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To Trust or to Contract?

by Jurgen Brauer, September 2003
Copyright: J. Brauer. No reproduction without permission.

When you must go to the hospital, and even when you see your family physician or dentist, you will be asked to sign a sheaf of legal papers. When your children go on a school-sponsored field trip, you will be asked to sign reams of legal papers. When you go on an adventure vacation – from scuba diving to white-water rafting – again you will be asked to sign a raft of legal papers. These papers are contracts. Contracts surround us everywhere. Why mustn't we sign papers when we buy a newspaper or a cup of coffee or a dress shirt? Whatever happened to trust? The answer is that trust is a contract as well. Not a written one, but an oral one. If not an oral one, then an unspoken one. But a contract nonetheless.

Trust is an understanding to behave in a certain way or face the consequences of breach of trust. Trust is like a contract.
Trust is an understanding to behave in a certain way or face the consequences of breach of trust, just as one must face the consequences of breach of a written contract. To trust or to contract is thus a false question. The real question is why do we sometimes resort to implicit contracts, sometimes to explicit, oral contracts, and sometimes to written ones? What determines which contracts we use when and what determines how elaborate our contracts are? One blessing of the economist's narrow view of the world is that the answer is immediately obvious: contracts are determined by costs and benefits. When I buy that cup of coffee, I pay and you hand over the goods. The probability that I will take the coffee and run off without paying is minimal, as is the probability that you will take my $1.50 without handing over the coffee. Thus there is little incentive to engage in drawing up and signing a contract. But when I sign on to a parachute-jumping adventure, the risk and hence the cost to the supplier that surviving family members will sue after my parachute fails to open is great. So is the benefit to the chute-jumping operator to hire and pay a lawyer to draw up a general contract of risk-assumption by the jumping customer.

If contracts minimize risk, trust minimizes costs. Suppose that you had to sign a contract each time you bought a cup of coffee. How many cups of coffee would you buy? For the customer, the hassle is not worth the coffee. For the seller, the legal and administrative cost would be exorbitant. Think of the many daily situations in which you trust someone and someone trusts you. Even if you have a labor contract (and most people do not), the contract can hardly specify in every possible detail the precise nature of your duties. Your supervisor says "call customer Brauer," and expects that you understand not simply to call but to try to sell some gadget to me. Your supervisor trusts you to have some common sense. If every detail had to be written out, your boss might as well do all the calling. (And you would have no job.) 

If contracts minimize risk, trust minimizes costs.
Many people argue that, somehow, trust has gone out of fashion but it has not. As the examples show, trust plays a hugely important economic role in minimizing costs of daily interaction and transaction between buyers and sellers, managers and employees, and every other relation. A society that lacks trust is a more costly society. Conversely, a society that cherishes and fosters trust is a less costly one. Trust facilitates interaction, be it social or economic. It facilitates exchange. Trust economies are efficient economies. In contrast, lack of trust hinders exchange. Trust takes time to develop. While it develops, interaction is limited and mutually beneficial exchange is on hold. When mutual trust is limited because we do not yet know each other well enough, we write contracts – in spite of their cost – to minimize the risk that misplaced trust would entail. This is the strength of contracts: it encourages trade that otherwise would not take place for lack of trust, or where the risk to trust is too great.

Trust requires repeated interaction before I get to know you well enough to trust you. The more mobile modern societies become, the more we rely on one-time interactions instead of on repeat interactions; the more we flit hither and fro, the less trust will develop, and the more contracts will be written and signed. Thus, when we bemoan the loss of trust and the rise of contracts, what we really mourn is the loss of repeated interaction and exchange that comes from long-term, stable neighborhoods. It is not that we suddenly have become incapable of developing trust; it is merely that we are so fleet and mobile, that the time necessary to develop trust is missing. So we sign contracts. It is simply a continuum. Trust is costly. It costs time. Contracts are costly, too. We pay a class of lawyers to draw them up, and we maintain courts and judges to adjudicate disputes.

Breaking contracts is costly, and so is the breaking of trust. Both breaches carry negative consequences. If you break the contract, I may sue you and claim damages. If you break my trust, you may lose whatever reputation you had and you may lose the opportunity to exchange with others on favorable terms. They might ask higher prices to cover the increased risk on account of your known trust breaking. They might ask you to pre-pay instead of granting credit. They might hold you to a different standard, view you with suspicion. You might be ostracized. Trust-breaking can be costly indeed.

Dr. J. Brauer is Professor of Economics at Augusta State University's College of Business Administration. He can best be reached via his web site (http://www.aug.edu/~sbajmb).