Trust, Control, and the Economics of Governance

Philipp Herold

• Publisher: Routledge
• Year: 2019
• Topic: Business
• eBook ISBN:
  9781000023343
• Subtopic: Business General
• Index: Business

In today's world, we cooperate across legal and cultural systems in order to create value. However, this increases volatility, uncertainty, complexity, and ambiguity as challenges for societies, politics, and business. This has made governance a scarce resource. It thus is inevitable that we understand the means of governance available to us and are able to economize on them. Trends like the increasing role of product labels and a certification industry as well as political movements towards nationalism and conservatism may be seen as reaction to disappointments from excessive cooperation. To avoid failures of cooperation, governance is important – control through e.g. contracts is limited and in governance economics trust is widely advertised without much guidance on its preconditions or limits.

This book draws on the rich insight from research on trust and control, and accommodates the key results for governance considerations in an institutional economics framework. It provides a view on the limits of cooperation from the required degree of governance, which can be achieved through extrinsic motivation or building on intrinsic motivation. Trust Control Economics thus inform a more realistic expectation about the net value added from cooperation by providing a balanced view including the cost of governance. It then becomes clear how complex cooperation is about 'governance accretion' where limited trustworthiness is substituted by control and these control instances need to be governed in turn.

Trust, Control, and the Economics of Governance is a highly necessary development of institutional economics to reflect progress made in trust research and is a relevant addition for practitioners to better understand the role of trust in the governance of contemporary cooperation-structures. It will be of interest to researchers, academics, and students in the fields of economics and business management, institutional economics, and business ethics.

Note that this work is the first of its kind that explicitly reflects on the societal realities, how these drive the assumption setting process, and how these assumptions influence the theory outcome.

1  Introduction

1.1. The Problem of Governing Cooperation

Growth and prosperity come from people cooperating with each other, by exchanging goods or services and thus realizing value from e.g. specialization or scale-economies (Greif 2000). Over time, cooperation spreads from local modes within families or tribes to interactions across the globe, transgressing legal and cultural borders. Progress and innovation have made the goods and services offered in such cooperative exchange more sophisticated. In the recent past digitalization has brought progress and ever increasing service offerings literally to people’s fingertips. As a result, people enter cooperation by delegating tasks in an increasing number and with increasing complexity—be it to doctors and scientists to secure health and well-being, to retailers and their wholesalers to provide goods or to “an app” and a driver to get a taxi.

At the same time, any such interaction exposes people to one another; they can use the freedom granted by such delegation to each other’s benefit or harm. For example, consumers may share private data with online service providers to enable improved offerings. But at the same time they run the risk that the service provider or sub-contractors may abuse or neglect the sensitivity of such data as cases of e.g. data sales or identity theft show. Such exposure gives rise to the question “how can actors form positive expectations of the behavior of other actors by whom they may be positively or negatively affected?” (Möllering 2005, p. 286). That is, how can actors govern such cooperation to protect themselves before they enter into cooperation and make themselves vulnerable? In this context, governance means ex ante safeguards against abuse for the ones delegating tasks and exposing themselves; vice versa for the ones assuming the task governance ensures they can credibly commit to their “promise” (Greif 2000). Governance can take the form of contracts or surveillance (i.e. control), or can stem from “knowing” that the provider of goods and services will act in one’s best interest (i.e. trust).

The example of data protection in the Internet shows how often consumers expose themselves to “strangers” in order to obtain services based on such data provided. This can be storing personal files in a cloud or enabling the aforementioned app to send a taxi. Protecting such data is a key theme today, raising many concerns about consumer protection. At the same time, research has shown that hardly anyone reads the fine print in contracts (for business to consumer relationships see Obar and Oeldorf-Hirsch 2016; for similar cases in business to business relationships see MacAulay 1963). Despite being offered the chance to confirm what the provider of goods or services will do, people delegate tasks with less governance than what is available. Wagstaff (2012) states that already back in 2011/2012 the average Internet user would have needed 76 days to read all their privacy policies—and the number of services used has increased since. Spending this time would take up much of what people hope to save by using such Internet services. Clearly, governance comes at a cost or may even be unavailable. The question thus is what means of governance are available, which one is the best, whether it is worth taking the risk or whether the cooperation is just not viable.

The complexity of social realities like globalization, specialization and digitalization has made governance a scarce resource. It thus is inevitable that we understand the means of governance available to us so that we are able to economize on such governance devices and make best use of them.

1.2. The Need for a Framework to Economize on Governance Devices

Within social science, the organization of cooperation is the research interest of New Institutional Economics (Ménard and Shirley 2014). Economics, in particular the economics of governance (Williamson (2005), offers us a framework to identify alternative means of governance as well as an explicit trade-off between them. However, economic theory of governance is mostly concerned with extrinsic motivation, such as market competition or contracting. This is linked to the assumption set of economics, in particular the key assumption that people are opportunistic. While this approach is prudent (e.g. Larson 2004), it is also found critical regarding its explanatory power for real-life observations as well as its normative impact.

Firstly, regarding the explanatory power, key concerns are that economic theory falls short of capturing the effect of intrinsic motivation on people’s behavior (Kreps 1997). For the data protection example above, the current economics of governance recommends reading the fine print to make best use of control via the contract. However, we can see that such control may be found unnecessary or too burdensome/too costly compared to alternative means. That is, the real-life solution is outside the solution-space of economics of governance in its current state. Consumers may find the provider trustworthy based on positive experience from the past, or they assume that reputation concerns/social control by the service provider will deter abuse of data. Reasoning like this, including intrinsic motivation of the service provider (i.e. trustworthiness), may explain why consumers rely on the trustworthiness they experienced as governance devices instead of contractual governance by reading the fine print. The question why so much cooperation is successful without market competition and contractual governance was mostly out of scope for economics till today (exceptions to the rule comprise e.g. Dixit 2004). Thus, a refined economics of governance appears necessary in order to include intrinsic motivation as a governance device.

Further, it has become more complex to organize and govern cooperation or any kind of interaction: in a globalized world across legal and cultural borders, where multiple but limited governance mechanisms are at play simultaneously; in an interconnected world, where people passively cooperate because their actions necessarily—but maybe involuntary—affect each other; in a world of specialization and thus complexity, where direct control can no longer be exercised; as well as in a digitalized world, where deception becomes easier. A deeper understanding of the incentives/temptations of all parties involved as well as the governance mechanisms (not) available becomes vital, because in real-life situations both trust and control are inevitable and thus both always play at least some role.

Secondly, regarding normativity, it turned out that the opportunism-assumption may be misleading because it imposes a unilateral prejudice (e.g. Ghoshal and Moran 1996). Time has shown that New Institutional Economics and Transaction Cost Economics in particular developed a successful research program based on the opportunism assumption. Regarding the question why firms even exist in free markets, Williamson’s Transaction Cost Economics has offered a compelling argument, based on the assumption that people act opportunistically. This assumption is not only prudent, but also underscored the problem Transaction Cost Economics is concerned with. However, while the opportunism assumption is very tractable, overextension could lead to unintended consequences at a societal level. Scholars like Ghoshal and Moran (1996) warn that training people to the assumption that others are opportunistic may breed excessive suspicion and undermine cooperation. The challenge for economics of governance is to incorporate intrinsic motivation as a factor to derive a trade-off between more governance devices and thus decrease normativity and increase explanatory power.

The unilateral assumption set can also become a shortfall when trying to reconcile the interpretations New Institutional Economics offers with those from other disciplines looking at organizations and institutions. Historically, economics has focused on extrinsic motivation/control, which inter alia lead to a fruitful research program at the interface of “law and economics”. However, as the research strand around relational contracts (e.g. Campbell 2004) shows, relevant law-research has successfully widened its focus beyond the neoclassical contract. For the same reason, there is little connection between even microeconomics and management sciences, which are more open to e.g. psychological insights. For example, management sciences have established the interplay of control (extrinsic motivation) and trust (intrinsic motivation) as a research topic for much longer and have derived a series of actionable recommendations (e.g. Long and Weibel 2018). Thus, one may reconsider the working assumptions of economics, not only to reduce unilateral normativity, but also to progress alongside “neighboring” disciplines, maintain consistency and remain relevant.

Against this background, the need to reconcile economic theory with real-life phenomena and the need to reduce unilateral normativity, the aim of this book is to develop an economics of governance that takes into account both control (i.e. extrinsic motivation) and trust (i.e. intrinsic motivation). Such “trust control economics” is to provide a view on the required degree of governance and how to best establish it—be it through extrinsic motivation (control) or building on intrinsic motivation (trustworthiness). Correspondingly, trust control economics has to explicate the trade-off between alternative means of governance including cost (signaling/screening and control/commitment) and benefits (the original motivation for even considering cooperation).

1.3. Structure of the Book

The aim of this book is to develop a theoretical framework that allows economizing on governance devices, i.e. to help users recognize and cope with the trade-off between the cost of governance and the level of security required regarding the aspired cooperation gains. The further aim is to develop a practical tool that allows analyzing governance structures on the basis of such theoretical framework, i.e. bringing the theory to use. Such a framework should provide insight into the ex-ante considerations by both the one delegating the task (trustor) and the one assuming the task (trustee) in order to enable better informed cooperation-decisions by both parties. The book thus proceeds at three levels. Chapter 2 to section 3.2 discusses the conceptual framework as a way to think about the governance of interactions at a theoretical level. Section 3.2 to chapter 4 focuses on the practical level, i.e. how to make use of the proposed “view of the world”. Chapter 5 reflects on the conceptual quality of the framework.¹

Chapter 2 lays out the conceptual foundations for a decision heuristic. It starts with an assessment of trustworthiness and control as governance devices, including their interplay. Firstly, the concept of trust and trustworthiness is recapitulated from trust research. Such research on trust is necessary to better understand this “feeling” one often has but seldom can say why. It is explored to what extent trust and trustworthiness can be the subject of a decision heuristic or “rational choice”. Secondly, it is explored whether trustworthiness and control are commensurable for economic analysis——that is, whether they can be considered substitutes or complements with regard to their function as “governance devices” and whether there is the possibility to economize between the two. It appears that one can argue both ways: Governance of cooperation is all about trust, because control devices can also be considered trustees; or governance is all about control, because trustworthiness can be considered self-control.

In chapter 3 the heuristic, including the theoretical framework, the basic pattern of governance accretion and a practical tool for analysis, is developed. First, it sets out how trust control economics can be derived as a framework for analysis by incorporating the issues identified in chapter 2 into an economic framework of governance. It is discussed how the framework enables economizing on trust and control, be they direct or through third parties. It can be seen that intrinsic motivation (trustworthiness) may be less costly and more effective, but harder to signal, and that extrinsic motivation (control) may be more costly and more imperfect, but easier to signal and establish ad hoc. Next, the extended trust sentence is proposed as formulation of the basic pattern underlying trust/governance assessment. It is shown how the extended trust sentence captures the essence of the theoretical framework in a rather intuitive manner and directs users’ attention to possibilities for ex ante structuring of the cooperation. Finally, the game of trust and control is introduced as a practicable tool for analysis, applying trust control economics to support users’ reflection on cooperation structures with regard to the adequacy of governance. Trust control economics and the extended trust sentence highlight how trust is inevitable in general, but trustworthiness of cooperation partners is limited in particular.

Chapter 4 illustrates the application of the extended trust sentence to real-life examples. The first section will illustrate a pragmatic approach to calibrating expected payoffs for trustworthiness given that trustworthiness is hard to observe for the trustor. The following three sections are organized along the archetypical types of trust intermediaries. For each, their role and their limit in “trustworthiness accretion” are shown by applying the extended trust sentence to real-life cases. The cases are selected to reflect the major intricacies of “contemporary modes of cooperation”. As a general insight it can be seen how intrinsic motivation (trustworthiness) may be less costly and more effective but harder to signal, and how extrinsic motivation (control) may be more costly and more imperfect, but easier to signal and to establish ad hoc.

Chapter 5 provides a conceptual assessment of the heuristic. This assessment will be based on a framework of tensions between conflicting goals that heuristics have to deal with. The first is the “rigor relevance gap”, i.e. how well a relevant problem is captured vs. what degree of generality is achieved. Secondly, the tension between re-enrichment and abstraction is considered, i.e. how well users can understand and employ the concept derived. In this context it is also discussed in how far the heuristic can be used for training trust decisions. Thirdly, the (re-)cognition gap, i.e. how well users can apply the concept to a given problem, is considered. This acknowledges the practical limitation of time and resources in decision making.

Concluding chapter 6 recapitulates the key findings of the book and gives a brief summary of result and limitations, both for theory and practice.

Note

1. For the sake of argument the reasoning will mostly take the trustor’s perspective. From a trustee’s perspective this would thus be the reasoning she expects on the part of the trustor. The text is not gendered and generally both genders are implied. For illustrative purposes it is spoken of trustor, he and trustee, she.

2 Understanding of Trustworthiness as an Intrinsic Institution

2.1. Trust: Expected Trustworthy Behavior

2.1.1. Encapsulated Interest as the Rational Choice Account of Trust

This chapter assesses trustworthiness and control as governance devices in order to identify or develop a heuristic that enables better decision making regarding the economics of governance. It is explored whether and under which conditions the concept of trust allows for being economized on as a governance device, and how trustworthiness and control can be made commensurable in economic terms. Critical issues that have to be accommodated in the theoretical framework are derived from the literature on trust and control with a focus on decision making.

In this first section, the trust literature is recapitulated to derive a (consensus) understanding of trust and trustworthiness and their role in the decision-making process. Particular attention will be paid to the question to what extent trust can be appreciated by economics as a “calculative” science as well as the relationship between trust and control. Given the numerous research-focuses within the trust literature (see e.g. Searle et al. 2018b for an overview of the state of the art across all themes of trust research), the following review cannot be exhaustive but aims to include salient contributions and give a fair view of insights and arguments. Especially, a rich body of empirical literature applying concepts of trust will be neglected here as only primarily conceptual contributions will be considered.

As a starting point, the Encapsulated Interest account is presented because it appears to be the “rational choice account of trust” and thus of best use for a decision heuristic. Hardin (2002) emphasizes that the Encapsulated Interest account assumes that the trust decision by the trustor is based on knowledge about the incentives (including trustworthiness) of the trustee. En...

Table of contents

• Cover
• Half Title
• Series
• Title
• Copyright
• Dedication
• Contents
• 1 Introduction
• 2 Understanding of Trustworthiness as an Intrinsic Institution
• 3 The Proposed Heuristic
• 4 Use-Test of the Game of Trust and Control
• 5 Conceptual Evaluation of the Heuristic
• 6 Concluding Remarks
• Publication Bibliography
• Appendix: Game Theoretic Contributions to Formalizing Trust Problems
• Index