Cheating Pays

As discussed in an earlier post, private ordering theories assume that the threat of a bad reputation incentivizes merchants to act honestly. This sort of governance by reputation, however, requires that cheaters be caught and punished. But cheaters do not set out to get caught. They set out to get away with their cheating. If they succeed, they can act opportunistically and yet retain the benefit of a good reputation. Thus, the key for the successful cheater is to cheat only to the extent that he does not get caught.

Theories of private ordering tend implicitly to talk about opportunism as undifferentiated wrongs. But the reality is that cheating comes in different packages. On the one hand, we have the big cheat: non-delivery, non-payment, selling unusable goods, hold-up. These are end-game cheats. Do them and your trading partner is unlikely to continue to do business with you. But far more common are small cheats: skimping just a bit on quantity; suppling a quality a little less than promised; delivering just a little late—not significant non-performance, not terrible performance, just not perfect performance.

Spread over a large number of transactions, however, chiseling at the margins can add up to a nice benefit for the chisler without attracting the attention of the victim, who may never discover the cheats or who may not want to call the chisler out for them. A victim may remain silent because she prefers to lump the loss—it is simply not worth spending time and energy on. Maybe the victim is not certain whether the imperfect performance was deliberate cheating or just a mistake. Maybe the victim has other reasons, such as switching costs, to continue to do business with the cheater. In these situations, the victim has no reason to spread reputation-harming gossip about the cheater.

If the victim does gossip, however, the careful cheater has a powerful counter: look at all these other people who have done business with me who will attest to my honesty. The cheater’s reputation might be scuffed up, but if he has sufficient countervailing testimony from other trading partners, his reputation is not necessarily ruined, and he can remain in business.

The argument in the article Cheating Pays is that the threat of reputational sanctions may cause merchants and firms not to commit significant cheating—if you stiff someone, word will get around and no one will want to deal with you. But same threat of reputational sanctions may not be able to prevent common low-level cheating precisely because the cheater tries not to get caught.

The article develops the so-called Cheating Pays scenario, which describes how cheaters can get away with low-level cheating. First, Cheating Pays assumes that the cheater will cheat partners who cannot or do not verify performance, while at the same time not cheating partners who can or do verify. Second, it predicts that the cheater will cheat only a little. He cheats right up to the point at which, if he is caught, he can justify the imperfect performance as a mistake and get away with it simply by paying compensation. If the cheater is careful, therefore, even those victims who catch him will believe the shirking was innocent and that the cheater is honest.

Ultimately, the cheater can continue this sort of cheating for a long time. His scheme will be uncovered if he gets greedy and begins to cheat too much to explain the discrepancies away as mere mistakes; if his victims communicate amongst themselves and discover his pattern of cheating; or if he is exposed by a whistleblower. But even after he is called out, the cheater can use those trading partners whom he did not cheat, or who never discovered his cheating, to challenge the negative gossip by attesting to his honesty.

The article uses the historical case against an ordinary London wholesale grocer named Francis Newton as a paradigm for the Cheating Pays scenario. In 1621, the Attorney General sued Newton for trade deceit, accusing him of cheating his trading partners on the weight of wares and containers. This quite quotidian case generated hundreds of pages of witness depositions, allowing us not only to learn about Newton’s frauds but also about how the gossip about him spread and was evaluated.

Newton cheated some customers but not others, or at least they never discovered it. This continued for ten years. When people he cheated did occasionally discover that he had shorted them, the cheats were small enough that Newton could excuse them as mistakes. The victims believed this excuse because weighing technology was imperfect. Newton was only caught in the end because two disgruntled former apprentices ratted him out. Three lawsuits followed, resulting in four years during which Newton’s reputation was dragged through the mud in court, in the taverns, and in the marketplace. Yet not everyone believed the gossip. Many of his customers and supporters shot back that Newton was not a cheater, and they knew this because he had never cheated them. They argued the apprentices had made up the accusations simply because they were angry that Newton had not taken them on as partners in his business. In other words, simply hearing gossip did not mean that the listeners believed it. They were willing to entertain alternate explanations for the available evidence.

In the end, the court found Newton guilty of fraud and fined him £1000—about £170,000 today (a sum he almost certainly never paid in full). And yet despite the lawsuits and the reputational damage, Newton stayed in business, in the same place and with many of the same customers, for the rest of his life. Reputation, therefore, did not perform the disciplinary role ascribed to it.

Private ordering is not a magic bullet solution to all market problems. Just as the legal system does not perfectly enforce honest behavior, so too the private ordering system has its gaps and defects. While private ordering may work well enough on average to sustain trade within a market, that is not same as saying it prevents all cheating. Low-level cheating will happen, because it can be profitable. Consequently, businesspeople who do not consider this sort of cheating to be merely a cost of doing business need to build verification mechanisms into their transactions and contracts rather than trust that reputation sanctions will disincentivize chiseling.

Emily Kadens is Professor of Law at Northwestern University.