Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't

affect our political and economic systems at large. And whether we look at political fund raising, criminal sentencing, or corporate behavior, we find that reputations permeate our decisions and actions in surprising ways.
What Keeps Politicians and Businesses Honest?
What restrains politicians and businesses from acting dishonestly? A lot of people would answer: nothing. Periodic political and corporate scandals have created a popular image of politicians and businessmen as little more than a collection of cheats, liars, and crooks. However, while there will always be some dishonest people in any profession, the vast majority of American politicians and businessmen do not end up being frog-marched out of their offices in handcuffs before a gaggle of news cameras with their heads held low in shame.
Cynics will argue that many cheaters are simply getting away with it. This notion often stems from a general view of our political and economic systems as inherently corrupt; perhaps “the system” takes otherwise good people and subverts them, or perhaps merely allows the dishonest to flourish. Either way, we are habitually told that politicians and businessmen are not to be trusted. The popularity of books propagating this view—Michael Moore’s Stupid White Men, for example, was the bestselling nonfiction book of 20021—testifies to the widespread perception that our political and economic systems provide a welcome home to the irredeemably depraved.
What this argument fails to acknowledge is that in both politics and economics, there is a strong, omnipresent incentive to behave honestly. One might assume this refers to the threat of prosecution for dishonest conduct—surely, not many people want to go to jail or pay heavy fines. But what about lesser kinds of cheating not subject to legal sanctions? What incentives do politicians have not to break their promises? What keeps businesses from flooding the market with low-quality or unreliable products? As it turns out, there is a powerful incentive toward honest behavior that is built into our democratic political system and free market economy—that of maintaining a good reputation.
Let’s begin by looking at businesses. High-quality products are usually more expensive than lower-quality varieties—think of the extra cost as a high quality “premium.” This premium has to be even higher than the extra cost of materials and production incurred in making a high-quality item. The additional premium represents the charge for buying from a firm with a reputation for selling high-quality products.2
The future profits from this premium is what a firm stands to lose if it cheats its customers. For example, imagine if a reputable maker of deluxe, expensive sports cars suddenly begins selling cars that quickly break down. Customers may initially pay high prices for the new cars, but as word spreads that they are unreliable, the firm will lose its good reputation. The company will then have to lower its prices because customers will no longer pay the high-quality premium for a car they know tends to break down.
The potential loss of profits stemming from the loss of a good reputation helps keep businesses honest. This holds true so long as a business is concerned with its future profits. But if a reputable firm has some low-quality merchandise and is going out of business, it may decide to try to sell off these products for the same price as its high-quality versions; the firm is no longer worried that it will lose its reputation or its ability to charge the high-quality premium because it has no future anyway.3
This is where the incentives for firms to act honestly differ from those of politicians. Analysts usually assume that politicians have a similar motivation for honest behavior as companies do; politicians won’t get re-elected if they break their promises, just like companies will lose sales if they cheat their customers. But there is a key difference between the incentives for firms and for people: firms can, at least theoretically, last forever, while people can’t. Firms—unless they are about to shut down—will always face the potential loss of sales stemming from dishonest behavior. But politicians don’t always have the incentive of re-election because eventually they will leave office one way or another.
This is called the “Last Period Problem,” and it indicates a weakness in the conventional wisdom that politicians are kept honest only due to their desire for re-election. If a politician only keeps his promises in order to get re-elected, why would he keep them after he decides to retire? Suppose a politician announces during a campaign that his next term will be his last. Why would voters elect him to a final term in which he will no longer have the threat of re-election to keep him honest? The answer is: they wouldn’t. And if he has no prospect for re-election to his last term, why would the politician keep his promises in his second-to-the-last term? The Last Period Problem thus unravels the supposition that a politician only governs with an eye to re-election.4
It may seem that three circumstances could resolve this predicament. Firstly, perhaps a politician could avoid the Last Period Problem by refusing to announce publicly that a forthcoming term will be his last (although this would not apply to the presidency, many governorships, and other public offices that are term-limited, or to House and Senate candidates who adopt voluntary term limit pledges). Secondly, a politician may hope to maintain his reputation throughout his last term in hopes of winning election to some other government position after his retirement, or securing employment as a lobbyist for some group that he “took care of” while in office. Finally, a politician may want to keep his reputation intact in order to pass it on to his children and assist their political careers.
To test these possibilities, I conducted a study of congressmen who retired in 1978. Nearly 40 percent of this group neither went into government service after retirement, nor went to work as a lobbyist, nor had children who went into politics, government, or lobbying.5 Surprisingly, the retiring congressmen who did not have these