Trust: a transaction cost influencing psychological mechanism

Our world is more and more characterized by complexity and interdependency. In the developing New Economy it is expected that the role of information and knowledge transfer, along with the role of cooperation, are some of the most important issues. Some psychological mechanisms, such as trust, will be instrumental ingredients of the new economy. It is speculated that the functioning of such complexity-reduction and cooperation-aiding, such a psychological mechanism as trust becomes a focal point of interest. This paper aims to clarify the workings and influence of trust on economic transactions, prices, and cooperation. Jorurnal of Economic Literature (JEL) code: D8, L14, P22 1 This paper is a part of the research carried out in the Information Economy and Identity Scientific School sponsored by the Hungarian Scientific Research Fund under the TS. 40768. research agreement. Paper presented at the conference on “Institutional and Policy Diversity – Its role in Economic Development”, Debrecen, Hungary, 3-5, November 2003. László Tóth is a member of the Information Economy and Identity Scientific School. E-mail: latoth@hotmail.com During the past century, mainly as a result of the rapid development of technology, humanity had gone through a change that had never been experienced before. Our world, including the world of economics, is more and more characterized by complexity and interdependency. In every aspect of life, people face an increased number of choices. As a result of the increase in the quantity of options, it becomes ever harder to predict the results of our decisions (Sztompka [1999], pp. 13.), or rather it becomes ever harder to make decisions that are economically rational. Because of these developments, the importance of well established complexity-reduction psychological mechanisms, such as trust, increases significantly. As the result of the technological boom a new era began, in which neo-classical economic theory proved inapt to explain various economic phenomenon. Partly because of this, in the past decade, the basic assumptions of neo-classical economic theory, such as profit maximizing, totally informed homo oeconomicus model, has received a countless number of criticisms. In economic science the homo oeconomicus model is used in order to help analyze economic phenomenon without bringing in the human factor with its complexity. However, in the new economy it becomes crucial to shift the focus from product characteristics to human beings interacting in their transactions and to their existing relations among each other. The main reason for calling for a shift in focus is that the characteristics of the new economy are significantly different from the characteristics of industrial society and economy. The organizations are larger and more complex than ever before, and at the same time they are less and less circumscribable. At all levels of the economy the mutual interdependence of the actors is growing (Sztompka [1999] p. 12.). The number of professionals with specific skills and knowledge in the job market has rapidly increased. These so-called specialists differ from the traditional workers in the sense that they are less interchangeable with others, as well as their skills in the given field are significantly higher than of their peers. For the professional completion of a complex task, there is a need for a highly specialized workforce, and a need is present for well-coordinated joint work of these specialists. Because of the rise of interdependency in the economy, there has been a call for a shift in the focus of economic science from competition to cooperation. According to Misztal ([1996] p. 269. – in Sztompka [1999] p. 12.), as the result of the growth in global interdependency, trust has become an essential element of cooperation. „Trust increases the efficiency of exchange by reducing the expectation of opportunistic behavior and consequently lowering associated transaction costs” (Bromiley and Cummings, 1995; John, 1984; in Bichierri, et. al. [2002]). Of course the importance of trust had been recognized long ago by economists; however, only today has it become necessary to re-examine this factor in relation to the workings of cooperation, to the formation of prices, and to the transpiration of transactions in the market and inside the organizations. The general role of trust in the economy Virtually all economic transactions include an element of trust as a building block (Arrow [1972]). Without trust the possibility of mutually beneficial economic transactions occurring decreases, and the chances for cooperation declines. „The result is lower economic welfare through less than optimal specialization and arguably lower social welfare more generally, as altruistic preferences remain unfulfilled” (Raiser [1996] p. 16.). Social scientists view trust not only as a lubricant of cooperation (Dasgupta [2000]; Sztompka [1999] p. 62.) but also as the lubricant of the entire „engine” of the social system (Hámori [1998] p. 89.). People, who do not trust in others will only cooperate in a system of formal rules and 2 For instance, „in the European Union, one half of the available workforce is outside the organization, not in full-time jobs” (Handy [1995]). regulations. Establishing and running such a system, the adherence to the regulations and the enforcement of the rules, creates a special type of tax in a society that operates under a low trust environment (Fukuyama [1995] pp. 27-28.). According to Fukuyama such an overregulated system is characterized by immensely long and complicated contracts, by the tendency for the rejection of innovative ideas, and by the inclination for settling disputes through legal means. The absence of trust, by increasing transaction costs, cuts down on the number of possible transactions, it reduces the chances of the realization of new ideas, and therefore it lessens overall economic potential. The problem of trust – mistrust, of course, is not a new phenomenon. When commerce became part of everyday life, in order to handle mistrust among actors in a transaction, people mechanized trust, in the form of locks and scales. Later when commerce grew into a more complicated system, there was a need for another type of manifestation of trust; that is, when laws, contracts, regulations and other abstract forms of trust appeared (Fitzpatrick [2001]. In an ever more complex and rapidly changing society, the level of predictability declines quickly, and the above mentioned forms of trust are unable to counter the growth of uncertainty. The special role of trust in the knowledge or information economy In the transactions of the new economy the role of information becomes a central issue. Information by itself or bundled together with any product emerges as the most important commodity of the new economy. Information differs from other products produced by the economy, for instance, from a pair of shoes, in a sense that it cannot be touched or inspected before purchase. Products bundled with information content to a certain degree can be inspected, but it is not so with products completely built of information. Once information goods are examined by the buyers, it turns out to be useless to purchase them, since their content has already been revealed. Therefore, the magnitude of the information asymmetry between the buyer and the seller, as explained by Akerlof (1970), will be much larger than in the case of traditional products. In transactions where information goods are traded, trust can greatly influence the price at which the product or service will be exchanged. The price of information is mainly determined not by its information content, but rather by the information connected to the product, such as who produced it, who sells it, and in what manner the buyer can use the product after purchasing it. Although the price asked by the seller could provide a signal to the buyer about the quality of the products or services, in practice it is unlikely that the price is an apt clue. After all, no one would choose either the least nor the most expensive surgeon for an important surgical procedure based only on this cost information. One would probably decide along another dimension. „The critical problem for the commercial providers of content is to find a way to convince the user that they actually have timely, accurate, relevant, and high-quality information to sell” (Varian [1998]); that is to say the content providers problem is that in what manner can they influence the trust level of the buyers. Within the knowledge management literature, especially in the practitioner oriented approach, it is a common occurrence to see statements such as: „Trust is, after all, the single most important precondition for knowledge exchange” (Rolland and Chauvel [2000] pp. 239. – in Ford [2001] p. 3.). This statement is particularly true in the case of tacit knowledge. One of the most important problems for organizations is the issue of handling this type of knowledge transfer among members of the organization. It is especially true for organizations 3 Transaction cost. „Keefer and Knack (1997) have recently found a positive association of trust to economic growth, where trust is measured by the degree of confidence individuals would have in an anonymous counterparty” (Raiser [1999]). 5 It could be the reputation of the doctor, or of the hospital. in the new economy, where in the global environment the two or more parties in a transaction do not know each other at all, the geographical distance between them is significant, their cultural backgrounds differ, and often their only mean of communication is electronic. Technological innovations, such as the Internet, allowed us to create a global marketplace. In this virtual marketplace a pricing mechanism often found in classical markets came to the front: bargaining. Fixed prices are characteristics of other parts of the economy, where