Trust in Transactions: An Economist's Perspective

Understanding trust economics can lead to breakthroughs in the market.

Foundations

Contributor / Niko Matouschek

Alvin J. Huss Professor of Management and Strategy
Kellogg School of Management / Economics

Economists care about trust because it is closely connected to economic activity. Its absence leads to lower wages, profits, and employment, while its presence facilitates trade and encourages activity that adds economic value. For sellers, trust can become a critical competitive advantage: Buyers are more likely to do business with companies that they believe to be “virtuous sellers”—that is, not solely interested in maximizing profit. To compete, profit-maximizing “rational” sellers must use contractual alternatives to trust, which are usually a poor and costly substitute. The result is that virtuous sellers can have an important influence on the market by creating incentives for rational sellers to mimic them.

Transcript

Trust is an issue that most people don’t associate with economics, yet economists actually care a great deal about trust. And they care a great deal about trust because, in the absence of trust, many value-creating transactions simply wouldn’t take place.

To take the quintessential economic transaction as an example — if you (the buyer) don’t trust me (the seller) not to sell you a lemon, then you won’t buy from me in the first place. And you won’t buy from me even if, in principle, I could make a product that you value more than it costs me.

And so, trust matters to economists because it enables and facilitates transactions that create value and therefore are good for all of us.

Or the other way around — trust matters because the absence of trust is an impediment to growth. It’s an impediment to growth in employment, wages and profits, and therefore makes us all worse off.

To be sure, not all transactions require trust. If, for instance, you can verify on the spot whether I’m selling you a lemon or not, then our transaction doesn’t require any trust. Or, alternatively, if we can write a contract that ensures I’m not selling you a lemon, then, again, we don’t need any trust between us to transact.

The problem is that in many situations, that’s not the case. In many situations, you can’t verify on the spot whether I’m selling you a lemon or not, and writing a contract is either costly or even impossible.

And in such situations, transactions do require trust. What the economic literature on trust tries to understand is how markets function when transactions do indeed require trust.

BUMPER: Rationality and Trust: "Good Types"

To explore how markets function when transactions require trust, it’s useful to start by asking yourself when and why it’s rational for market participants to trust each other — that is, to believe that the other side is going to follow through with their promise, even if it’s not in their immediate economic interest to do so.

There are really two reasons for why it may be rational for you (the buyer) to trust me (a seller). One is that you may think that I’m what’s called a “good-type” or a “virtuous-type seller” — that is, I’m not really a coldhearted homo economicus who, at any moment in time, tries to maximize his profits.

Instead, I’m somebody who incurs, essentially, a psychic cost from not doing what I’ve said I was going to do. Even if there’s just a small number of these virtuous sellers — these virtuous sellers are in short supply, as you might think they are — they can still have significant impacts on how markets work.

One implication comes from the fact that if you’re a virtuous seller, you have a competitive advantage over regular rational ones.

If you’re known to be a virtuous seller, buyers want to transact with you. And to compete, the regular rational sellers have to create essentially contractual alternatives for trust that are both costly and typically imperfect substitutes for trust.

And so, somewhat paradoxically to being committed not to maximize your profits at any moment in time actually increases your profits. And so, being virtuous is not just good for your soul, if you want, it’s also good for your bottom line.

And that’s why virtuous sellers, or so-called virtuous sellers, can play an important role in a market, even if there’s just a small number of them.

Economic historians, for instance, sometimes argue that one of the reasons for why the Quakers played such an important role in the British economy in the 18th century is because they were known to be trustworthy.

And so, people knew that they would keep their promises, even if it were not in their immediate economic interests to do so. That put them into a competitive advantage vis-à-vis other business people and led to them playing a disproportionately important role in the economy.

BUMPER: Rationality and Trust: Good Incentives

A second implication of having virtuous sellers in the market is that if there’s uncertainty about who is who — who is virtuous and who is rational — then the rational sellers have an incentive to try to mimic the virtuous ones.

That’s going to be costly for them today because they have to forego some profit opportunities today, but then they reap the benefit of being perceived as virtuous tomorrow.

There’s a large literature on reputation games in economics, as it tries to understand the incentives, how they play out, what extent there is scope for this mimicking behavior, and how the mimicking behavior affects the functioning of markets — whether it’s overall good for the market or whether it’s bad for the market.

Now, suppose that you know that I am a coldhearted homo economicus; can it still be rational for you to trust me? And the answer is yes, provided that I care not only about today’s transaction with you but also about future transactions, either with you or with others.

In deciding whether to honor my promise to you, then, I face a trade-off. By breaking that promise today, I can make more money today, but now it comes at a cost of less future business, essentially.

As long as I care enough about the future, it is then rational for me to keep my promise to you. And since it’s rational for me to keep my promise to you, it’s rational for you to trust me in the first place.

Repeated interactions, then, can allow a coldhearted homo economicus — somebody who’s known to be a rational agent — to commit to behave as if he were a virtuous one and to do so without having to rely on any formal contracts.

Now, for that to work, two things have to be true, generally speaking: One is I, that seller — that coldhearted seller — have to care enough about the future. And two, there has to be enough transparency, in the sense that current consumers can observe enough about how I’ve treated past consumers.

And there’s a large literature on repeated games in economics that tries to understand exactly when and how these reputation mechanisms that work through repeated interaction operate.

In summary, then, there are two strands in the literature: one focuses on good types, and one focuses on good incentives. And together, they have a number of implications and shed light on a number of economic issues and phenomena.

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Without trust and transparancy in business, consumers fall at risk of getting ripped off whenever they shop.

If You’re Getting Ripped Off, It’s Not Surprising

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Contributor / Niko Matouschek
Niko Matouschek Economics Building Brands,Leadership,Long Term Focus,Sharing Economy,Vulnerability I think it’s an underappreciated fact that successful market economies, like the U.S., exhibit a lot of trust — trust between market participants who are both anonymous (they don’t know each other well) and who are self-interested.

If you look at the sharing economy, for instance — to a large extent, their success depends on their ability to create trust between third parties, trust between somebody who wants to rent out their apartment and trust between somebody who wants to rent that apartment.

Or if you think about yourself — every day, you trust people who you don’t know and you trust them to do things that are actually not in their self-interest. And more often than not, you don’t get disappointed.

If I told my wife that the U.S. economy exhibits a lot of trust, she would be very skeptical — rightly so because the history of corporate misdeeds is a long and distinguished one to which we’ve had many colorful, recent, new entries.

But the fact that people get ripped off is not really surprising. What’s surprising is that they’re not getting ripped off more often. What’s surprising is that I can go into essentially any store anywhere in the United States and be reasonably sure that I won’t be sold a lemon. That’s what’s surprising.

BUMPER: Is It Naïve to Invest in Trust?

Firms do so in two ways, both of which involve making it costly for themselves to break their promises in the future. The first is that they hire people and are run by people who don’t just care about profits but also care about being trustworthy.

There’s essentially people, if you want, who incur a psychic cost if they break their own promise.

Now, in an age in which many emphasize the cutthroat nature of business, this may sound naïve and quaint, but it’s not, because, in a market in which trust is important, being trustworthy gives you competitive advantage.

A historical example of this are the Quakers in the 18th century, who played a very important role in the British economy at the time, even though there’s only a relatively small number of them.

And it’s often argued that one of the reasons for why they had such an important role in the economy was precisely because they were known to be trustworthy; they were known to follow through with their promises, even if it was not in their immediate economic interest to do so.

And that’s what gave them a competitive advantage; that’s why people seek them out to trade with them.

We see the same thing today with firms like Keller Williams and the like, trying to hire people who are not just skillful but also what they call “ethical.”

I don’t think that that’s just a cheap PR stunt; I think firms try to hire trustworthy employees not just because it’s a moral value that they might care about but because it’s an economic asset in which they can earn a return.

The second is that firms commit themselves to a long-term strategy that emphasizes and importance of repeat in future business — because if I’m not just a pop-up store but I also care about future business, then there’s a cost to me of breaking my promise to you today, which is that there’s going to be less business for me in the future.

So, repeat transactions can serve as a commitment device. For this to work, though, two things have to be true: First, not only me but also my employees have to care about the future enough.

And so, it’s important that I’m providing them with the right kind of incentives — with long-term incentives and not just short-term incentives.

And the other issue is that transparency is important. It’s important that customers are able to observe how I’ve treated other customers in the past.

So, that’s why things like feedback mechanisms in the electronic marketplaces are really useful because, there, if I cheat you, you’re going to go online and write a review, and that’s going to be costly to me. And because I know that, I’m less likely to cheat you in the first place.

BUMPER: When It’s Unwise to Trust

I think it’s rational to trust firms that care about the future, and it’s foolish to trust firms that don’t care about the future.

For instance, it’s foolish to trust a pop-up store. A pop-up store is not going to be around tomorrow, so they have no incentive to keep any promises they are making to you.

Maybe less obviously, firms that are close to bankruptcy — those are run by managers who care much more about today’s profits than about future profits because if they don’t increase today’s profits, they’re going to be out of business in the first place.

Another example would be firms in which employees are being rewarded very strongly for short-term performance — for quarterly earnings or quarterly performance — because, again, decisions are then made by employees who care a lot about the present profits, and they care much less about future profits.

So, again, these are the kind of firms in which I’d be suspicious about whether or not they’re going to keep their promises.
Healthcare providers must recognize the importance of trust and communication in building stable relationships with patients.

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Contributor / Kelly Michelson
Kelly Michelson Pediatrics Communication,Distrust,Healthcare,Measurement Research about trust in the healthcare setting has generally taken two approaches: the first is to look at it in a qualitative fashion, so to hear personal anecdotes and learn what we can from that; and the other is to look at it in a more quantitative fashion, using scales and measures to see how trust relates with specific outcomes or specific variables.

From the qualitative research, we know that things like developing partnerships, developing relationships, demonstrating competence are all very important components of establishing trust in the relationship.

Most of the quantitative data related to trust in a healthcare setting use trust scales to compare a measure of trust to a particular variable — looking at things like, do women tend to be more trusting than men of their healthcare provider? Are there racial differences related to trust? Are there differences in providers’ and healthcare settings’ relationship to trust?

And these concepts help us to think about how we act — in a clinical setting, for example — and what we teach trainees about how to build trusting relationships with their patients or with others in the healthcare team.

BUMPER: Trust and Communication

Much of what we know about trust in the pediatric intensive care unit comes from literature that looks at communication and how communication unfolds in this particular setting.

We know from some qualitative work, from Carnevale et al., that trust is a really important part of communication in the pediatric intensive care unit.

These authors interviewed physicians, nurses, and parents about communication, identified three different components of communication. And of note, one of them was relational communication. And one key factor in developing relational communication that they identified was fostering trust.

And in another work by Ames et al., we find that trust is not only an important component for healthcare providers to focus on but also for parents.

In this work, the authors interviewed parents of children who were in the pediatric intensive care unit and asked them about their roles. And one of the three roles that they identify was actually that the parents should be trying to establish a trusting relationship with the healthcare providers in the PICU.

In another study done by Vivian et al., we learned about the importance of communication among staff members in the pediatric intensive care unit.

In that study, staff members were interviewed, and we found that poor communication among caregivers within in the intensive care unit can impact trust and therefore impact how they care for patients.

So, again, we’re seeing the importance of trust between providers and patients (or, in my case, parents) but also among providers.

BUMPER: Trust in Critical Decision-Making


In terms of decision-making in the intensive care unit, much of the literature has focused on issues related to pretty challenging decisions for children who are very sick, things like withdrawing or withholding life-sustaining efforts if a child was seriously ill — some pretty serious decisions.

Some of the research I’ve done, for example, has looked at what kind of influencers contribute to a parent’s deciding whether or not to withhold or withdraw life-sustaining therapies if their child was so sick that that became something to consider.

And what I found was that distrust was one of nine important factors that parents are weighing in terms of making that kind of decision.

In another study, Meert et al. interviewed parents of children who had died in the pediatric intensive care unit to find out more about their experiences. And they found that parents who felt that clinicians were withholding information also had a sense of betrayal or distrust towards those physicians.

BUMPER: Enhancing Trust in the Intensive Care Unit

But it’s really important not just to know what happens in the intensive care unit and where trust fits into communication and decision-making; now that we have all that information, we really want to try to impact trust and to enhance better trust and better communication and hence better decision-making in the intensive care unit.

For example, Curtis et al. looked at an intervention where he tried to change multiple components of what was going on in the intensive care unit, including identifying champions for this work, providing feedback to clinicians.

Interestingly, he didn’t find that that intervention changed his primary outcome.

In another effort done by Lautrette et al., they actually educated clinicians about how to conduct a family conference.

And they came up with this mnemonic called VALUE, and each of the letters stand for something different — specifically that you should value and appreciate what the family is saying during a meeting, acknowledge their feelings and emotions, that you should listen to what they say, that you should try to understand their situation and their values, and that you should elicit questions from them.

So, they actually taught clinicians a little bit about how to focus their communication during family conferences in the intensive care unit. And they actually did find a difference.

They found that for families who had family conferences with clinicians who were trained in this manner, those surrogates to the patients in adult ICUs had less anxiety and depression after their loved one had died and less symptoms of post-traumatic stress.
Judging trust and trustworthiness is important in all aspects of our lives even grocery shopping.

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Foundations
Contributor / Bruce Carruthers
Bruce Carruthers Sociology Government,Institutions and Context,Legal Guarantees,Reputation Management,Social Psychology,Vulnerability As a social scientist, I’m very interested in trust as it concerns people because really society, human cooperation, human coordination, all of the activities that we do together, really depend on trust.

And you might kind of wonder, well, trust sounds a bit like faith? You know, we’re just going to take people on faith.

And don’t we have a bunch of ways of coordinating our activity and making sure that the left hand knows what the right hand is doing, and I can figure out what’s going on vis-a-vis my employer or all the people that I interact with — and don’t we have a bunch of formal coordination devices like contracts or instructions or standard operating procedures?

Why aren’t those good enough? Why do we have to go beyond that and trust people? And there’s a couple of reasons for this. And one of them is that, as wonderful as these formal devices are, they really do have limits.

And one of the reasons is that contracts and other instructions, lists, standard operating procedures, all of these devices — they’re always incomplete; that is, the world is more complicated and unpredictable than we can anticipate.

And so, stuff will happen that will effect whatever it is you’re doing with these other people. It will have an impact on your ability to execute whatever it is you’re trying to do, and it’s not going to be in the contract what’s up.

You might think to yourself, “Well, maybe trust isn’t such an issue if we go to the marketplace.” Let’s think about markets and capitalism and self-interest and competition — maybe that’s a world in which contracts and other formal devices will be sufficient.

And once you’ve got an airtight contract, you don’t have to worry about the personal character or the trustworthiness of the people you’re dealing with, because you’ve got a good contract and you hired a good lawyer.

So, the most famous person who thought about this sphere, of course, was Adam Smith in his famous book The Wealth of Nations, which really did talk about the virtues of capitalist production and competitive markets and so forth.

And I think it’s very telling that before he wrote The Wealth of Nations, Adam Smith wrote a book on The Theory of Moral Sentiments.

And in this previous book, he posited that people are linked through strong bonds of sympathy and empathy and trust, and that on top of this, we’re able to have markets and capitalism and all that kind of fun stuff.

It was clear to me (and I think clear to Smith) that some measure of some baseline, some foundation of trust is very important even in social settings where we might think that the issue of trust can be solved or avoided.

You might want to ask, when does trust arise? I’ve talked about it as kind of ever-present — it’s all over the place. But really, there’s two elements that drive trust situations.

One of them is uncertainty, and the other is vulnerability — that is, people are uncertain about what others are going to do (they don’t know what’s going to happen in the future), and they’re vulnerable to what those other people do to the extent that their interests and those other people’s actions are intertwined.

So, the trick for dealing with a trust situation is really addressing these two key elements: either trying to deal with uncertainty by acquiring more information and learning (or trying to figure out) what is likely to happen in the future.

…Or by managing your vulnerabilities and thinking about ways to mitigate or reduce the impact (or the potential harm) that others’ actions, future actions, could have on your interests.

So, this kind of sets up a generic recipe book for how to deal with trust situations. How do people trust?

People rely on a lot of heuristics, rules of thumb, to decide who is trustworthy and who is not, and that distinction is really important because you can’t go through the world trusting everyone, and you can’t function in the world if you trust no one.

And so, what you have to do at the simplest level, is kind of put everyone into two bins: there’s people that are trustworthy; there is people who are not. And you want to be able to trust the trustworthy and avoid those who are not trustworthy

I’m going to offer a couple of distinctions that help clarify the discussion of trust. And one of them is the difference between trust and trustworthiness. And this really speaks to who is doing the trusting and who is being trusted.

One party trusts the other, and the other party may or may not be trustworthy — that is, they deserve the trust. But someone who is trustworthy may not be trusted, and someone who is trusting may end up trusting someone who is not trustworthy.

So, these two things have to be kept separate. Another distinction is the distinction between generalized and relational trust.

Generalized trust really speaks to the question of how you deal with strangers. Do you trust abstract institutions? Do you trust the average citizen that you might run into on the street?

That kind of a thing — where you’re really dealing with someone with whom you have no relationship and about whom you have no prior information. What kind of ambient or generic level of trust do you have?

Relational trust is, what happens after you start to get to know someone? What happens after you start to develop a social relationship?

You have a history together; you have contracts; you have prior transactions. That is a very particular and non-anonymous form of trust, and it is really driven by the nature of the interaction that you have with that individual.

Other pages in Videos:

Pages in The Trust Project at Northwestern University