The Limits of Contracting and Trust: Key Findings

Research

CONTRIBUTOR / Niko Matouschek

ALVIN J. HUSS PROFESSOR OF MANAGEMENT AND STRATEGY
KELLOGG SCHOOL OF MANAGEMENT / Economics

Contracting is a critical tool for enabling economic exchange, but its effectiveness can be hindered by several factors, including a lack of enforcement mechanisms, high costs, and the fact that relevant information is sometimes missing. These limits create an important role for trust, which fosters exchange by rewarding sellers who are “good types”—that is, they are committed to keeping their promises, and they positively influence the behavior of other sellers. Trust also creates incentives relating to the power of reputation in cultivating relationships.

Transcript

The economic literature on trust really builds on and grows out of the neoclassical models of the economy that people like Arrow and Debreu worked on in the 1950s.

Now, in these kinds of models, by design, there’s no role for trust, because either the market participants can verify the quality of the product on the spot or they can costlessly and perfectly contract with each other.

Now, even though there’s no role for trust in these models, it’s still a useful starting point for us because if what you’re trying to do is understand the role of trust in an economy and to what extent it limits the efficiency of the economy, you need to have some comparison point — because if what you’re trying to do is understand to what extent the lack of trust limits the efficiency of markets, we need to compare that to something.

And a natural comparison point is an economy in which there is no lack of trust.

The other reason for why these neoclassical models are a useful starting point for the literature on trust is that they highlight the fact that there’s no role for trust if contracting is perfect. And so, to understand trust, we first have to understand the limits of contracting.

BUMPER: Economics of Contracts

That’s what brings me to the literature — the economic literature — on contracts. And one way to think about this literature is in terms of the different types of impediments to contracting that you might be concerned about.

One of them — one that’s probably less well known in the literature but I think important to the current context — are problems with enforcement. Suppose that the state, the government, doesn’t enforce contracts or doesn’t do so efficiently, then what do we do?

Here, Diego Gambetta has this fascinating book about the origins of the Sicilian mafia, in which he argues that the core function, at least initially, of the mafia was to serve as essentially a contract enforcement agency that regular businesspeople would go to when they’re trying to write a contract in which they’re committing themselves to some future action.

Other strands of the literature look, for instance, at just the cost of writing contracts. Suppose there’s no problem with having contracts enforced, but writing contracts itself is costly. My colleague Ron Dye, here at Kellogg, wrote one of the first, if not the first, paper on costly contracting, essentially.

Then there’s the enormous literature on, essentially, endogenous contracting costs, where contracting’s costly because the parties can either take hidden action or there’s a problem with hidden information.

And then finally, there’s a strand that looks at what we call “incomplete contracting” — that is, it’s trying to capture the idea that sometimes we’re simply not able to describe in words the kind of product or service that we’re trying to trade later on.

BUMPER: Economics of Trust

Once we understand the limits to contracting, we can start talking and thinking about trust and the role of trust in the economy. Here, there are really two literatures.

The first one essentially assumes that there’s at least a small number of sellers who, for whatever reason, are committed to selling a good product. They’re committed to keeping their promises.

And then, the question is, what’s the implication of the presence of these good-type sellers, if you want, for the functioning of markets?

Now, one set of papers, which is called the “Gang of Four” papers, is concerned with the incentives of the bad types, if you want — the ones who are not committed to always doing the good thing — to mimic the good agents.

So, we’re trying to understand, to what extent is this mimicking behavior possible, and how does it affect the functioning of markets?

If the literature on reputation games is about good agents, the literature on repeated games is about good incentives. Here, the starting point is to not assume that there’re good agents: everybody just does what’s in their own best interest.

Now, the question is, in that kind of situation, to what extent can repeated interaction, repeated transactions between these agents, allow them to commit to not break their promises?

Now, the key issues here turn out to be to what extent the agents are what we call “patient” — to what extent do they care about future business versus current business?

And the other is transparency — to what extent can current agents observe what has happened in the past? Whether, for instance, I really have broken my promise in the past or not.

BUMPER: Applications and Empirical Evidence

Finally, we can talk about applications and empirical evidence. One application that people have looked at is to what extent reputations are attached to corporate names and can then be traded in the market for corporate control.

The goal is, here, to try to understand to what extent this motive of trading reputation can explain real-world mergers and acquisitions.

Another application that people have studied is the market for illegal drugs, which is exactly the kind of market in which trust is important because if I’m buying drugs from you, A) I can’t verify on the spot the quality of the product, and B) we can’t write contracts.

And so, this is exactly the kind of market which only works if there’s trust between the buyer and the seller.

But in contrast to other markets, this is a market that the government may want to undermine. And it may try to undermine it by undermining the trust between buyers and sellers.

And so, then you can ask to what extent you can do that — for instance, by designing sentencing guidelines appropriately.

In terms of historical studies, the most famous are probably by Avner Greif, who looked at trade in the 11th century, a time when the trading partners couldn’t rely on the governments to enforce contracts.

He studied community-enforcement mechanisms that allowed these parties to transact nevertheless. Essentially, if you cheated on a transaction, then you were going to be punished not just by the counterparty of that transaction but by the community at large. And that provided you with incentives not to cheat in the first place.

The most recent studies use big data sets to try to understand reputational incentives in the marketplace.

My office neighbor, Tom Hubbard, for instance, has this really interesting paper about incentives in the market for car repairs — which, again, is a market in which trust is really important because if I, the car repair shop, tell you that you need a repair, you don’t really know whether you need it or you don’t.