Trust in Transactions: An Economist's Perspective

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.