The Role of Market Forces in
Assuring Contractual Performance
Klein and Leffler
Assume constant Marginal Cost, No Fixed Cost
Ch=cost of producing a high quality unit
Cl= cost of producing a low quality unit
Ph=price of a unit seller says is high quality
Pl=price of a unit seller says is low quality
Ph-Ch=one period payoff to not cheating
Ph-Cl=one period payoff to cheating
It does not pay to cheat when Ph is
sufficiently high
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Ph-Cl < Ph-Ch+(Ph-Ch)/r
Ph>Ch+r(Ch-Cl)
For example: High quality AC, Ch=$600
Low quality ac, Pl=$200
r=.1
Ph=$640
(Without the possibility of cheating Ph=$600)
The role of gov’t
“When this condition [high Ph] is combined with
an extremely high cost of quality assurance via
explicit contractual guarantees, governmental
supply may be the cheapest alternative.” p. 636
Examples
Police (a private police force would be both over
and under vigilant: arbitrary fines, little
protection)
Fire (not respond in time)
Even if the police or FD under perform they will
not be terminated, and this is the reason they
are public
What about rating firms (Moody's, S&P)?