Trading on continuity: Product quality upgrading under weak institutions

A substantial share of aggregate exports is generated through long–term relationships between firms. Yet, many export relationships are short–lived, with average durations of only one to two years and few surviving much longer (Aeberhardt et al., 2014). The longevity of such relationships is central to both the static and dynamic quality choices of exporting firms. Producing high–quality goods is costly, and the benefits from it often accumulate only over time. As a result, longer relationships are more likely to justify the costs associated with quality provision. While many forces can limit the duration of exporter–importer relationships (e.g. demand volatility, search frictions, financing), a central mechanism is the strength of contracting institutions.

One reason contract enforcement is central is that quality provision is often specific to the relationship it is supplied in. Alongside the cost of a better product it consists of adaptation to the buyer’s requirements, responsiveness, problem-solving around the product. That part has no value outside the relationship it was built for so separation destroys it rather than transferring it, and no court can order it back. The loss falls on both sides. For the exporter, the cost comes first and the return arrives only if the relationship lasts. The buyer can therefore refuse to pay for quality once it has been supplied. Where no court will make it pay, that prospect discourages the investment in the first place — the hold-up problem that Macchiavello et al. (2026) document in the Colombian coffee chain. But the buyer gives it up too, which makes it an instrument: the exporter can use it to make leaving expensive and outside options less attractive. My paper builds on that second channel and shows that the mechanism can run the other way.

This paper studies how the strength of contracting institutions shapes the dynam- ics of product quality upgrading within firms’ export relationships. While canonical models emphasize firm heterogeneity and learning about foreign demand as key de- terminants of product quality (Verhoogen, 2008; Brambilla et al., 2012; Manova and Zhang, 2012; Hallak and Sivadasan, 2013), this literature largely abstracts from the bilateral nature of firm–to–firm relationships. More sophisticated, differentiated prod- ucts tend to be contract intensive (Nunn, 2007) and thus highly relationship–specific. In such settings, exporters depend critically on the stability of their trading relationships. Premature termination risks the loss of sunk investments and forecloses the return to quality provision, that realizes only in the long–term. When courts cannot enforce agreements effectively, relational contracting and reputation building can be- come substitutes for contract enforcement, shaping firms’ production and investment decisions (Macchiavello, 2022).

I set out a simple framework in which the exporter’s position inside a relationship consists of two stocks that courts treat differently. Seizable working capital such as an unpaid invoice, or goods in transit can be ordered returned, so where courts are weak a buyer who walks away keeps the uninsured part of it. Relationship capital, which is buyer–specific know–how, adapted processes, or joint engineering, is destroyed by sep- aration rather than appropriated, and no court can restore it. Enforcement therefore reaches the first stock and not the second. The exporter defends what is uninsured by relying on the relationship itself, supplying more of the relationship–specific part of quality than it would otherwise choose, because that is the part the buyer cannot replace and therefore gives up by leaving. How much is worth supplying depends on how much the exporter stands to lose, and that stock grows with tenure while expo- sure does not keep pace. The model generates several testable implications. First, conditional on entry quality, exporters serving destinations with weaker contract en- forcement upgrade quality more, and this difference widens beyond a threshold re- lationship age rather than disappearing as relationships mature. This is where the framework differs from an account based on learning: a belief converges once the buyer is known, so the gap it supports must close, whereas a stock that keeps accu- mulating leaves one that does not. Second, the difference in upgrading is larger for products in which relationship capital accumulates more rapidly. In these products, the value of preserving the relationship grows faster, strengthening the exporter’s response to weak enforcement. Third, relationships are more likely to survive in destinations with stronger enforcement, although this advantage diminishes as rela- tionships mature. Stronger enforcement limits what a departing buyer can retain and makes opportunistic exit less attractive, but as the relationship develops the quality the exporter has accumulated makes leaving less and less attractive.

I test these predictions on German customs records of firm–product–destination ex- ports from 2011 to 2020, which follow each export relationship from its first year onward. Quality is the demand–side residual of Khandelwal et al. (2013), which al- lows me to adapt a measure of quality that reflects the broader idea of quality in the model. Identification comes from comparing firms starting to export the same product in the same year but to different destinations. I find strong support for my theoretical predictions. Conditional on the quality with which a relationship enters, exporters serving weak-enforcement destinations upgrade faster at every observed tenure, and the institutional gradient in cumulative quality growth widens rather than closes as relationships mature. The gradient is steeper in contract-intensive products, where relationship capital accumulates faster. Relationships also survive longer where enforcement is stronger, but this survival advantage attenuates with tenure. Robustness analyses show that the results are not driven by composition changes, that they survive alternative fixed-effect structures, a pooled tenure-based specification, and alternative measures of the dependent variable. Finally, I exploit sharp mid-relationship changes in destination enforcement in a stacked event-study design. Improvements in enforcement slow subsequent quality growth within other- wise comparable exporter-product-destination relationships supporting the core result of this paper.

Keywords: international trade, institutions, relational contracting, quality, survival, Germany

JEL-Classification: F10, F12, L14