Thursday, 10 September 2009

Trust in Markets

Sam Robbins and I attended a fascinating workshop yesterday at the OFT, titled Trust In Markets.

It covered three areas: the nature of trust and its importance in economic exchange; trust and the law; and how trust is manifested in some specific industry sectors (online marketplaces and finance).

I'm especially interested in trust as an economic concept. Clearly trust is an absolute prerequisite for many kinds of economic systems to even function. Any system in which transactions are not instantaneous; anything where the quality and nature of the product is not fully known in advance of purchase; and any financial system where credit is offered - will operate smoothly only if parties broadly trust each other. The crowning theory of microeconomics, the Arrow-Debreu theorem, can only work where futures markets are available - and futures markets can only work if parties know that their contracts will be honoured over time.

Sometimes trust can be replaced, in the short term at least, by physical enforcement of contracts. But the transaction costs involved in enforcement are so huge as to act as a huge drag on market efficiency, and few if any markets in the real world can rely solely or even substantially on enforcement.

So trust is fundamental to the operation of free markets. But how much do people really trust each other and what does this mean in an economic model? If I enter into a transaction with you, I want to trust that (1) you'll act with honesty and good faith; (2) you will actually be able to deliver what you say you will; (3) that we both clearly understand what we're actually agreeing to do. For a perfect market to work, all three of these kinds of trust should be perfectly fulfilled.

In the real world, though, none of them are completely true. So how far are the buyer and seller from this ideal in any given transaction? How close do they need to be for the transaction to work?

And in a series of transactions between similar parties, how much cost can be absorbed in the early iterations in order to gain trust to make the future ones more profitable?

If we don't have full trust in each other - perhaps because we don't know each other - what institutions, frameworks or third-party services can supplement or replace this trust?

The idea of building a model of trust has been investigated broadly in computer science, so Kieron O'Hara was on the panel with a nice starting point for what trust might mean. But in economics, the concept hasn't been widely modelled.

For example, a recent article which touches upon the concept is Competition builds trust by Francois, Fujiwara and van Ypersele at VoxEU - but this is an econometric study which takes trust as a simple survey measurement and does not examine it cognitively. Similarly, Greg Mankiw asked a few weeks ago what kind of institutions we trust but doesn't explore what it really means to trust something.

So the above questions point the way to what model of trust might be incorporated into a larger cognitive-behavioural theory of economics. Any model that we propose should give us a way to answer, or at least examine, most of these questions.

The conference stimulated a lot of other ideas so I'll be posting more about this in the coming weeks - including a first version of my economic model of trust.

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