Handbook on Contemporary Austrian Economics

138 <strong>Handbook</strong> on contemporary Austrian economics
has an incentive to default on repayment with the same baneful effect on
cooperation and exchange as cases offraud, per the example above. Many
other varieties of potential post-contractual opportunism pose essentially
the same problem.
Reputation - a spontaneously ordered mechanism of contractual
enforcement - often solves this problem where state enforcement is a
costly or otherwise impractical means of securing contractual compliance.
Instead of suing Jimmy B., for example, you boycott his establishment
and encourage others to do so as well, warning them of his penchant for
fraud. By boycotting Jimmy B. and damaging his reputation, you reduce
his future income stream. Provided he does not discount the future too
heavily, in the face of this possibility, he finds that he makes more money
by satisfying his customers than by cheating them. Because of reputation,
Jimmy B.'s contracts with his customers are self-enforcing.
The basic idea here can be extended to much more valuable exchanges
and many more kinds of contracts. For instance, as I discuss below, international
traders rely on a similar spontaneously ordered mechanism to
secure their exchange partners' compliance with contracts worth many
millions of dollars involving the transnational movement of goods. Also,
on the Internet, reputation supports exchange agreements through seller
rating and feedback systems, such as eBay's. These systems appear to
work quite well. According to eBay, less than one-hundredth of I percent
of its online exchanges involve "fraud or other kinds of post-contractual
opportunism. I discuss the equally impressive evidence of contractual
compliance in the international arena below.
Reputation is not the only privately created institution of contract
enforcement. There are others that work in conjunction with reputation
to improve its effectiveness. Costly specific investments are one example
of this (see, for instance, Williamson, 2005). Producers credibly commit
themselves to cooperate with potential customers by making costly,
upfront, firm-specific investments that they lose if they go out of business.
Investments in firm-specific physical capital, logos, and even signage are
examples of such investments. Since these investments only have value to
the producer if his firm stays open, and his firm can stay open only if his
customers are satisfied, these investments enhance the producer's incentive
to comply with his contracts, reducing his temptation to behave opportunistically.
They act as a sort of hostage or bond the producer loses if he
fails to comply with his customer agreements, imposing a large cost on the
producer that he wants to avoid.
The frequent use and success of these particular spontaneous orders
in preventing opportunism has led some to suggest that social interactions
in general could be based in these arrangements (see, for instance,