CONTRACTING FOR COMPLEX PRODUCTS

The great promise of markets is the win-win gains that buyers and sellers realize from exchanging money for products. Buyers and sellers enter market exchanges seeking to make themselves better off. Buyers are looking for a product that will provide them with more value than the price they will pay for it. Sellers only exchange their products for prices that are worthwhile to them. Neither the buyer nor the seller is looking to do favors for the other, yet a successful exchange leaves each better off as each party provides a resource in exchange for something else of higher value. In an ideal world, all exchanges would result in such win-win outcomes. In the real world, win-wins do not always occur because sometimes the buyer or seller holds an advantage that it can and does exploit at the other’s expense. Perhaps the seller knows that its product is defective, but can deceive the unsuspecting buyer into buying it anyway. Maybe the buyer convinces the seller to deliver the product, but delays or withholds payment.

Markets can fail for many reasons, more than we need summarize here (Brown, Potoski, and Van Slyke, 2006; Mankiw, 2012; Weimer and Vining, 2005; Girth, Hefetz, Johnston, and Warner 2012; David, 1985). The examples of “losing” outcomes above are instances where one or both parties know more about their side of the transaction than does the other (e.g. the seller knows the product is defective, but the buyer does not), showing how markets can fail when buyers and sellers do not have enough information about the exchange. The problems associated with insufficient information are compounded when it is difficult for one or both parties to exit an exchange and enter into a new one. If the buyer cannot find an alternative seller for the product he needs or the seller cannot easily sell her product to a different buyer, the risk of being taken advantage of in the exchange increases (Bel and Fageda, 2011; Malatesta and Smith, 2011a). A win-win exchange is easier to achieve when both the buyer and potential sellers know a lot about the product and when entering and exiting the transaction is easy. We call these exchanges “simple.”