Trust as Social Capital and the Process ofEconomic Development

by

Patrick Francois (UBC) and Jan Zabojnik (USC)

1 Introduction

• Trust levels seem to matter for economic outcomes

— Evidence in first lecture

• Economists almost unique in treatment of trust

— Economists emphasise calculativeness or Incentive Compatibility which has been

well explored

— For example: New Institutionalists applied to LDCs, Dasgupta (1988), Greif

(1993), North (1990)

• Other social sciences are more behavioral

— Some individuals are “trustworthy”

— Sociology, Psychology, Organizational Studies, Marketing, Political Science

• Batson (Handbook of Social Psychology)

— Discusses anticipation of guilt and reward:

“The ability to pat oneself on the back and feeling good about being a kind,

caring person, can be a powerful incentive to help.”

• Adam Smith:

“We endeavour to examine our own conduct as we imagine any other fair and

impartial spectator would examine it. If, upon placing ourselves in his situation,

we thoroughly enter into all the passions and motives which influenced it, we

approve of it, by sympathy with the approbation of this supposed equitable

judge. If otherwise, we enter into his disapprobation, and condemn it.”

• Why might this matter for development?

— In LDCs (contracting incompleteness) emphasized by development studies liter-

ature

— In order to overcome these problems number of institutions arise:

∗ Supplier networks

∗ Industrial clusters

— Lack of trust is impediment to their success

• Suggests heterogeneity of types:

— i.e., agents are different ”types”, some trustworthy, others are not

• Recently, culture linked to factors that limit acquisitiveness in order to sustain mar-

kets.

— Robert Putnam (1993), Role of social capital in comparing North/South Italy.

— L.E. Harrison (1992)Japanese development highlighted “radius of trust”

— Jean-Phillipe Platteau (1994a, b) and (2000) importance of a “generalized

morality” allows trade where formal sanctioning not present.

— Kaushik Basu (2000) “rationality limiting norm,” rule out some forms of oppor-

tunistic behavior

— Seligman (1997) notion of “generalized reciprocity”

• Here we similarly equate trustworthiness with “social capital”.

• Treat trusworthiness behaviourally

— There are “Trustworthy” agents: ‘people who keep their promises even if not in

pecuniary self interest’

— And ”Opportunists”: income maximizers

• First Problem: Any explanation of social phenomena which relies on exogenously

given type differences (e.g., sometimes people are trustworthy, and society devel-

ops, other times they are opportunistic and it does not) is TAUTOLOGICAL and

USELESS.

• Necessary to account for where types come from

• Here: Types Evolve

— Standard approaches (fitness based replicator) are not so useful here: Fershtman

and Weiss (1998), Nyberg (1997), Lindbeck, Nyberg and Weibull (1998),

— Alternative approach (utility based replicator) is used: Boyd and Richerson

(1985) and Noe and Rebello (1994), Bisin and Verdier (2001), “cultural se-

lection”,

∗ Utility based replicator: evolutionary selection based on preferences of parents,

not just fitness

• Rationality also plays a role

• Firms/Entrepreneurs determine mode of production (they are rational). Two choices:

— “modern” production

∗ vulnerable to opportunism, but high return

— traditional production

∗ safe, but lower return

• Returns to firm choices depend on types in population:

— Population with many trustworthy favours choice of modern production

— Population with few trustworthy favours choice of traditional

• But returns to types depend on choices of firms

— Trustworthiness is costly but highly rewarded in trusting interaction. No use

being trustworthy in a world where no one takes the chance on trusting

— Opportunism favored in a world without trust

• Symbiosis (complementarity between trustworthiness and modern production) leads

to multiple steady states

— High trustworthiness level→ extensive modern production is rational choice for

firms → implies good chance for trustworthy to reap extra reward → evolu-

tionary support for high trustworthiness levels

— Low trustworthiness level → little modern production is chosen by firms →implies few opportunities for trustworthy to benefit→ low trustworthiness levels

• Principal difference between the way in which production changes and culture/trustworthiness

(or social capital) changes.

— Mode of production is a firm choice and can change fast

— Culture changes gradually

• Welfare and productivity higher in high trust steady state

• Possible explanation for large cross country productivity differences

— Hall and Jones (1999), King and Levine (1994) and Klenow and Rodriguez-Clare

(1997), Prescott (1998)

• But the interaction of Slowly Evolving culture and Fast Acting firms can be prob-

lematic

• Policy

— Too advanced production can erode social capital.

— Temporary support can be valuable.

— Infant industry protection can be good.

— Trustworthiness should be directly encouraged.

— Gradual change is good.

• Suggests why late developers might be in low trust state

— Trust intensive productivity improvements can fail

— Slow moving culture V rapidly moving firms

• Related literature

— Cozzi (1998) and in Fang (2001)

— Noe and Rebello (1994)

— Benabou Tirole (2006)

2 The Model

• Infinitely lived economy, discrete time,

• t denotes a period, corresponds to one generation’s lifetime

• 2 types of agents: entrepreneurs and contractors

2.1 Entrepreneurs

• Unit measure each born each period and die at end of period

• Choose between “modern” and “traditional” production

2.1.1 Modern Production

• pt ∈ [0, 1] denotes proportion in modern production

• Vulnerable to opportunistic contractors

• No formal contracting

• Entry cost k sunk

• If production successful generates π (pt)

— π0 < 0, π00 ≤ 0, π (0) = πu, π (1) = πl

• Output division through bargaining

— απ (p) to entrepreneur

— (1− α)π (p) to contractor

• Moral Hazard

— Benefit b > 0 to contractor not honoring commitment

— Cutting corners, lowering quality, pilfering, shirking, tardiness, etc.

— It matters

(1− α)πu < b.

2.1.2 Traditional Production

• Returns equal 0

• No contractors

2.2 Preferences of contractors

2 types, Trustworthy (T ) and Opportunists (O)

Trustworthy (T )

uTt = yt + dtγ − F

• F > 0, γ > 0

• dt = 1 if individual met commitments, and dt = 0 if no commitments made

• uTt = −∞ if commitments broken

Opportunists (O)

uOt = yt

2.3 Cultural Evolution

• Successful enculturation need not correspond to payoff maximization

• One for one reproduction

• Direct socialization

— Parent makes child same type

• Indirect socialization

— Child socialized by non-parent

• Let β denote proportion of T type

• Let Pijt denote probability that child from family of type i is socialized to trait j

• Probability of direct socialization for either type

— dT (βt, pt) , dO (βt, pt)

• Probability of indirect socialization for either type depends on frequency

— βt, (1− βt)

Thus

PTTt = dT (βt, pt) +

³1− dT (βt, pt)

´βt

PTOt =

³1− dT (βt, pt)

´(1− βt)

POOt = dO (βt, pt) +

³1− dO (βt, pt)

´(1− βt)

POTt =

³1− dO (βt, pt)

´βt (1)

And

βt+1 − βt = βt (1− βt)hdT (βt, pt)− dO (βt, pt)

i.

Or

dβt = βt (1− βt)hdT (βt, pt)− dO (βt, pt)

i. (2)

• Assume direct socialization probability increasing in parental effort

• Parental effort increasing in expected utility from being own type

dβt = βt (1− βt)Φ³EhuTti−E

huOt

i´. (3)

— Φ : R→ [−1, 1] ,Φ0 > 0,Φ (0) = 0

• Adjustment is “gradual”

2.4 Entrepreneurial dynamics

Expected net returns are αβtπ (pt)− k

Assume Entry immediate

• pt adjusts instantaneously

• For βt such that αβtπu − k > 0 :

αβtπ (pt)− k = 0

• For βt such that αβtπu − k ≤ 0

pt = 0

2.5 Matching Process

Generally excess supply of contractors since if contracting

• uTt = (1− α)π (pt) + γ − F > −F

• uOt = b > 0

Assume random matching

E[uTt ] = pt [(1− α)π (pt) + γ]− F

and

E[uOt ] = ptb.

Implying

dβt = βt (1− βt)Φ (pt [(1− α)π (pt) + γ − b]− F ) . (4)

2.6 Parameter Restrictions

Assumption 1. If everyone trustworthy, production always profitable:

απ (1) = απl > k.

Assumption 2. If no one trustworthy, production never profitable:

πu is finite valued

Assumption 3.

(1− α)πu + γ − b > 0.

Assumption 4.

(1− α)πl + γ − b < 0,

3 Analysis

EhuTi−E

huO

idetermines evolutionary pressure:

pt [(1− α)π (pt) + γ − b]− F (5)

• Independent of β

p[(1-α)π(p)+γ-b]-F

p pA pB

Figure 1: Evolutionary incentives as a function of p

Proposition 1 Under Assumptions 1-4, if, and only if, there exists at least one value

of p ∈ (0, 1) such that p [(1− α)π (p) + γ − b]−F > 0. Then there is a unique

stable interior equilibrium,³pA, βA

´in which:

βA³1− βA

´Φ³pA

h(1− α)π

³pA´+ γ − b

i− F

´= 0

and

βAαπ³pA´− k = 0.

dβ=0 dβ=0

dp=0

p

β

Figure 2. dβ = 0, and dp = 0 loci

(βB,pB)

(βA,pA)

p

β

Figure 3. Interior Steady States

Under Assumptions 1-4 there exists a stable steady state with no modern production and

complete opportunism, (β = 0, p = 0). There also exists a steady state at (β = 1, p = 1)

but this is unstable.

3.1 Dynamics

B

A

(0,0)

(1,1)

p

β

Figure 4. Dynamics

Welfare

Definition: Situation A is a welfare improvement over Situation B if and only if in Situation

A the expected utility of each agent type - entrepreneur, trustworthy and opportunist, is

at least as great as it is in situation B, and, moreover, at least one of the agent types has

strictly higher expected utility in A than in B.

Proposition 2 Welfare in the stable interior steady state,³βA, pA

´exceeds that in

the stable corner steady state,(0, 0).

3.2 Openness and development

• 80’s and 90’s see a shift from ISI to ELI

• Potential returns are higher

— πW (p) > π (p) for all p

• Scale of production greater

— kw > k

• Efficiency enhancing

—

πW (p)− kW > π (p)− k, for all p. (6)

pA

β

pAW pBW

Figure 5. Change in β̇ = 0

(βA,pA)

pA

β

pAW pB pBW

(βAW,pAW)

Figure 6. Convergence with trust non-intensive development

(βA,pA)

pA

β

pAW pB pBW

Convergence with trust-intensive change

SupposeπW (p)kw <

π(p)k and consider an economy starting in the

³pA, βA

´steady state. Let p : αβAπw (p) = kw be denoted p0. If p0 > pBW

then the economy uniquely converges to the welfare improving³pAW, βAW

´steady state. If p0 < pBW then the economy uniquely converges to the welfare

dominated (0, 0) steady state.

(βA,pA)

pA

β

pAW pB pBW

(βAW,pAW)

Figure 8. Convergence to low steady state

3.3 Policy

• Obviously — encouragement of trustworthiness is beneficial

— Altenburg and Meyer-Stamer (1999) Proyectos de Fomento in Chile and the

Empresas Integrados in Mexico,

— Rhyne and Otero (1992),

• Gradual change is good

(βA,pA)

pA

β

pAW pB pBW

(βAW,pAW)

Figure 9. Gradualizing Change

Short term protection of modern producers can help

• Subsidy, S such that p solving:

αβπW (p)− kW + S = 0,

exceeds pBW

• Humphrey and Schmitz (1998 p.54-56) “Kick Start” in Germany, Denmark and

Chile.

4 Conclusions

• If culture/social capital/generalized trust is slow to change and com-plementary with improved technologies, may be good to implement

change slowly

• There may be a disadvantage to being a follower country