Market forces, reputation, and contractual performance

In the previous section we examined a situation where sellers breached their contractual obligations by failing to deliver the good. But contractual obligations can also be breached in other ways. For example, sellers can promise to deliver a high-quality good (which has been purchased at a high price) but instead deliver a low-quality good. Klein and Leffler (1981) examine this situation and show that under certain circumstances, market forces and the pursuit of long-run profits can induce firms to deliver high-quality goods when they have promised to do so, even though there is no legal obligation for them to do so.

The basic idea of their analysis is as follows. Suppose that there is a good that comes in two kinds of quality: high and low. Consumers have unit demands and will purchase as long as their valuations for the good exceed the price that they pay. Similarly, producers will supply the good as long as the price received is at least as large as the production costs. The gains from trade are maximised when the high-quality good is produced and consumed.

Consumers can only ascertain the quality of the good after they have purchased it. Alternatively, the pre-purchase costs of quality verification are sufficiently high to exceed the gains from trade.

We assume that the benefits to consumers of the high- and low-quality good are BH and BL respectively, and that production costs are cH and cL. Finally, suppose that firms are price takers and that there are two

possible market prices, PH and PL that they can charge. We assume that BH > BL, cH > cL, PH > PL, and that BH - cH > BL - cL.

There are several possible outcomes that could occur in this market. If consumers decide to pay a high price and firms deliver the high- quality good at this price, then consumer net benefits are BH - PH and producer profits are PH - cH. On the other hand, a firm could decide to pocket the high price and deliver the low-quality good, in which case consumer net benefits are BL - PH and producer profits are PH - cL. The other configurations and decisions are shown in the payoff matrix in Table 8.3.1.

This game is straightforward to analyse. Since cL < cH, it is a dominant strategy for the producer to choose to produce the low-quality good. And since the producer has this dominant strategy, the consumer will only choose to pay the higher price if PH < PL which we assumed did not hold. Therefore, the unique Nash equilibrium of this one-shot game is for the producer to produce a good of low quality, and for the consumer to purchase the low-quality good at a low price. This equilibrium is inefficient.

Now suppose that there is the opportunity of a long-lived economic relationship between buyers and sellers, so that the game above is repeated an infinite number of times. Suppose that consumers adopt the following decision rule: pay a high price as long as the good consumed in the previous period was of high quality; otherwise never again pay the high price.

We will show that if the firm adopts a strategy of producing a high- quality good as long as the consumer pays a high price, then this combination of strategies can be sustained as a subgame perfect equilibrium of the infinitely repeated game. Consider the strategy of the producer. The payoff from producing a low-quality good in the current period is:

Table 8.3.1 The payoff matrix in the Klein-Leffler model


High Quality

Low Quality


High Price

(BH - PH, PH - cH)

(BL - PH, PH - CL )

Low Price

(BH - PL, PL - CH )

( Bl - Pl , Pl - Cl )

On the other hand, suppose that the producer decides not to cheat. Then his payoff is:

Thus the producer will decide not to cheat if:

A similar set of calculations for the consumer show that consumers will pay the high price as long as:

If BH - BL > cH - cL then there exists a S < 1 such that it is subgame perfect equilibrium for the efficient outcome to occur in every period (note, however, that there are also many other equilibria).

B + c

To see this, suppose that BH - BL > cH - cL. Let PH = H H and

= B^ . Then: 2

L 2

so setting S = — +1 ——— +e where ?> 0 is a small positive number,

will give us the required result. The intuition behind this result is as follows. If the common discount factor is sufficiently large, then both parties value the future highly enough to be willing to give up the (relatively high) current (but one-off) benefits of breaching their contractual obligations, plus the (relatively low) gains from low-quality trades, in exchange for obtaining an continued stream of (slightly lower) payoffs from fulfilling their contractual obligations. The key insight is that it is possible for such behaviour to be sustained in the absence of formal rules around contractual performance and damage measures for breach of contract.

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