Economics 103 Lecture # 21 Economic Organization: Contracts and Markets

Market Enforced Product Quality How do you know, when you buy a That it’s actually going to be a Snickers bar … and a good one? If it was bad, would you take the company to “Your worship …

The problem is, if we’re not willing to punish a firm for cheating us, then they will cheat us all the time. - but that means all we’ll get is bad quality. It is like buying a used car on the side of the road. You know you get junk. So how can a market solve this problem?

Suppose we have a firm that can sell HIGH quality or LOW quality. Suppose the consumer can only tell the difference once he gets home. Suppose HIGH quality costs more to produce. Suppose firms are price takers. Suppose that if a firm rips you off, you tell all your friends, and by tomorrow no one in the entire world will ever buy from the firm again.

We would have a situation as follows: Clearly, the dominant strategy for the firm is to rip you off. The one time cheat is better than earning zero profit forever. But then no one would pay the HIGH quality price.

The solution is to pay the firm a “quality premium” for honestly selling high quality. But how can this little profit compete with the one time large gain from cheating? Ans: because you get it forever.

But now the firm is earning a profit, and that can’t happen in equilibrium. But to eliminate the profit would mean the firm would cheat! Solution:. The fixed investment capital is “Reputation Capital.”

How many remember Why would he do this on TV?

How many times have you seen an ad like: …

Sears:

Why did banks used to look like:

The miracle mile:

Signals When firms can’t tell what quality their workers are before they hire them, they might rely on signals. Signals are all over the place.

For signals to work they must be correlated with quality, and It must be more expensive for the low quality types to acquire the signal. The Veal Signal.

What might be some other signals?

Related to signals are Screens. -here an event (like an exam) screens out the low quality individuals. My favorite example of a screen was the Duel of Honor.

Background: Three Types of Duels. 1. The Judicial Duel / Trial by combat.

2. The Chivalrous Duel

3. The Duel of Honor.

Characteristics and Facts of Duels of Honor The cause was trivial: insults, touching, slur, ‘coolness of manner,’ accusation of lying. Outcome was irrelevant with respect to social standing. Regulated by strict sets of rules. Held in private, always illegal. Reconciliation was common after the duel. No defensive weapons allowed. Lethalness falls over time, mostly through choice of weapons Begins c Ends mid 19 th century. Was the sole domain of the aristocracy until the end.

- -...in a state of highly polished society, an affront is held to be a serious injury. It must, therefore, be resented, or rather a duel must be fought upon it; as men have agreed to banish from their society one who puts up with an affront without fighting a duel. [Samuel Johnson, quoted in Boswell, p. 484, 1980]

Dueling was designed to: Dueling was costly because:

Evidence 1. Limits on Participation. Very high social capital types not allowed to duel - Lower members of society never allowed to duel. Once we recognize dueling as a screen, all of the puzzling features fit perfectly.

2. Cause, Identity of challenger/challenged, outcome … irrelevant. - all consistent with the duel as a screen..

3. Duels made π exogenous.

4. Role of seconds … To prevent cheating

5. No patronage system, no dueling Why the decline of dueling? -