Reflections from Europe

The Failure of Market Failure: Part I. The

Problem of Contract Enforcement
Anthony de Jasay*

October
Part I | Part II

Anthony de Jasay

2,

2006

Received wisdom advances two broad reasons why government is

entitled to impose its will on its subjects, and why the subjects owe
it obedience, provided its will is exercised according to certain
(constitutional) rules. One reason is rooted in production, the other
in distributionthe two aspects of social cooperation. Ordinary
market mechanisms produce and distribute the national income, but
this distribution is disliked by the majority of the subjects (notably
because it is 'too unequal') and it is for government to redistribute it
(making it more equal or bend it in other ways, a function that its
partisans prefer to call 'doing social justice'). However, the market
is said to be deficient even at the task of producing the national
income in the first place. Government is needed to overcome
market failure. A society of rational individuals would grasp this
and readily mandate the government to do what was needful (e.g.
by taxation, regulation and policing) to put this right.
In this two-part essay, I claim that at least some, if not the whole, of
the market failure argument fails to prove its case. In Part I, I look
at the problem of contract enforcement and in Part II at the
provision of public goods. There have been other writings using
related arguments to the same effect, but one more such will not be
too many.

1. One-Off Contract Execution

The division of labour implies exchange and exchange is the
execution of a tacit or overt contract. In standard theory, if one
party to a contract executes his part by delivering as agreed, the
other party's optimal course of action is to take the delivery and
walk away without delivering his part. The first party knows this
and correctly concludes that his best course of action is not to
deliver. The second party knows that this is the case. Therefore the
parties will not contract and the mutually advantageous exchange of
deliveries will not take place. (The well-rehearsed model of this
interaction is, of course, the notorious prisoners' dilemma which has
been a cornerstone of arguments for political authority from the

1950s to the 1980s, though it has since been somewhat eroded by

the widening understanding of game theory.)
If circumstances permit the two parties to execute simultaneously,
the problem disappears, since each delivery is contingent on the
other, so that both parties are best off if each delivers. Plainly,
however, it is not always convenient or efficient to insist on cashon-the-barrelhead dealings. A modern economy is inconceivable
without the bulk of exchanges being non-simultaneous. Do
contracts involving credit or other non-simultaneous execution
require a third party, such as the state, to see to it that both parties
fulfil their commitments?
It used to be thought that in a small-scale, 'face-to-face' society, say
the village cattle market, no third-party enforcer is necessary,
because no party to an exchange could risk to default and face loss
of reputation and even retaliation in some unpleasant form. In large
groups of 'faceless' contracting parties, on the other hand, each
could default with impunity. Hayek, for one, strongly argues that in
the 'great society' where anonymous dealings prevail, a firm legal
framework was needed to underpin the free market which could not
function at all without it. His 'spontaneous order' emerged inside
this (non-spontaneous) framework.
This type of 'market failure' argument, that comes strangely from a
Hayek who is widely venerated as a champion of classical
liberalism, fails mainly by getting the facts wrong. The most
obvious one is the unworldly idea of contracts between anonymous
parties who can walk away from the contract without delivering
their side without anyone knowing who they were. There are no
anonymous contracts. Where thousands of faceless customers
stream through the checkout counters of a supermarket, they have a
contract with the bank who issued their credit card, and the card
company has a contract with the supermarket, each party to each
contract being duly named and identified. In wholesale trading
dealers in the same trade know a good deal about their
counterparties half a world away and if they do not, their bankers
and brokers do. Default risk is shifted, often to specialised
intermediaries, to whomever will assume it at the least cost because
best able to minimise it. For relevant purposes, the wide world is a
face-to-face society, or at any rate functions much like one.
The other fact of life that standard market failure theory does not
get right is that while many market exchanges are done in the form
of one-off contracts that are fully executed once each party has
made one delivery, many moreprobably the greater part of
aggregate market exchangesis not. It is run on continuing
contracts providing for repeated executions, often an indefinite
number of times.

2. Repeated Executions
The example that first springs to mind is the labour contract, where
the employee agrees to render some service week by week, month
by month, and the employer agrees to pay him at regular intervals,
for a period or until either party terminates the contract by giving
due notice. Similar contracts with repeated delivery often govern
the supply of parts and materials to manufacturers and the supply of
finished goods to commerce. They typically run for an indefinite
yet uncertain duration.
Unlike the one-off kind, such contracts do not obey the logic of the
prisoners' dilemma where 'take the money and run', i.e. deliberate
default, is the best strategy. Defaulting on any given delivery at any
link of the chain of deliveries breaks the chain and normally wrecks
the contract. Therefore it pays only if the gain made by defaulting
on a single delivery outweighs the present value of all future gains
that would accrue if the contract went on to its indefinite term.
The balance in favour of continuing to deliver as agreed (or pay as
agreed) will be vastly strengthened if the potential defaulter loses,
not only the anticipated gains from the contract he would break, but
also the potential gains from other contracts that third parties would
decline to conclude with him after they learned that he was a
defaulter. The forgone gains from potential contracts, added to the
forgone gains from the contract the defaulter has actually broken,
create a strong conjecture that carrying out commitments under the
system of repeated contracts is a self-enforcing convention.
This conclusion parallels the deduction, made by numerous
theorists and therefore known as the Folk Theorem, that mutual
cooperation through a series of indefinitely repeated games, each of
which has the structure of a prisoners' dilemma, is a possible
equilibrium.

3. Free Riding
Little is left, then, of the market failure argument which holds that
the market cannot spontaneously generate the contract enforcement
required for its own functioning. If this argument were valid, a
really free market would be a logical impossibility. 'Real existing'
markets would all depend for their very existence on the scaffolding
of an enforcing apparatus.
It so happens that most 'real existing' markets do make some use of
the enforcement service provided by the legislator, the courts and
the police. Why is this the case if the market failure argument is
invalid and there are adequate incentives for rational economic
agents to adhere to a self-enforcing convention of contract

fulfilment?
The short answer is that punishing and hence deterring default is
rarely costless. Even passively boycotting the defaulter involves
some cost in inconvenience, even though incurring the cost may be
the means of preventing a greater loss. If much the same result can
be got without incurring any cost, that method will be preferred.
Once legislatures, courts and policein one word, the government
is in place, maintained by the taxes it has the power to exact,
firms and individuals will rationally prefer to entrust the task of
enforcement to it and enjoy the illusion of getting something for
nothing, instead of making the effort themselves. They perceive this
as a chance to free-ride on the taxes paid by everybody else, and do
not perceive that ultimately their own taxes must increase to cover
the cost of all the free riding others will also prefer to do. The
tendency fits nicely into an important objective of every
government, namely the goal of discouraging private enforcement
and vesting in the state the monopoly of all rule enforcement.

4. The Enforcement Agency

It is a long way from putative market failure to the risks of
overwhelming political power, but that long way must nonetheless
be travelled. Textbook theory rather blithely teaches that since
contracts are inherently default-prone, their binding force must be
assured by the services of a specialised enforcement agency (such
as the state). However, if the agency is to be bound by tacit or overt
contract (such as a constitution) to a best-effort service in the
interest of all bona fide economic agents, that contract itself needs
enforcement, for why else should the agency not go slack or biased
or otherwise abusive? Plainly, however, the enforcement agency
cannot be entrusted with enforcing such a contract against itself.
The supposed remedy could well be much worse than the disease.
Perhaps herein lies the ultimate failure of the market failure thesis.

* Anthony de Jasay is an Anglo-Hungarian economist living in France. He

is the author, a.o., of The State (Oxford, 1985), Social Contract, Free Ride
(Oxford 1989) and Against Politics (London,1997). His latest book,
Justice and Its Surroundings, was published by Liberty Fund in the
summer of 2002.