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

The relative price of locally-produced 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. Milk buyers who desire a steady supply of milk enter into relational contracts with milk sellers, paying a price premium for stable access to milk. This framework is consistent with our data. Producers sell to the same buyers year-round, producers with more variable milk production sell fewer months of the year and are more likely to sell cheese, and more price inelastic buyers are more loyal to their seller. Finally, we give evidence against other explanations for this pricing puzzle including the existence of more general non-dairy-specific market failures and the relative ease of transporting and storing cheese