Informal Contracts in an Incomplete Market: The Price of Milk in Paraguay

The relative price of locally produced and locally sold milk and cheese in rural Paraguay is puzzling, apparently leaving opportunities for arbitrage. Despite requiring additional labor and inputs, the price of cheese per liter of milk is lower than the price of a liter of fluid milk. We propose a framework of relational contracts to explain this puzzle. Consumers who desire a steady supply of milk enter into relational contracts with producers, paying a price premium for stable access to milk. This framework is consistent with our data. Producers sell milk to the same consumers year-round; producers with more variable milk production sell milk fewer trimesters of the year and are more likely to sell cheese, and more price inelastic consumers are more loyal to their seller. There are other potential explanations for this pricing puzzle including collusion among milk sellers, milk quality differentials, and the relative ease of transporting and storing cheese compared with milk. We give suggestive evidence that consumers’ desire for stable access to milk fits the data best.