equilibrium of the game through playing in the experiments. For example, subjects may use counteroffers in the initial periods of the games while they learn that in equilibrium the buyers must offer a contract in which the seller does not have incentives to counteroffer. In practice the possibility to counteroffer in NEH and PEH introduces an additional source of inefficiency because bargaining is costly and the surplus available for the parties shrinks when a counteroffer is used. To account for this, we explore the efficiency loss in different ways: the effects of lost trade, of the use of counteroffers, and of trades of low-quality goods. Though, we use the quality unconditional and conditional on trade as well as the adjusted surplus that is, total surplus generated by the quality supplied adjusted by the losses from the alternating offer game as measures of efficiency. When no trade occurs, all the efficiency is lost because according to the theoretical predictions trading is the efficient outcome. This is equivalent to trading q = 0. In completed transactions, efficiency loss is the difference between the traded quality and q = 10, or equivalently, the difference between the adjusted surplus generated and the highest possible surplus. Recall that the surplus is given by S N = 5q and the adjusted surplus by AS = π B b + πb s, where πb B and πb s are given by πbn B, πb sn, πbp B, and πb sp, depending on the enforcement treatment. That is, the adjusted surplus takes in account the a cost of delaying trade from the use of counteroffers. We first explore the resuts on efficiency by looking at quality unconditional on trade and the level of quality conditional on trade. Consider the average quality unconditional on trade in Table II. Consistent with the trading results, distributing bargaining power does not affect efficiency through lost trade; in fact, bargaining has a significant and positive effect on efficiency when enforcement is absent (MW test, p= for NEH vs. NEL, and p= for PEH vs. PEL). When quality conditional on trade is examined, the results are similar (quality conditional on trade in Table II). When partial enforcement is in place, there are no differences in the level of quality traded (MW test p=0.3201) even when we compare quality levels from only offers (MW test p= offers in PEH vs. PEL ) or only counteroffers (MW test p= counteroffers in PEH vs. PEL). In the absence of enforcement, the quality conditional on trade is significantly higher in NEH (MW test 19

20 p=0.0005). The higher efficiency is driven by those contracts achieved in offers which averaged a quality level of 7.71 that is significantly higher than the average quality level in counteroffers, 6.37 (MW test p=0.0675). Though, higher quality provision is not explained by sellers who feel more responsible to adhere to their own promises, but by the emergence of informal incentives. Regression estimates for quality conditional on trade in panel A of Table V confirm the results. We estimate several models to account for the possibility of individual effects at the buyer-seller pair level. The first column presents censored regression (Tobit) estimates for quality conditional on trade; 9 the second and third column presents Random Effects and Random Effects Tobit estimates respectively; and the fourth column presents Hausman-Taylor estimates to account for the possibility of correlation of the regressors with the individual level effects. 10 In addition, because unobserved pair-specific effects may cause the error term to be correlated within a pair over trading rounds, the robust standard errors were adjusted for clustering on pairs in the Tobit and Random Effects estimations and bootstrapped standard errors are reported for the Random Effects Tobit and Hausman-Taylor estimators.the base treatment in all regressions is NEL and treatment dummy variables for NEH, PEL, and PEH are included as explanatory variables. We also control for trading history, subject characterictics, and learning effects as explained previously. 11 Although, we prefer the estimates for the treatment effects in the Tobit model after controlling for subjects personal characteristics and clustering errors at the buyer-seller-pair level, all specifications yield consistent results. Similar to the non-parametric analysis, quality conditional on trade is significantly higher in NEH than in NEL, while there is no significant difference between PEH and PEL. With respect to the adjusted surplus, the non-parametric results show that there is no difference when the possibility of conunteroffering is introduced and there is no enforcement; although the non-parametric results show that the adjusted surplus is lower when partial enforcement and bargaining interact, after controlling for trading history, subjects characteristics and learning effects, the difference disappear (parametric analysis in panel B of Table V). Thus, there is no evidence of a significant effect of high bargaining on adjusted surplus regardless of the enforcement level. The 9 Quality data is censored at the extreme values, 1 and The Hausman-Taylor estimator is a transformed Random Effects model with instrument variables that allow to estimate the time-invariant regressors that a Fixed Effect model cannot estimate. 11 We also estimated the models by including interactions of the history control and treatment variables to account for the possibility that the history may be conditional on the treatment. We do not find evidence of joint-significance and therefore we exclude them from the estimation and we do not report the results. 20

21 TABLE V. Efficiency Outcomes Panel A: Quality conditional on trade Tobit Random Effects Random Effects Tobit Hausman-Taylor NEH dummy (0.7309) (0.5096) (0.5319) (0.6590) PEL dummy (0.7432) (0.5652) (0.5892) (0.7115) PEH dummy (0.6748) (0.5235) (0.5365) (0.6510) Lagged quality (0.0732) (0.0320) (0.0382) (0.0361) Lagged payment deviation (P c -P) (0.0142) (0.0071) (0.0076) (0.0077) Constant (1.8057) (1.5718) (1.6595) (3.0087) Wald test p-values PEH=PEL p-values (0.831) (0.634) (0.643) (0.975) PEH=NEH p-values (0.001) (0.002) (0.003) (0.008) PEL=NEH p-values (0.002) (0.001) (0.002) (0.02) Panel B: Adjusted Surplus Tobit Random Effects Random Effects Tobit Hausman-Taylor NEH dummy (3.8604) (2.9146) (2.9503) (3.3520) PEL dummy (3.7747) (2.8701) (2.9348) (3.5145) PEH dummy (3.2649) (2.6075) (2.6333) (3.2969) Lagged quality (0.3763) (0.1770) (0.2165) (0.1963) Lagged payment deviation (Pĉ-P) (0.0705) (0.0402) (0.0433) (0.0449) Constant (9.2083) (8.8417) (9.3751) ( ) Wald test p-values PEL=PEH p-values (0.591) (0.807) (0.806) (0.507) PEH=NEH p-values (0.000) (0.043) (0.041) (0.044) PEL=NEH p-values (0.003) (0.115) (0.117) (0.246) Notes: Standard errors reported are robust and adjusted for clustering on buyer-seller pairs in Tobit and Random Effects estimations (224 clusters), and are bootstrapped in the random effects Tobit and Hausman-Taylor estimations. Asterisks indicate the significance level of the estimate: * at 10% level, ** at 5% level and *** at 1% level. Estimations have the no enforcement-no bargaining (NEL) treatment as the base and dummy variables for the bargaining-no enforcement (NEH), bargaining-partial enforcement (PEH) and no bargaining-partial enforcement (PEL) treatments as explanatory variables. Additional controls are history dependence controls (lagged chosen quality and lagged buyers deviations in the price), dummies for each period, and demographic variables including gender, age, employment status and GPA (coefficients are not reported). All estimations use data on complete transactions only. The number of observations is 724 for all regressions. 21

22 regressions in panel B account for the 27 and 52 trades that were achieved through counteroffers in the NEH and the PEH treatments, respectively. The estimations show that high bargaining does not have a significant effect on the adjusted surplus regardless of the level of third-party enforcement. The effect of high bargaining on efficiency is summarized in Result 2. Result 2. High bargaining does not decrease overall efficiency (quality unconditional on trade), quality conditional on trade nor adjusted surplus. This result supports Hypothesis 2. Even when considering all efficiency loss lost trade, the use of counteroffers, and trades of low-quality goods bargaining did not have a negative effect on efficiency relative to the comparison treatments, that is, NEL vs. NEH and PEL vs. PEH Results on profits and distribution of surplus Hypothesis 3 predicts that the seller s profits and share of surplus are higher under the high bargaining treatments. In addition, the effect of bargaining on the sellers distributional outcomes is predicted to be higher when third-party enforcement exists. Note that subjects in the bargaining treatments could play the equilibrium and offer higher payments to the sellers in the offers to avoid the use of counteroffers or sellers could exercise bargaining power and try to obtain higher payments through counteroffers. The evidence suggests that contract enforcement supports the sellers exercise of bargaining power. The sellers submitted more counteroffers when third-party enforcement was in place (77% in PEH vs. 5% in NEH, Table II). The estimates in column two of Table IV show that enforcement has a positive and significant effect on the probability that a seller submits a counteroffer. In addition, the interaction of bargaining and enforcement has a significant negative effect on the probability of offer acceptance (column one in Table IV). The combination of these two results suggests that subjects rejected more offers and followed with a counteroffer submission more often when third-party enforcement was available. This result is also supported by the non-parametric analysis in Table II. The results on the distribution of payoffs are similar. Table VI shows the OLS estimations for the distributional outcomes. 12 The dependent variables are the buyers and sellers gross profits, 12 As in the case of the quality conditional on trade estimations, different models were estimated to account for the possibility of individual effects at the buyer-seller pair level. We also estimated the models by including interactions 22

23 TABLE VI. Distributional Outcomes Buyer Profits Seller Profits Seller Share Spread of Payoffs NEH dummy (2.9315) (2.7736) (0.1689) (5.2808) PEL dummy (2.6464) (1.9731) (0.1891) (4.1409) PEH dummy (2.7013) (2.0751) (0.2091) (4.4059) Lagged quality (0.2227) (0.1568) (0.0168) (0.3368) Lagged payment deviation (P c P ) (0.0690) (0.0475) (0.0034) (0.1104) Constant (7.9395) (6.3202) (0.5781) ( ) Wald test p-values PEH=PEL p-values (0.033) (0.11) (0.177) (0.008) PEH=NEH p-values (0.000) (0.048) (0.000) (0.000) PEL=NEH p-values (0.032) (0.735) (0.009) (0.141) Notes: Results reported are OLS estimations. Standard errors reported are robust and adjusted for clustering on buyer-seller pairs (224 clusters). Asterisks indicate the significance level of the estimate: * at 10% level, ** at 5% level and *** at 1% level. Estimations have the no enforcement-no bargaining (NEL) treatment as the base treatment and dummy variables for the bargaining-no enforcement (NEH), bargaining-partial enforcement (PEH) and no bargaining-partial enforcement (PEL) treatments as explanatory variables. Additional controls are history dependence controls (lagged quality chosen by seller and lagged deviations in the price paid by buyers), dummies for each period, and demographic variables including gender, age, employment status and GPA (coefficients are not reported). All estimations use data on complete transactions only. The number of observations is 724 for all regressions. the sellers share of surplus, and the spread of payoffs. The share of the surplus is measured as the sellers payoffs over the total adjusted surplus while the spread of payoffs is defined as the difference between the buyer payoffs and the seller payoffs. That is, a negative spread of payoffs implies that the seller obtained higher profits than the buyer from the contract. The baseline treatment in the estimations is NEL. Dummies for treatment effects were used as explanatory variables, and the same controls as previous estimations were used (control for subjects of the history control and treatment variables to account for the possibility that the history may be conditional on the treatment. The results are consistent across models and the estimations are in the appendix E (tables E-1, E-2, E-3 and E-4). 23

24 characteristics, previous trading history and learning effects, and clustering errors at the buyerseller-pair level). Note that high bargaining with no enforcement does not significantly affect the distribution of the payoffs (NEH dummy not significantly different from zero in all estimations). Introducing enforcement has a negative and significant effect for the buyers profits and positive and significant effect for the seller share, suggesting that buyers get lower profits and although the sellers profits are higher but not significantly different, the sellers share of surplus is significantly higher when partial enforcement is in place. Therefore, enforcement changes the share of surplus in favor of the sellers. The results also indicate that the allocation of bargaining power has a significant effect on the distributional outcomes when third-party enforcement exists. Note that the PEH dummy is significantly different from zero for all four estimations. Altering the bargaining power in favor of sellers when third-party enforcement exits reduces buyer profits and the spread of payoffs and increases the seller profits and the sellers share of surplus. These results indicate that sellers obtain higher payoffs and capture more of the surplus when third-party enforcement and bargaining jointly existed relative to the control treatment. Furthermore, when partial enforcement exists seller profits were significantly higher when counteroffers are possible (PEH vs. PEL); moreover, the sellers got higher profits than buyers under the PEH treatment (Table II). The joint effect of bargaining and enforcement is also notable when estimating the effect on the total payment as harmonized measure of distribution. Actual total payment conditional on quality is higher when high bargaining and partial enforcement coexist (table E-5). The results are summarized next. Result 3. High bargaining increases sellers payoffs and share of surplus only when third-party enforcement exists. The existence of third-party enforcement supports the effect of high bargaining on the sellers profit even though the the sellers share of surplus does not change. Figure II shows the magnitude and distribution of the gross surplus by treatment (see parametric analysis in table E-6 that relates the efficiency (surplus) and distributional outcomes (payoffs)). Overall, the results suggest that when contract enforcement is absent, high bargaining has a positive effect on informal incentives resulting in a higher surplus but buyers and sellers profits are not significantly different from when bargaining does not exist, though high bargaining does not achieve any redistribution of the surplus in the total absence of formal enforcement. 24

25 FIGURE II. Magnitude and Distribution of Surplus by treatment Adjsuted Surplus Buyer Payoff Seller Payoff 0 NN No No NB No Yes PN Yes No PB : Treatment Name Yes : Price Enforced Yes : Seller Counteroffers On the other hand, enforcement favors sellers profits. Enforcement does not significantly affect efficiency but it has a significantly positive effect on sellers profits and a significantly negative effect on buyers profits. The joint existence of enforcement and high bargaining further supports the effect of enforcement on the sellers profits. This joint effect indicates that when third-party enforcement exists bargaining serves as an important redistributive tool by increasing the sellers profits and decreasing the buyers profits. As a result, high bargaining and enforcement have positive effects on the sellers rents; however high bargaining only has a significant effect when it coexists with third-party enforcement. High bargaining alters the surplus distribution when the price is enforced because such price functions as a commitment device for the buyer. Higher bargaining power for the seller increases her share of surplus and future gains from the contract while decreases the buyer s expected gains. As the buyer s surplus share decreases, his value for the relationship also decreases resulting in more incentive to act opportunistically and take short-term gains. The existence of the enforceable base payment reduces the buyers incentive to renege because it lowers his short-term gains from 25

26 deviation. Therefore, he is better off sharing more of the surplus with the seller through a higher base payment and continue trading than taking small short-term gains with no future trading. 4. CONCLUSIONS Asymmetric bargaining power and constraints in formal contract enforcement are prevalent in many contracting situations. These market features affect the profits and quality of life of market participants, especially those who navigate environments with weak institutions and more concentrated markets. Policies that attempt to balance the bargaining power have been discussed with the objective of increasing the contract rents that parties with low bargaining power receive. This paper reports the results of an experiment designed to investigate the effect of the allocation of bargaining power on efficiency and the distribution of profits when third-party enforcement is partially or fully unavailable. The results provide insights into the effects of the formal implementation of bargaining on the long-term relationships between principals and agents. In addition, the exogenous variation of the level of enforcement provides experimental evidence that can aid policy makers to understand how the institutional environment affects the implementation of such policy in terms of efficiency and distribution of surplus. We find that the level of formal enforcement is key to achieving a successful redistribution of the contract benefits through a bargaining process. Distributing the bargaining power through the possibility of counteroffer does not suppress informal incentives when formal enforcement is absent. In fact, trading parties increase the level of cooperation and self enforce contracts more frequently, which enhances social efficiency. However, these informal incentives are insufficient to significantly increase the benefits for the sellers (that is, agents). Our findings show that a government must implement at least partial contract enforcement to support the redistribution of the contract benefits. Nevertheless, more research is necessary to understand the impact of contract enforcement and bargaining on the distribution of payoffs. For instance, characteristics of the trading relationships could impact the implementation of bargaining policies and the distribution of rents. Trading partners involved in a long-term relationships can develop empathy and other preferences may be taking into account when sharing contracting rents. On the other hand, other aspects of the market such as 26

27 the level of competition, (i.e., market power), can impact the distributional outcomes. Understanding the interaction of market power and bargaining power and the role of other-regarding preferences will give additional insight in the best policies to redistribute surplus and should be consider for future research. 27

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32 APPENDIX A. SCREEN SHOTS Section not necessary for publication only for reviewers. FIGURE III. Buyer screen shot FIGURE IV. Seller screen shot FIGURE V. Seller s option to counteroffer 32

33 FIGURE VI. Seller s choice of quality FIGURE VII. Buyer s choice of payments FIGURE VIII. Payoffs screen FIGURE IX. Termination rule 33