On the Formation of Buyer-Seller Relationships when Product Quality is Perfectly Observable

Abstract

This study explores the formation of buyer-seller relationships in markets with observable quality. We develop a model that explains why relationships form in equilibrium within such markets. A key feature of our model is that as individuals gain experience in the marketplace, they resolve uncertainty over unobserved bargainer types. Relationships thus form as a means to reduce such transactions costs and uncertainty. We explore the usefulness of our theory by using a battery of simulations and experimental treatments. Overall, we find that our theoretical predictions are largely confirmed. Interestingly, the quantitative impact of relationships on overall market efficiency depends critically on the extent to which market structure affects the matching of buyers and sellers that could profitably transact. In certain important cases, a greater number of buyer-seller relationships can reduce market efficiency.