Trust and Social Collateral

This paper builds a theory of trust based on informal contract enforcement in social networks. In our model, network connections between individuals can be used as social collateral to secure informal borrowing. We de…ne network-based trust as the highest amount one agent can borrow from another agent, and derive a reduced-form expression for this quantity which we then use in three applications. (1) We predict that dense networks generate bonding social capital that allows transacting valuable assets, while loose networks create bridging social capital that improves access to cheap favors like information. (2) For job recommendation networks, we show that strong ties between employers and trusted recommenders reduce asymmetric information about the quality of job candidates. (3) Using data from Peru, we show empirically that network-based trust predicts informal borrowing, and we structurally estimate and test our model. E-mails: [email protected], [email protected], [email protected], [email protected]. We thank Attila Ambrus, Susan Athey, Antoni Calvó-Armengol, Pablo Casas-Arce, Rachel Croson, Avinash Dixit, Drew Fudenberg, Andrea Galeotti, Ed Glaeser, Sanjeev Goyal, Daniel Hojman, Matthew Jackson, Rachel Kranton, Ariel Pakes, Andrea Prat, Michael Schwarz, Andrei Shleifer, Andy Skrzypacz, Fernando Vega-Redondo and seminar participants for helpful comments. A growing body of research demonstrates the importance of trust for economic outcomes.1 Arrow (1974) calls trust “an important lubricant of a social system”. If trust is low, poverty can persist because individuals are unable to acquire capital, even if they have strong investment opportunities. If trust is high, informal transactions can be woven into daily life and help generate e¢ cient allocations of resources. But what determines the level of trust between individuals? In this paper we propose a model where the social network in‡uences how much agents trust each other. Sociologists such as Granovetter (1985), Coleman (1988) and Putnam (2000) have long argued that social networks play an important role in building trust.2 In our model, networks create trust when agents use connections as social collateral to facilitate informal borrowing. The possibility of losing valuable friendships secures informal transactions the same way that the possibility of losing physical collateral can secure formal lending.3 Since both direct and indirect connections can serve as social collateral, the level of trust is determined by the structure of the entire network. Although we present our model in terms of trust over a borrowing transaction, it can also apply to other situations that involve moral hazard or asymmetric information, such as hiring workers through referrals.4 To understand the basic logic of our model, consider the examples in Figure 1, where agent s would like to borrow an asset, like a car, from agent t, in an economy with no formal contract enforcement. In Figure 1A, the network consists only of s and t; the value of their relationship, which represents either the social bene…ts of friendship or the present value of future transactions, is assumed to be 2. As in standard models of informal contracting, t will only lend the car if its value does not exceed the relationship value of 2. More interesting is Figure 1B, where s and t have a common friend u, the value of the friendship between s and u is 3, and that between u and t is 4. Here, the common friend increases the borrowing limit by min [3; 4] = 3, the weakest link on the path connecting borrower and lender through u, to a total of 5. The logic is that the intermediate agent u vouches for the borrower, acting as a guarantor of the loan transaction. If the borrower chooses not to return the car, he is breaking his promise of repayment to u, and therefore loses u’s Trust has been linked with outcomes including economic growth (Knack and Keefer 1997), judicial e¢ ciency and lack of corruption (La Porta, Lopez-de-Silanes, Shleifer, and Vishny 1997), international trade and …nancial ‡ows (Guiso, Sapienza, and Zingales 2008), and private investment (Bohnet, Herrman, and Zeckhauser 2008). Glaeser, Laibson, Scheinkman, and Soutter (2000) show in experiments that social connections increase trust. Field evidence on the role of networks in trust-intensive exchange includes McMillan and Woodru¤ (1999) and Johnson, McMillan, and Woodru¤ (2002) for business transactions in Vietnam and transition countries; Townsend (1994) and Udry (1994) for insurance arrangements in India and Nigeria; and Macaulay (1963) and Uzzi (1999) for …rms in the U.S. We abstract from morality, altruism and other mechansisms that can generate trust even between strangers (e.g., Fukuyama (1995), Berg, Dickhaut, and McCabe (1995)); hence our de…nition of trust is like Hardin’s (1992). 4 In related work, Kandori (1992), Greif (1993) and Ellison (1994) develop models of community enforcement where deviators are punished by all members of society. More recently, Ali and Miller (2008), Bloch, Genicot, and Ray (2005), Dixit (2003) and Lippert and Spagnolo (2006) explore models of informal contracting where networks are used to transmit information. In contrast, in our work the network serves as social collateral.