Firms, Courts, and Reputation Mechanisms : Towards a Positive Theory of Private Ordering

This paper formulates a positive model that predicts when parties will employ private ordering to enforce their agreements. The typical enforcement mechanism associated with private ordering is the reputation mechanism, when a merchant community punishes parties in breach of contract by denying them future business. The growing private ordering literature argues that these private enforcement mechanisms can be superior to the traditional, less efficient enforcement measures provided by public courts. However, previous comparisons between public and private contractual enforcement have presented a misleading dichotomy by failing to consider a third enforcement mechanism: the vertically integrated firm. This paper develops a model that comprehensively addresses three distinct types of enforcement mechanisms - firms, courts, and reputation-based private ordering. The model rests on a synthesis of transaction cost economics, which compares the efficiencies of firms versus markets, and the private ordering literature, which compares the efficiencies of public courts versus private ordering. It hypothesizes that private ordering will arise when agreements present enforcement difficulties, high-powered market incentives are important, and the costs of entry barriers are low. The paper then compares the model's predictions to documented instances of private ordering, and this illustrative test suggests that the model is consistent with empirical studies in the private ordering literature