The Limits of Contracting and Trust: Key Findings

Contracting is an important step in building an international trust economy.


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.


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.

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Understanding trust economics can lead to breakthroughs in the market.

Trust in Transactions: An Economist's Perspective

Contributor / Niko Matouschek
Niko Matouschek Economics Economic Exchange,Economics,Legal Guarantees,Long Term Focus,Mergers and Acquisitions,Regulation,Reputation Management,Social Psychology 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.
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

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.
Although credit reports adequately quantify trust, they are not necessarily the best thing to base relational trust on.

Jacked Up Ratings: Problems with Quantifying Trust

Contributor / Bruce Carruthers
Bruce Carruthers Sociology Credit,Government,Measurement,Sharing Economy BUMPER: Jacked Up Ratings: Problems with Quantifying Trust

One of the things that happens is, as we rely on quantitative measure of underlying features, like a quantitative measure or score that measures somebody’s creditworthiness or how trustworthy they are.

As these scores become consequential, as people start to take them seriously, and as they are used in actual important decision-making, there’s an incentive for people to corrupt them, to game them, to stop paying attention to what it is they’re measuring and instead focus on the measure.

And there are a couple of really clear examples of this becoming a big problem.

And one was, in 2008, people realized that the bond rating scores that had been attached by Moody’s and S&P and Fitch and whatnot, and that were attached to asset-backed securities based on subprime mortgages.

That the investment bankers and the rating agencies worked together to try to jack up the ratings as high as possible so that whenever outside investors looked at a security, they saw, “Oh, it’s AAA. Well, that’s great.”

Had they been savvy (and now they’re very savvy because they know what the problem is), they might have realized that, in fact, that AAA rating was a score that was kind of jacked up.

And so, I think in a world in which the quantitative information becomes increasingly important, what you have to do is be a sophisticated consumer of numbers and always be mindful of their limits and vulnerabilities. And you simply cannot take them too seriously.

BUMPER: Re-Engineering Trust with Peer-to-Peer Lending

Peer-to-peer lending is a very interesting experiment that, again, takes advantage of the IT revolution.

It used to be that if you were going to do peer-to-peer lending, it was going to happen in your small hometown. Those were your peers.

Those were the people who could trust you, who knew about your business, who might be willing to lend to you or whose business you knew about and to whom you might be willing to lend.

And what we’ve done is, we’ve sort of disconnected what used to be the high correlation between social knowledge and geographic concentration.

And so, peer-to-peer and similar models are re-engineering some of the differences between relational lending and relational trust and generalized trust in very interesting ways.

It’s a re-articulation of the connection between personal and impersonal. It’s a way of saying, “We can personalize what would otherwise be a default impersonal situation. We can create peers out of people that aren’t even in the same country.

Other pages in Videos:

Pages in The Trust Project at Northwestern University