Contracting with uncertain level of trust

Abstract

The paper investigates the impact of trust on the form and the terms of contracts. A formal model of a bilateral game between a buyer and a seller is presented. The paper focuses on the case where the level of trustworthiness of the buyer is uncertain. It is shown that if the seller's trust equals the buyer trustworthiness, then the social welfare, the amount of trade and the agents' utility functions are maximized. It is demonstrated that underestimating the buyer's trustworthiness tends to harm both agents. The role of advance payment contracts for improving trustworthiness is discussed. It is shown that in the case where the buyer is distrusted, advance payment contracts are efficient in terms of amount of trade and social welfare. It is proved that in this case both agents prefer an advance payment contract to a standard uncertain payment contract. Advance payment F-contracts are proposed. It is proved that these contracts are incentive compatible and that they eliminate inefficiencies caused by asymmetric information about trust.