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The list of mechanisms for coping with time inconsistencies, informational

asymmetries and potential abuses of information includes contracts of various kinds, and

regulations. Trust itself might be added to this list, viewed as a simpler and less

expensive avenue for carrying on exchange in the presence of informational and other

problems. Parties that are fully trusting of each other still need to work out the details of

their relationship, but they do not need to stipulate incentives and penalties in advance,

and if successful, they will not need to spend resources on adjudicating conflicting

claims.

At a broad level, the degree of trust that prevails among parties to economic

transactions depends on a number of factors. Trust has been observed to vary across

countries (e.g., Yamagishi, 1988, Greif, 1994, Fukuyama, 1995, and Buchan and Croson,

1999), and it has been suggested that high-trust cultures enjoy better economic results

because they can execute more transactions at lower cost. An interesting question

concerns the relationship between the maturity or level of development of a market

system and the level of trust in a society. Is there less trust, or more, between agents

transacting in a developed economy that relies on large and anonymous markets, as

compared to a less-developed economy that relies on interactions among small numbers

of traders? Was there more trust in the old economy than in the new economy? What

economic responses are being engendered by the changes in trust levels?

In this chapter, we will develop a framework for understanding the determinants

of trusting by, and trustworthiness of, economic agents. We do so first at a general level,

and then as applied specifically to electronic commerce. We show how the insights of

evolutionary behavioral science and the findings of experimental economics can be

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integrated with game-theory to provide a realistic yet rigorous account of trust. And we

investigate how the human cognitive machinery that evolved in settings of face-to-face

interactions in small groups not only impinges on, but helps to make possible, those leaps

of faith in the absence of which electronic commerce could not be conducted.

Definitions

The new economy has been variously characterized as the information economy

and the knowledge economy.3As we see it, the new economy represents the

culmination of a long process of accumulation of scientific and applied knowledge in

diverse fields. The digital revolution acted as a catalyst and an enabler of breakthrough

achievements in many fields, by permitting the rapid storage, retrieval, communication,

and analysis of vast amounts of information, both quantitative and qualitative. In this

sense, the new economy is the information economy.4This economy requires

comprehending, analyzing, and synthesizing large amounts of information, which in turn

typically require greater knowledge both general and specialized as well as the ability

to execute complex tasks. The complexity of tasks has increased, and, in this sense, the

new economy is also the knowledge economy.

When we say that A trusts B we mean that A believes that the probability that

B will not harm her, or that B will live up to his commitments, is high enough to warrant

some potentially risky action on As part (Gambetta, 1988, Dasgupta, 1988, and Kreps,

1990; Williamson, 1993, Ben-Ner and Putterman, 2001, and others use similar

3Hakkio (2001) provides a useful overview; see also articles in Litan and Rivlin (2001).4De Long and Summers (2001) compare the digital revolution to (what William Nordhaus called) theillumination revolution, but argue that the latter did not create a new economy (De Long and Summers,2001).

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definitions). The trust that A places in B is a state of subjective belief which can be

indexed by the probability that A attaches to Bs choosing a desirable response.

However, we can sometimes measure this trust by observing As choices. The extent of

trust is a function of both characteristics of A and B and of characteristics of the situation.

Among these characteristics is Bs degree of trustworthiness, an attribute that is

determined by the costs and benefits associated with building and maintaining a

reputation, the cost and ability to deceive, the agents preferences and values regarding

acceptable modes of behavior, and the anticipated actions of other parties that bear on the

costs of engaging in prohibited behavior.

Reputation

Reputation is the perception others have of an individual or institutions

character or, in the term used by economic theorists, type. A retailer may have a

reputation for selling high-quality goods, another a reputation for being a cheap outlet for

low-quality goods. An individual may have a reputation for being honest and reliable,

another a reputation for being late to meetings; and so on. Depending on circumstances, a

reputation may be widely or narrowly known among potentially interested parties, and it

may be strongly or more tentatively held. The stronger the reputation of B for a certain

character, the likelier it is that party A will know what kind of action to expect of B (the

more concentrated the distribution of expectations of Bs actions held by A); and

assuming a favorable reputation, the stronger will be As trust in B.

Economic analysis is helpful inanalyzing the incentives B faces to live up to his

word. If there will be other opportunities for interactions between A and B in which

having A judge B to be relatively trustworthy would be to Bs advantage, then it may be

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worth Bs while to invest in such trust by carrying through on his promise. Consider, for

instance, the trivial example in which the same transaction will be repeated between A

and B an unknown number of times. Simply giving A and B the common knowledge that

the transaction will be repeated without a pre-specified end point may lead A to reason

that it is in Bs interest to keep his promise. Thus, B becomes more trustworthy in As

eyes, ceteris paribus, the longer the prospect of ongoing interaction, without implying

any change in Bs underlying character.5

Reputation with third parties has essentially the same effect. Suppose that A and

B are among twenty individuals or firms that engage in a certain type of transaction

repeatedly, each time being randomly assigned to a new partner. If the actions of each

party are made known to the others in a sufficiently transparent manner, then B has

reason to fulfill his promise to A even though he may not interact with A herself again. B

fulfills his promise because it raises the likelihood that other parties will choose to trust

him when he is assigned the same position in interactions with them. By contrast, if

information does not travel beyond the pair of interacting parties, and if the chance of

interacting with the same party twice is small, B has less incentive to follow through on

his promise to A.

The structure of interactions can be expected to impact not only on Bs behavior,

but on As expectations about Bs behavior. When A and B are informed that the result

of their interaction will be broadcast to other parties and that the interaction will be

repeated many times among randomly paired members of this group, A has more reason

to trust B than if their interactions were private information only, since she knows that B

5This is an extremely simple rendition of the standard model of reputation; see, for example, Kreps (1990)and Gibbons (2001).

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has an incentive to reciprocate now so as to earn a reputation that will help him in future

interactions.

Third-party enforcement

The trustworthiness of an agent may be bolstered by assurances provided by third

parties such as the government, courts of law, or even mafia enforcers. Party A may trust

B to deliver goods for which A has paid, for example, because there is sufficient

probability that B will be incarcerated if he fails to do so. Rather than relying on signals

of trustworthiness, such as reputation for behaving in a certain way or keeping promises,

a party to a transaction may obligate itself through an enforceable contract or be forced to

behave in a trustworthy fashion due to regulation. A can trust B if the expected penalty

for misbehavior is higher than the expected gain that can be obtained by violating the

promise.

Preferences and values

So far we have grounded trustworthiness in considerations based solely on Bs

self-interest. But Bs trustworthiness may also be grounded in his or her preferences,

values, or moral character. We can distinguish between preferences that are self-

regarding, ones that are other-regarding, and ones that are process-regarding (Ben-Ner

and Putterman, 1998). The self-regarding dimension is the usual concern for ones self-

interest; the other-regarding dimension is Bs concern, if any, for As well-being. If A

knows B to have a sympathetic regard for her, she has more reason to believe that B will

follow through than if she knows B to be indifferent to her or to despise her. The law

favors parental trusteeship in matters pertaining to their children because it attaches a

high probability to other-regarding preferences toward a child. But other-regarding

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preferences may also be important among friends, neighbors, members of the same

ethnic, or occupational group, etc.

Process-regarding preferences are those concerned not with the effect upon a

particular other person, but with adherence to a norm, rule, or principle. Of special

relevance for trust are norms of truth-telling and of adherence to ones word. Another

relevant norm may be fairness. If A believes that B cares about fairness and that B

believes the deal that has been agreed to is a fair one, this will raise Bs trustworthiness in

As eyes. A perception by A that B is concerned about fairness could be one reason why

A does not try to push B to agree to a worse deal, for A may believe that B would

consider such a deal to be unfair, and would therefore be less likely to implement it.

Economicsexperiments provide evidence for the presence of other- and process-

regarding preferences. When asked to accept or veto a division of money proposed by an

anonymous co-participant, subjects in the ultimatum game (see Camerer and Thaler,

1995) regularly reject offers perceived as unfair, even though this means rejecting a

positive sum in favor of nothing. Invited to divide a sum when the other subject is denied

the right of refusal, most subjects (in the dictator game) still choose to share positive

amounts. The degree of other-regardingness or of adherence to norms of fairness seems

to vary with gender (Andreoni and Vesterlund, 2001, Eckel and Grossman, 2001, Ben-

Ner et al. 2001a, 2001b), with social distance (Hoffman, McCabe and Smith, 1996), with

confidentiality from the experimenter (Hoffman et al., 1994, Eckel and Grossman, 1996),

with ethnicity of divider and recipient (Fershtman and Gneezy, 2001), with culture

(Henrich et al., 2001), and with personality as measured by psychological profiles (Ben-

Ner et al., 2001a, 2001b).

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Another process-regarding preference of importance to trust for which economics

experiments provide evidence is reciprocitythe tendency to deal generously with those

who treat us kindly and to incur costs to punish those who cheat us. Under some

circumstances, a rational self-interested actor will feign reciprocity in a repeated

interaction if others are believed receptive to signals of type.6 But this should not be the

case among self-interested players in a one-shot game. Nevertheless, Fehr, Gchter and

others (summarized in Fehr and Gchter, 2000) find that most subjects respond positively

to more generous offers in simulated employment relationships, and that they both punish

and anticipate punishment for violations of expected reciprocity or adherence to a norm

of mutual cooperation. McCabe, Smith and collaborators find many of their subjects

reaching higher-paying equilibria by risking and reciprocating cooperation (see Hoffman,

McCabe and Smith, 1998). And Ben-Ner et al., 2001b, find a tight correlation between

the amounts their subjects were given in a one-shot dictator game and the amounts each

shared with the same anonymous subject when their roles were unexpectedly reversed.

These experimental findings suggest that many individuals are trustworthy even

in the absence of repetition, reputation, and enforcement. Where do such preferences

come from, and how might they be anticipated, so as to influence trust in market

interactions? Work in the socio-biological and evolutionary psychological genres by

biologists, anthropologists, psychologists, and economists suggests that a perfectly selfish

and rational human species is implausible, and that evolution rather imbued human

beings not only with altruistic sentiments towards their offspring and other close kin, but

also with other predispositions including (a) a concern with how one is viewed by others,

6See Kreps, Milgrom, Roberts and Wilson (1982). If there is common knowledge that all individuals arestrictly self-interested, then there is no rational basis for engaging in reciprocity in a finitely repeated game.

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(b) an inclination to attempt cooperation when facing positive-sum interactions of the

social dilemma variety with persons in similar positions, (c) a tendency to keep track of

whether cooperation is reciprocated and to seek to punish cheaters, and (d) a receptivity

to certain kinds of moral reasoning, paralleling the pre-disposition to grasp grammar.

Cultural selection is also argued to have influenced the evolution of social norms because

societies with different degrees of success (e.g., in fostering internal cooperation and

controlling internal conflict) were differentially successful in propagating their values

(Boyd and Richerson, 1985; Henrich, forthcoming). The preferences of the acculturated

individual are phenotypic expressions of the genes, and are affected by a variety of

environmental influences and cues. This includes interaction between self-interested and

other- or process-regarding preferences: for instance, one who has frequent self-interested

incentive to behave as if honest by nature may come to be habitually honest and to value

this as part of her self-image (Ben-Ner and Putterman, 1998 and 2000).

Trusting

In addition to As perception of Bs trustworthiness, the probability A attaches to

Bs choosing a desirable response is influenced by a number of other factors. First,

trusting is enhanced by the trustors ability to detect deception.7 Although it is rooted,

perhaps, in a universal human alertness towards and talent for the detection of cheating in

social dilemmas (Cosmides and Tooby, 1989), A will be more confident of her ability to

detect potential deception the more access she has to information regarding potential

partners reputations, the more experienced she is in gauging trustworthiness, and the

7Deception is not the only thing that transactors fear; they are also concerned with incompetence andunintended errors. But for simplicity, we ignore honest mistakes in most of this discussion.

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better her knowledge of the distribution of types of potential partners. Some of our

ability to evaluate a partners honesty depends on capacities to read facial expression,

vocal intonation, and body language, which makes it of interest to see how reputation

transmission and character appraisal function in the context of electronic commerce.

Whether A has a broad inclination to trust, independently of facts and information, may

also color her likelihood of detecting deception.

Information

An agent who is better informed about her potential partners will, on average,

earn more from a sequence of interactions, permitting choice of partners, than will an

otherwise identical but less informed agent. Information about trustworthiness may be

passed via word-of-mouth through social networks, culled from media reports,or

obtained from formal records and compilations such as bankruptcy records, consumer

reports, and so on. The better social networks, media, and formal information processing

institutions like banks work, the better the information individuals have about parties

with whom they may transact, and the greater the trust they place in their transactions.

The most important sources of information about the trustworthiness of potential

trading partners are direct experience and word-of-mouth in social networks.8 Denser

social networks, with more interactions among the individuals involved, offer more

opportunities to exchange information. Another factor is the strength of the links among

members, including their affective qualities. It is possible that the shorter the distance

among members of the network the more trustworthy they will be. Distance is a

8See Granovetter (1995), who argues that people rely on contacts acquired through various social and worksettings to obtain information about potential career opportunities. Putnam (1995) contends that the level oftrust between individuals increases when the level of their social interaction increases. See Sobel (2002)and Manski (2000) for different perspectives.

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multidimensional concept, which reflects salient attributes of the individual, in some

cases including, for instance, ethnicity or socio-economic class, and how he or she relates

to others as a function of these attributes.

Preferences and values

As own preferences and values also affect the probability that A trusts B.

Differing experiences probably interact with differing inherited dispositions to make

some people more trusting than others. Some marketing professionals take advantage of

this variation. For example, in the summer of 2000 a trial of the company Publishers

Clearinghouse uncovered the existence of mailing lists of so-called suckers, people who

are trusting, and of people who are not trusting. Another aspect of preferences is As risk

attitude. Individuals who are equally trustingi.e., attach equal likelihood to B not acting

harmfullymay differ in their actions due to differences in their risk attitudes, with the

more risk-averse individuals acting as if they were less trusting.

Interactions between trusting and trustworthiness

Seeing trusting as judgment by A of the trustworthiness of B leads to

consideration of actions that B may take to influence As perceptions. We have already

referred to certain situational factors that can affect As estimate of the likelihood that B

will follow through on a promise. Sometimes measures under Bs control can raise his

trustworthiness as perceived by A. For example, B can raise his likelihood of being

trusted by A by taking steps that increase their chances of future interaction or that assure

that what he does in the present exchange becomes public knowledge, and that A knows

that it does. Becoming genuinely trustworthy by way of, say, an active religious

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affiliation, and conveying such trustworthiness through ones overall demeanor, may be

one more way for B to gain the trust of others.9

There may also be measures under As control that can increase Bs

trustworthiness. Consider, for instance, that the more B has to lose by reneging on his

agreement with A, the more sensible it is for A to trust him to fulfill his promise. One

way to make B more trustworthy, then, is to hold out the prospect of an ongoing stream

of rentsearnings above that of the next best alternative exchangeby offering B a

favorable share of the gains from trade (Klein et al., 1978).

Since reputation and the prospect of future interactions play a large role in

deterring breaches of trust, the coming into view of a previously unpredictable last period

can be a serious source of concern to party A. In true end-game play, there is nothing

to deter Bs misconduct apart from a trustworthy character. Although the appearance of

end-game conditions may be impossible to predict with much accuracy, the probability

that they will arise is nonetheless greater in some kinds of relationships than in others,

and this may be taken into account by the prudent agent A. Where the chance of the

unpredictable arrival of such an end-game is substantial, it is desirable to find a partner

who not only has strong strategic reasons to be trustworthy, but who also is honorable

and trustworthy by character, and who will not change his behavior when strategic

motivations are removed. All else being equal, partners deemed to have such qualities

would be in greater demand in such instances. Whether a companycan have a

trustworthy nature as opposed to simply surrounding itself with well-advertised

incentives to return trust, is an open question. But it is important to what follows that the

9B might also, of course, engage in acts intended to create the impression of good character without havingsuch a character in actuality. Tadelis (1999) and Bacharach and Gambetta (2001) discuss this sort ofsituation.

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human psyche may have a strong inclination to relate to companies as if they were

persons, and thus to impute characters to them, whether or not there is a possibility of

their having them.

From the Old Economy to the New Economy: Technological, Economic and Social

Changes and their Effects on the Determinants of Trust and the Level of Trust

In this section we investigate the effects of changes associated with the new

economy on the factors that determine trust in diverse business transactions, and we

evaluate the net effect on trust in various areas of economic activity.

Information collection, transmission, retrieval and analysis, and communication

It is worth restating the well-known fact that the availability of information of

almost any kind has increased enormously in recent years, and that the tools for

processing information have advanced in great leaps as well. This provides a much

improved basis for decision-making, and for faster decision-making and execution of

decisions in the new economy than in the old.

When considering buying a product afflicted by considerable asymmetric

information, buyers have several options. First, they can go to established organizations

and hope that their sustained existence is proof of their reliability. Second, they may

inquire about the reputation of organizations with which they consider transacting,

seeking information through their social or business networks, professional organizations,

and business publications, and so on. The new economy adds to this the wealth of

information on the Internet, which complements and supplements the first two options.

The Internet is abuzz with information brokerage about a large number of manufactured

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goods as well as services such as hospitals, financial products, and daycare centers. Much

of the information is presented in raw form, which lends itself to extremely useful

analysis, but also to misunderstanding or misrepresentation by unskilled and

unsophisticated users.10 Individual buyers and sellers reputations become enshrined in

records, such as those maintained by online auctions houses like eBay.11

Chat rooms

operated for the benefit of specialized professionals provide an efficient forum for the

distribution of information about economic agents. The Internet provides an invaluable

source of comparison of prices and product specifications available at a fraction of the

cost of that which was available in the old economy.

The rapid collection and transmission of high-quality information reduces

asymmetric information in most areas of commerce, contributing to the production of

trust in various markets. But along with the collection, storage, and transmission of

valuable information there is also trading of valueless information that requires resources

to wade through, as well as malicious information in the form of rumors intended to

misinform.12The vast amount of information may overwhelm some users who cannot

digest it, cannot discern important from unimportant information, cannot separate good

information from bad, or cannot analyze it correctly. The less informed and the less

10Information about mortality rates for specific hospital procedures falls in this category. A low mortalityrate may mean that a hospital is better than higher-mortality hospitals, but it also may mean that thehospital deals only with easy cases. As economists know full well, only careful analysis (in the case ofhospitals, of the case mix) can help make sense of even the best and most detailed data. (We thank BurtonWeisbrod for providing this example).11

On eBay the general transaction records of each buyer and seller are public for all to read, as are thecomments of their transactors. Of course, it is possible to assume new user identities, but that reduces thesize of the record and therefore curtails the possibility of building a reputation. And it is always possible toplay an endgame, as some sellers have done in order to commit fraud. Buyers in particular are known to beweary of new sellers, and they are less likely to make purchases from sellers who have received negativecomments. Buyers assume all risk, as eBay does not provide guarantees or warranties for goods traded onits site, yet fraud seems to be quite infrequent, suggesting that the mechanism described above works well.Statistics about fraud on the Internet, separately for auctions, are provided at the end of this section.12Not all rumors are malicious in intent or consequence. A common rumor is spread in order to affect theprice of a stock to the advantage of the rumor monger.

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sophisticated in the analysis of information will benefit less and, to the extent that they

appreciate their own weakness, will be less trusting. In a similar vein, since the process of

collection and analysis of information, as well as making decisions on the basis of the

analysis, has been speeded up immensely. Some agents are likely to make more mistakes

than others, making them less trusting than those who can make better decisions.

Furthermore, the requirement for greater speed may not allow enough time for many

agents to engage in the full range of actions aimed at detection of deception. This also

translates directly into less trust. The scandals involving the manipulation of information

by large corporations that are identified with the new economy (e.g., Enron, Global

Crossing, and Worldcom) have, according to various analysts, the media and politicians,

lowered trust in the system.13

These scandals have shown that even the sophistication of

large organizations is insufficient for the detection of deceit by sophisticated agents.14

Face-to-face interactions and social contexts

In the old economy many business interactions were with humans staff or, at

times, telephone operators in various business and many interactions were repeated at

the grocery store, bookstore, barber, beautician and so on with the regular staff. The

new economy changed the nature of many of these interactions. For one thing, many

13See, for example, Business Week Online (www.businessweek.com), Can You Trust AnybodyAnymore? January 28, 2002, Felix Rohatyn, The Betrayal of Capitalism, The New York Review of

Books, February 28, 2002, pp. 6-8, Jeff Madrick, Enron: Seduction and Betrayal, The New York Reviewof Books, March 14, 2002, pp. 21-24, Accountability for Accountants, Editorial, The New York Times, p.A22, June 4, 2002., and Patrick McGeehan, Goldman Chief Urges Reforms in Corporations, New York

Times, June 6, 2002, page 1.

14The constant struggle against manipulation of information leads to many innovations. For example, thefight against theft of information protected by passwords may lead to measures such as the shutting downof accounts that experience dictionary attacks numerous attempts to crack the password. However, thiscan open the door of attempts to shut down rivals accounts (for example, during bidding wars). Theattempt to circumvent the vulnerability of old search engines that focused on keywords on web sites toself-serving seeding of keywords led to google.com type attempts to use mentions of other sites as the keyto search engines, only to become vulnerable in turn to the establishment of sites whose main purpose wasto channel referrals to other sites, in a large pyramid-like scheme.

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interactions take place without the intervention of a live individual, for instance on the

Internet or with automated telephone systems. Furthermore, many of the live interactions

are not repeated with familiar persons, because of the increased size of many

establishments (which reduces the chance to encounter a given staff member repeatedly)

because many consumers as well as firms take their business to where the terms seem to

be best, and because people are more mobile.

These changes have three effects. First, the ability to establish trust through

repeated interactions is weakened. Second, less face-to-face interaction among agents and

increased impersonality lead to reduced ability to detect deception, and thus reduce the

level of trust, ceteris paribus. However, greater availability of information may be a

strong offsetting factor. Third, many interactions in the new economy are devoid of social

context because they represent quantitative information; this leads to reduced ability to

detect fraud and cheating, and therefore reduces the level of potential trust.

Economists and other experimenters have performed dozens of experiments with

the voluntary contribution mechanism (VCM), a representation of a stylized collective

action problem (or n-person prisoners dilemma). In these experiments, a number of

subjects are assigned to a group, given an endowment of money, and asked to divide the

money between a personal account and a group account. Money placed in the group

account is scaled up and then divided equally among all group members, while money

placed in the personal account belongs to the individual alone. All group members

together are better off when all members place all of their endowment in the group

account, but the individual group member is best off when he alone keeps his money,

while sharing in the money that the others have placed in the group account.

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In benchmark VCM experiments, in which subjects remain anonymous to fellow

group members, contributions to the group account are typically well above the

neoclassical prediction of complete free-riding, but the average contribution tends to

decline from around 50-60% to about 10-15% of endowment with ten repetitions.15

Experiments have shown that groups tend to achieve much greater cooperation more

money placed in the group account when their members engage in pre-play

communication, that is, when they meet for a few minutes and communicate before

making their allocation decisions.16

Since the neoclassical prediction is that

communication will have no effect, because subjects still lack the means to enforce any

agreements reached, this finding suggests that subjects feel some confidence in their

abilities to size up one anothers characters during their meetings.17

What is not clear

from these early communication experiments is the respective roles played by (a) the

dropping of anonymity among group members, (b) the opportunity for open-ended verbal

conversation, and (c) other aspects of communication such as facial expressions and body

language, the communication of signs of sincerity by vocal intonation, and so on. The

relative importance of these different elements were tested in two recent experiments.

Brosig et al. (2002) conducted a baseline experimental treatment in which no

communication was allowed, then a face-to-face treatment in which subjects met around

a table for a few minutes of unstructured communication, and finally a treatment in which

15See, for example, Isaac and Walker (1988).

16See, e.g., Isaac and Walker (1988) who find that the average contributions stabilized at 100% when pre-play communication was allowed (Figure 1). See also Walker et al. (1991), and Bochet et al. (2002).

17Perhaps a typical subject leaves such a meeting thinking most of those people are probably like me; theywont be so quick to go back on the word they gave me to my face just to earn an extra dollar or two. Andif we cooperate rather than cheat, well all come out ahead.

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subjects could communicate simultaneously on video monitors and by an audio channel,

but without meeting in physical proximity. A treatment in which subjects could

communicate via an audio channel, but without video images of one anothers faces, and

another treatment in which subjects could see one anothers faces through a camera for a

few moments but were not permitted to communicate verbally, were also added.

What the authors found was that audio-visual communication was almost exactly

as effective in generating cooperation among subjects as was the face-to-face meeting,

whereas audio communication alone was only a little more successful than the non-

communication baseline, and a visual display of fellow subjects faces without audio

communication had no efficacy relative to the baseline. The authors suggest that

combined facial and verbal communication may be necessary to generate maximal trust

due to human beings informational processing and emotional equipment, which was

formed in ancestral environments where face-to-face communication was almost the only

kind possible.

In a separate experiment, however, Bochet et al. (2002) compared non-

communication and face-to-face communication treatments with (a) a numerical cheap

talk treatment in which subjects could display possible non-binding decisions numerically

on one anothers computer terminals, with further time to react to one anothers possible

choices, before each period of binding choice, and (b) a chat room treatment in which

subjects could engage in open-ended written communication within their groups in on-

line chat rooms before every few periods of play, without learning one anothers

identities. They found that the numerical cheap talk treatment yielded no real

improvement in cooperation over the no-communication baseline, but that the chat room

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treatment generated almost as much additional cooperation as did face-to-face meetings.

These findings, and the contents of the on-line communication sessions, suggest that it is

the ability to use language to frame the problem as one of group cooperation, and to issue

express declarations of commitment to courses of action, rather than face-to-face

interactionper se, that explains most of the increase in cooperation in the face-to-face

and audio-visual communication treatments. Just why Bochet et al.s chat room was

more effective than Brosig et al.s audio-only treatment remains unclear.

Market size

The size of the market on which both manufactured goods and services are

transacted has been increasing in the new economy. This trend is particularly significant

for products that in the old economy were produced and consumed in a restricted

geographical area. First, transportation costs have declined, and transportation has

improved in both safety and speed. This resulted in the more efficient movement of

goods to people and of people to services. For example, many thousands of people fly

airplanes to watch a circus in Las Vegas, attend a theatrical production in New York City,

or visit a theme park in Orlando; the effective size of demand for this sort of services has

expanded in some cities substantially beyond the local market. Second, transmission of

data through various electronic media such as the Internet, CDs, and DVDs makes it

possible to experience activities from locations other than where they are produced,

generated, or displayed. One can view a painting or a sculpture from multiple angles

without going to a library, let alone a museum, by going on line. One can take an on-line

course or participate in a seminar discussion via a satellite link or the Internet, inspect

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homes while house-hunting, or buy on-line just about anything from just about anywhere,

at very low transaction costs.

The increase in the size of the market implies that an individual may have

encounters with more firms in the new economy as compared to the old economy. As a

result, there will be potentially fewer repeated interactions, fewer face-to-face

interactions, and lower probability that different members of the same social community

will interact with the same firms. Consequently, one can learn less from ones own

experience, or from the experience of ones friends, colleagues, or members of the

physical community, and therefore the particular forces that feed trust are likely to

weaken. However, the information revolution has not eliminated such familiar

compensating mechanisms as branding and the use of centralized venues of exchange,

and new mechanisms have also arisen, as we will see in the next section.

Mobility and community

The geographical mobility of people has increased in the new economy. In many

parts of the developed world, indicators such as the proportion of the population of a city

that was not born in the city in which they reside and the average length of residence in a

locality, suggest that the percentage of residents who have long-term connections to the

localities in which they live has declined. The turnover in the workplace has also

increased.18Greater mobility reduces the strength of traditional networks whose members

transmit information from one to another and over time. When this mechanism is

weakened, a source of trust is also weakened. The weakening of communities may also

18See the special issue ofJournal of Labor Economics, Volume 17, Number 4, Part 2, October 1999,dedicated to an examination of the question of whether tenure and job security have declined.

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cause the weakening of commonly shared values and norms, which are important for

trusting and trustworthiness.

Trust in business-to-business (B2B) relations

Most of the foregoing discussion applies to relationships between individuals and

firms as well as among firms; after all, firms are composed of individuals and are

represented in their dealings also by individuals. However, there are important

differences between organizations such as business firms and individuals that merit brief

attention.19

In particular, unlike an individual, an organization can change its composition

and thus, for instance, be able to claim that it has eliminated from its ranks employees

and executives who are not trustworthy. In an attempt to assume a character and claim

continuity of it, many organizations develop corporate cultures that supersede the

individuals that populate them at any given time. Furthermore, corporations seek to

develop teams of employees that are recognized in the market by professionals; such

teams often move together and may bring down companies they desert and raise the

fortunes of companies they join or establish.

There are additional elements involved in business-to-business (B2B) relations

that are substantially different in relations among individuals or in consumer-to-business

relations. One important case concerns the supply chain, which is increasingly conducted

through the use of the Internet and related tools. In a supply chain, the retailer derives

competitive advantage from being very responsive to changing consumer demand, and

from maintaining low inventories, thus lowering costs. In order to sustain these features,

the entire chain of production upstream from the retailer through its various stages must

19For a more detailed examination of differences between individuals and firms, see Ben-Ner andPutterman (2001).

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be very responsive, fast, and trustworthy. Supply chain relationships involve many parties

that depend on each other to ensure the timely supply of appropriate inputs. It is critical

in this highly interdependent system that all parties can trust each other; this trust must

prevail not only among those who transact directly with each other, but also among those

who are not in direct contact but who depend upon each others performance for their

own successful performance.

Somewhat different issues arise in the relationship between purchasers and

suppliers. In the old economy there was a system of long-term relationships between

purchaser and suppliers that ensured that suppliers were reliable, and that they provided

appropriate parts, components and other materials. That system entailed long-term

relationships that permitted the establishment of records and reputations; these

relationships were shielded from short-term competitive pressures on suppliers. In

contrast, in the new economy purchasers may switch among suppliers very rapidly.20

The technology for such switches exists. Since the technology of production allows swift

and inexpensive adaptations of the supplier to different purchaser requirements, and

transportation costs are steadily declining, increasingly making the location of production

relative to the point of final sale relatively unimportant. The purchasers predicament is

how to accumulate relevant information about potential suppliers, and how to evaluate

reliability and reputation in a comparative fashion (see Dellarocas, 2001, for a detailed

analysis of this issue)

20This is particularly true when the purchaser is a relatively large manufacturer (such as a car company) orretailer (such as a national department store). Because of the limited number of brands that can besustained even in large markets, manufacturers of branded products, department stores and other sellers ofconsumer goods are on the short-side of the market, giving them power that suppliers of commodities andother goods do not have. We return to this point in the next section.

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A variety of business intelligence software products has been developed to

allow companies to keep track in real time of the performance of their business partners

in a wide range of areas of interest to them. Price, quality, timeliness, and reliability can

be analyzed rapidly and links with new suppliers can be established via the Internet in a

very short time thanks to the compatibility of various types of enterprise software. In a

system like this trustworthiness is a business necessity since minor deviations from

promised or implied standards can lead to loss of business.21

Privacy and identity theft

Whereas anonymity in the sense of facelessness and lack of full-fledged identity

as consumers and firms with flesh and blood, and bricks and mortar has increased in the

new economy, there has been a concomitant decline in privacy. The two trends did not

just happen concurrently, but they are actually the results of the same developments and

often different sides of the same phenomenon. If in the old economy a newspaper

subscriber wanting to suspend delivery for a vacation had to communicate directly (in

writing, by telephone, or in person at wee hours of the morning) with the person who

delivers the newspaper at the door. In the new economy, all that is necessary is to call a

24 hours a day automated machine (which recognizes the caller ID) and key in the dates

of vacation. While in the old economy a customer may be recognized, for better or worse,

at some retail and service outlets. In the new economy, many of the encounters are

anonymous because of automation, high staff and customer turnover, or because they

occur on the Internet. However the data about customers in these transactions are often

21See, for example, Rick Whiting, Biz Intelligence Turns to Suppliers,Information Week, October 15,2001, pp. 57-58, and www.informationweek.com/techcenters/sw/bizapps/bizintelligencefor additionalarticles on this subject.

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The issue of privacy extends to identity theft. Personal data, particularly credit

card information, are stolen off servers around the world, and then traded on illicit

markets. Given the greater risk involved in online commerce (as well as the greater

instability of companies involved in it), online businesses pay higher credit card fees for

transactions with their customers than do non-online business.24

Theft of credit card

records has also been a factor contributing to the bankruptcy of a company that traded in

computer money.25The risk of identity theft reduces trust in online commerce, especially

with respect to unknown companies and those trading in regions where theft is more

common (particularly the former Soviet Union).

Trust and fraud online

The developments associated with the new economy have opposing effects on

trusting and trustworthiness, and therefore on the level of trust that prevails in the

economy and society. The phenomenal increase in the availability of information has

elevated the trustworthiness of individuals and organizations with records that can be

stored and accessed for credible verification of reputation based on past actions. This has

become indispensable for corporations in their dealings with each other, and is a growing

tool in the hands of individuals in their dealings with firms. In the case of both firms and

individuals the explosion of information and tools with which to analyze it seems to favor

those with the ability to use the information and the tools; their ability to trust their

trading partners has increased, and their opportunities to gain from trade has also

24Online retailers pay 2.5% plus 30 cents per transaction as compared to 1.5% plus 30 cents paid bytraditional stores, according to research by the Gartner Group, reported by Linda Rosencrance, Survey:Retail Fraud More Prevalent for Online Vendors,Computerworld, 7/24/2000, Vol. 34 Issue 30, p20. Seealso Matt Richtelm, Credit Card Theft Thrives Online as a Global Market, New York Times,May 13,2002, and Bob Tedeschi, Seller of Online Currency May Have Been Victim of Fraud, New York Times,August 27, 2001.25See Tedeschi, idem, describing flooz.com, a purveyor of online currency.

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increased. However, those with limited sophistication may actually be lost amidst this

wealth of information, and their trust in individuals, firms, and the entire system is likely

to diminish along with their trust-dependent gains from trade.

It is hard to know whether the net effect on trust of increased market size and

mobility, and of reduced face-to-face contact, will be positive or negative. Writing in the

middle of 2002, when the media reveal new instances of fraud in large companies

committed on a daily basis, the trustworthiness of the entire business sector seems to be

questioned, or, as some business and political leaders state, trust in the entire system is at

a low. The sources of these problems are complex and are not grounded only in the

developments associated with the new economy, and certainly not only with those

aspects of the new economy emphasized in this chapter. But the timing seems to cause

many people to reflect on the credibility of new economy and of the economy as a

whole.26

Is there more fraud online than in the offline world? We have already noted that

credit card transactions are more expensive on-line than in traditional stores, because of

the higher incidence of fraud in the former.27This is significant, because the vast majority

of transactions on line are paid for with credit cards.28

And in all likelihood, Internet

auctions are also far more prone to fraud than traditional auctions. At the same time it is

important to recall that the new economy has provided many new opportunities for

example, to participate in auctions for beany babies (the highest category of auction

26See note 12, above.27In its survey of 160 companies, half of which use the Internet to sell products, the Gartner Group foundthat credit card fraud is 12 times higher online than in the physical retail world; see Rosencrance, cited infootnote 23, above.28The Gartner Group, in the survey reported above (reported by Rutrell Yasin, Merchants Still Fearful ofCredit Fraud,Internet Week, July 10, 2000, issue 820, p. 31), found that 90% of transactions online areexecuted with credit cards.

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fraud), or purchase exotic or inexpensive items from faraway places which did not exist

before.

The main source of information on Internet fraud statistics is the Internet Fraud

Complaint Center (IFCC), a partnership between the National White Collar Crime Center

and the Federal Bureau of Investigation that began operation in May 2000. During

calendar year 2001, IFCC processed 16,775 referrals deemed fraudulent; each of these

referrals was sent to an average of three law enforcement and regulatory agencies. A

plurality of fraud referrals concern auctions (42.8% of fraudulent referrals), 20.3%

concerned non-delivery of merchandise and payment, 15.5% regarded an investment

scam referred to as the Nigerian Letter Fraud, another 9.5% were credit or debit card

fraud, and the remainder were other forms of fraud. Of these complaints, 9,864 involved

a victim who reported a monetary loss with a mean loss of $1,804 (a median of $435).29

Of course, fraud is committed more often than it is detected.30

Internet-only companies enjoy rather low trust, according to the Harris Interactive

Poll.31Only 26% of respondents trust at least somewhat such companies, as compared to

60% who trust food companies, 59% who trust banks and retailers, and 53% who trust

computer software companies. Even the unpopular telephone companies and the media

enjoy the trust of more respondents (35% and 30%, respectively). Only biotech, oil,

entertainment, and tobacco companies fare worse.

29

During 2001 the agency also received another 17,165 referrals that were deemed to be non-fraudulent innature, as well as 17,138,551 unique hits on its web site, www.ifccfbi.gov, where the statistics cited in thissection can be found in two documents, IFCC 2001 Internet Fraud Report, and Internet Auction Fraud.The definitions of different types of fraud appear in Appendix A of the Fraud Report. Fairly similarstatistics are reported by the National Consumers League at www.fraud.org.30According to the National White Collar Crime Center (The National Public Survey on White CollarCrime, February 2000), only one in ten incidents of fraud ever make their way to the attention ofenforcement or regulatory agencies.31Harris Interactive Health Care News, November 2001, Table 1, athttp://www.harrisinteractive.com/news/newsletters/healthnews/HI_HealthCareNews2001Vol1_iss26.pdf.

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Responses by Firms and Others to Changes in Levels of Trust

In the previous section, we concluded that there is a segment of online

transactions where trust is more difficult to generate and that there are many individuals

who find it more difficult to assess trustworthiness in the new rather than the old

economy. There seems to be ample awareness that weak trust hampers certain activities,

and that gains can be made by enhancing it through various individual and collective

actions. In this section we evaluate such actions.

One of the most visible measures adopted to improve trust online consists of the

securing of online communications, and security verification, which are efforts to create

trustworthy online vendors. As of this writing, VeriSign is the leading provider of

Internet trust services, which include Web presence services, security services,

payment services, and telecommunications services. The companys web site digital

certificate services are used by most, if not all, of the Fortune 500companies with a web

presence.32 Secure socket lock (SSL) connections, which secure the pathway through

which data are sent over the Internet, are used to encrypt the shopping portion of a

session, such as browsing activity. A secure electronic transaction (SET) secures only

the payment portion of the session. With SET, credit card information, including the

credit card number and expiration date, is encrypted so that even the merchant never sees

this data, thus helping to prevent potential merchant fraud. Displaying the VeriSign and

like companies seals (such as Trust-E) helps a vendor to convince customers that

transmitting such data on its web site is a safe procedure.

32See Verisign Marketing Summary(visited June 16, 2002).

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Numerous Internet companies, VeriSign included, also demonstrate their

trustworthiness by establishing alliances with well-known firms and, in some cases, with

respected nonprofit organizations, particularly institutions of higher education.33

While

the appearance of a new store or of one with the sign Under New Management may

raise the concerns of wary consumers, the latter can quickly see whether the company

operates in a new and dedicated facility, whether it is a well staffed store, and so on. In

the case of a new Internet company, there are fewer such obvious signs. Thus, perhaps

the quickest method of gaining customers trust in the Internet company is to associate

with a trustworthy entity an established firm or organization not suspected for its

motives. In other cases the established firm is an Internet company that serves essentially

as a conduit for the unknown company. For example, Amazon.com provides on its site

links to other companies and extends its guarantee to buyers of their products.

External certification is a step towards improving trust, but of course it cannot be

a substitute for the trustworthiness of a specific company, because it does not speak to the

question of timeliness, quality, and reliability, and it does not constitute a guarantee of

certain conduct or a warranty of certain performance of the product. Alliances between

reputable companies and unknown partners, when they are substantive, provide the

greatest source of trustworthiness for the unknown partners, since it is deemed unlikely

that reputable companies will spend their reputations vouching for the trustworthiness of

a new company if they cannot verify trustworthiness. They are likely to extract a

significant price for their participation in the alliance, however, the more so the more

33The need to share knowledge, capacity, and other resources are not the only reasons for alliances amongfirms. A survey of large and reputable firms web sites reveals an amazing array of alliances which, at leastin some publicized cases, involve mainly the rubbing off of the large companys reputation on thesmaller and newer partner, often for a fee paid by the latter. See also Ben-Ner (2002).

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costly is verification of the junior partners trustworthiness. For this reason, many firms

seeking to operate on the Internet will have to look for other ways to establish their

trustworthiness.

The acquisition of trust is made easier by the identification of a company and its

products with a brand, but successful brand recognition requires large investments.

Individuals appear to have a limited span of attention and seem able to process

information on a small number of brands only. Although the information gathering and

processing capabilities of the new economy may enable some consumers to widen their

gazes, the evidence to date seems to point in the direction of increased market

concentration.34

Whereas prior to the recognition of trust issues salience the new

economy seemed to be giving rise to greater decentralization of economic activities and

more entry by small firms that could operate in spatially unlimited markets, it now

appears that the trend has been reversed. The shakeout of the technology and Internet

sectors in March of 2000, and other developments prior to and since that date, resulted in

the elimination of a large number of small firms and a dramatic rise in mergers and

acquisitions.35

The emergence of click and mortar companies that merge physical presence

with online activities as a dominant mode of commercial operation seems to answer the

need for trust associated with established traditional companies, including ease of return

of merchandise. This hybrid form provides great flexibility in accessing rich information

about a vast array of products through the Internet all the while it maintains physical

34The electronic bookmarks and favorites lists have unlimited capacity, but managing them becomes formany people a matter of limited attention span.35On the change in the size distribution of firms (without attribution to trust issues), see White (2002). Forstatistics on mergers and acquisitions, see White (2002) and statistics published in current issues of

MergerstatandMergers and Acquisitions magazines.

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presence from which consumers appear to derive comfort and afford it more readily their

trust, because of seeing is believing and because warranty policies seem to be more

believable when an actual store can be visited to effect a return or exchange of a product.

The alliances formed between Amazon.com and large companies such as Target and

Microsoft, and other similar arrangements and joint ventures may further signify a trend

towards greater economic concentration.

Conclusions

Trust issues arise in all exchange relationships in which both sides of the

exchange cannot be carried out simultaneously in one place, or where there is asymmetric

information about quality or other attributes of what is changing hands. In the old

economy, such issues were often partly addressed by repeat dealings with entities at least

represented by known faces and names. Many sought trustworthiness by trading with

members of the same ethnic group, church, or club, and individuals and firms advertised

their characters by conspicuously being good citizens, attending church or giving to

charity.

By facilitating trade with almost no geographic limits, the new economy allows

for greater choice among trading partners, but at a loss of personal interaction. By

facilitating information flow and processing, it supplies more bases for evaluating

trustworthiness, but consumers can be overwhelmed by the quantities of information

available and by the complexity of the strategies needed to evaluate it. Consumers are

also wary of the ways in which the information they supply to sellers can be abused.

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Although to some the question of trust in electronic commerce may seem

reducible to a set of technical issues such as encryption, we have argued that to do

business on line, parties still need to trust, that is to say to gamble on the reliability of

their partners. Both rational calculation of how much ones partner stands to lose from a

breach of faith, and gut appraisal of the partners character, remain present even where

the partner is a company, to which the concept of character may be hard to apply. Brand-

named verification services, branded sellers, large-scale firms, alliances between

established and old companies, click-and-mortar hybrids, and economic concentration

are among the common responses to these and other problems.

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