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Subject Area: Political Theory

Market-Assured Contract Performance - Leonard P. Liggio, Literature of Liberty, Spring 1982, vol. 5, No. 1 [1982]

Edition used:

Literature of Liberty: A Review of Contemporary Liberal Thought was published first by the Cato Institute (1978-1979) and later by the Institute for Humane Studies (1980-1982) under the editorial direction of Leonard P. Liggio.

Part of: Literature of Liberty: A Review of Contemporary Liberal Thought, 20 vols. 19781-982

About Liberty Fund:

Liberty Fund, Inc. is a private, educational foundation established to encourage the study of the ideal of a society of free and responsible individuals.


Market-Assured Contract Performance

Benjamin Klein and Keith B. Leffler

  • University of California at Los Angeles and University of Washington

“The Role of Market Forces in Assuring Contractual Performance.” Journal of Political Economy 89 (August 1981): 615–641.

An implicit assumption of the economic paradigm of market exchange is the presence of a government to define property rights and enforce contracts. An important tenet of the legal-philosophical tradition upon which the economic model is built holds that without some third-party enforcer to penalize stealing and reneging, market exchange would be impossible. Nonetheless, economists have long considered communication factors such as “reputations” and brand names to be private devices which provide incentives to assure contract performance in the absence of any third-party enforcer.

The authors assert that even the existence of perfect communication among buyers (guaranteeing the loss of all future sales to a cheating firm) is not sufficient to insure noncheating behavior in the present. They then analyze the generally unrecognized importance of increased market prices and nonsalvageable capital as possible methods of making quality promises credible. Consumers are not aware of these methods as theory, but they act as if they recognize the forces at work.

The authors' analysis implies that consumers can sucessfully use price as an indicator of quality. They refer to the fact that consumer knowledge of a gap between a firm's price and salvageable costs (i.e. the awareness of a price premium) supplies quality assurance. A necessary and sufficient condition for a company's performance is the existence of a price sufficiently above salvageable production costs, so that the nonperforming firm loses a discounted stream of rents on future sales which is greater than the wealth increase from nonperformance. This will generally imply a market price greater than the perfectly competitive price and rationalize investments in firm-specific assets. Thus advertising investments become a positive indicator of likely performance.