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No contract no Problem

No contract no Problem

Operating a business in a developing country is not always for the faint of heart. But new research suggests that long-term relationships between buyers and sellers can go a long way toward overcoming obstacles like political instability and weak governing institutions.

To build his case, Ameet Morjaria, an assistant professor of managerial economics and decision sciences at the Kellogg School, turned to the rose trade in Kenya—a thriving industry that he says has “managed to set up a supply line to the developed world. And they’ve achieved this in a relatively short period.”

Just how healthy is the rose industry in Kenya? Today, an estimated 500,000 Kenyans on over 100 flower farms depend on the trade for their livelihood. The nation’s flower exports have grown from about 11,000 tons in 1988 to more than 136,000 tons in 2014, making Kenya the third-largest exporter of cut flowers in the world. Many of these flowers head to the European Union, where they account for about a third of all flower sales.

The rose trade’s rapid growth has been driven by Kenya’s sunny climate, low labor costs, and strong air-transportation links to Europe. And this has all been done in the absence of formal contracts. Since flowers are highly fragile and perishable, contracts would be unenforceable, with buyers and sellers making claims that no court could verify.

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So instead, buyers and sellers rely on longstanding relationships. Morjaria and his coauthor, Rocco Macchiavello of Warwick University, examined these relationships, finding that despite their informal nature, some look much like successful long-term relationships in any commercial domain, with sellers willing to forgo even substantial short-term profit in order to maintain them.

Stress Test

In a contract-free industry, relationships offer stability and predictability for both sides of the transaction. Sellers are able to plan their production schedule in advance, while buyers have a reliable supply at a known price.

But buyers and sellers have another option: the flower auctions in the Netherlands. Here sellers are not obligated to deliver particular quantities of flowers, and buyers can purchase only the volume they need. Generally, the Dutch auctions act as proving ground for fledging rose producers or as a safety valve when a seller’s established customers cannot absorb its entire supply. (In addition, the auctions provide a reference price that helps buyers and sellers ground their relationship in a common understanding of the prevailing market conditions.)

“If I’m in a valuable relationship, then I’m going to make an extra effort to protect it.”
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Morjaria and Macchiavello wanted to investigate just how committed rose growers were to their relationships with their regular buyers. In the years preceding Kenya’s 2007 presidential election, the researchers observed the value of these relationships to be sizeable, with sellers often giving up short-term gains of up to 30% in order to keep their commitments. But what happened when extenuating circumstances made commitments especially difficult—and expensive—to honor?

A short period of violence followed the nation’s contentious presidential election. Business operations in some regions remained unaffected by the violence, but in the areas directly affected by the unrest, workers either fled the region or were unable to move about safely. Rose-producing firms lost about half of their workforce for the duration of the violence (only about 5 percent of which they were able to replace). The loss of workers directly affected their output. It was, as the researchers put it, “a large, unanticipated, and short-run shock to the production” capacity of the affected firms.

Moreover, Kenya’s electoral violence happened during one of the industry’s busiest seasons—the run-up to Valentine’s Day—and flower prices at auction were high. Since the basis for relationships between rose producers and buyers was trust, rather than formal contracts, the sellers who were impacted by the violence were free to squeeze as much profit as possible out of their reduced output by selling their flowers on the open market. The well-publicized violence also offered a “free pass” for sellers who wanted to renege on prior commitments.

Strategic Loyalty

Morjaria and Macchiavello predicted that sellers would nonetheless honor their direct relationships with buyers rather than exploit the short-term price spike. “If the relationships are valuable,” Morjaria says, “you will see certain evidence in the data. If I’m in a valuable relationship, then I’m going to make an extra effort to protect it.”

Indeed, rose sales to the Dutch auctions in the regions affected by violence dropped about 50 percent from normal times, but sales to direct buyers dropped only 16 percent. “Sellers in the conflict region gave up profits from delivering to the auctions at higher prices to protect their direct relationships,” the researchers write. (There was no observable effect on rose sales in the no-conflict region, where sellers had sufficient crop to honor existing relationships while still sending some flowers to auction.)

A model created by the researchers made a further prediction: that the sellers in the conflict region would not treat all customers equally—instead giving priority to buyers that they were trying to prove themselves to. In other words, when a rose-producing firm was still establishing its reliability with a buyer, that relationship would take priority over an older relationship, in which the seller was already a known quantity.

Sales data from 2004 to 2008 suggested that—as predicted—sellers prioritized relationships that were relatively young and still developing by holding to their delivery schedules as much as possible. They gave less attention to relationships that were either very new (and hence not yet valuable enough to focus on) or well established (in which the seller had already proved itself to be a reliable partner).

“As the relationship evolves, you reach a point where you’ve put in a lot of effort and you can sort of take a step back and expect that your past interaction will serve you in the future,” Morjaria says. “So you put in less effort as the age of the relationship grows. People have already made their impression of you.”

The Reputation Dividend

Efforts to build and maintain a strong reputation appear to pay long-term dividends. Growers affected by the electoral violence lost half of their workforce overall—but this average obscures a key difference. Growers who had direct relationships with buyers, and thus wanted to build reputations as reliable partners, often took proactive steps to retain their workforce by setting up camps near the flower farms for workers threatened by violence. As a result, they were able to retain a larger share of their workforce than the growers who sold primarily to the Dutch auctions. They also, in some cases, extended the hours of workers and paid overtime wages.

Their efforts to keep to their delivery schedules seem to have paid off. The researchers found that, overall, 17 percent of relationships between buyers and sellers from the conflict region did not survive to the following season—a rate twice as high as in the no-conflict region. But this failure rate depended on the the seller’s reliability. More reliable sellers lost fewer buyers, thus preserving their longstanding (and, over time, lucrative) relationships.

Morjaria’s research demonstrates how, even in an environment highly inhospitable to contracts, buyers and sellers have found a way to form valuable partnerships. Of course, in other industries, and in other markets, contracts are far more enforceable. But it is rare, Morjaria explains, for there to be no contractual “pain points.” He believes that firms new to an industry would do well to understand their particular contractual ecosystem, and to consider whether they, too, might need to prioritize relationships in times of scarcity—or even, he suggests, to “operate at initial lossess in order to acquire a good reputation.”

Finally, Morjaria’s work offers an explanation for commonly observed practices such as certification programs and business associations. Longstanding relationships can offer considerable value, but by their very nature, they are time-consuming to form and maintain. Associations and certifications are proliferating—especially in developing countries—because they offer sellers a speedier way to signal their reliability and to generate positive perceptions in potential buyers the world over.

http://insight.kellogg.northwestern.edu/article/no-contract-no-problem

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