Secrets of the Emperors Club (12 March 2008)

Perhaps you are wondering, as I am, why Eliot Spitzer needed to pay $4,300 for a prostitute. I'm no sex-trade expert, but surely the sex couldn't be 43 times better or the woman 43 times better looking than the average $100 hooker. My initial thought was that purchasing expensive women to have sex with is a way of making love to your own net worth, which is probably far more arousing than mere flesh could be when you have reached certain rarefied heights of social prominence. By paying far more for them than anyone would have to, one asserts a kind of profligate power of sheer wastefulness that supplants the tired pleasures of sex, which any poor slob can enjoy -- perhaps this absurd expenditure compensates for the inability to consume hookers conspicuously. It's akin to the phenomenon of wine seeming to taste better when we believe it cost more money.

But Tyler Cowen has a different theory.

It's not so hard to explain:
"The conditions under which transactors can use the market (repeat-purchase) mechanism of contract enforcement are examined. Increased price is shown to be a means of assuring contractual performance. A necessary and sufficient condition for performance is the existence of price sufficiently above salvageable production costs so that the nonperforming firm loses a discounted stream of rents on future sales which is greater than the wealth increase from nonperformance. This will generally imply a market price greater than the perfectly competitive price and rationalize investments in firm-specific assets. Advertising investments therefore becomes a positive indicator of likely performance."
That's Klein and Leffler, JPE, 1981

In other words, Spitzer had to pay an extreme amount to ensure the prostitute's silence and trustworthiness. Sort of the same reason umpires make a lot of money, to discourage them from fixing games.

I wonder if people happen upon such a strategy subconsciously, or if actual extortion is involved.