lecture_3_tab - Trust Reference: Chen (2000) Promises,...

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ECOS3003 Lecture 3 1 Trust Reference: Chen (2000) Promises, Trusts and Contracts, JLEO v16, n1, 209-232 Basic Idea – people are ‘trustworthy’ and will be honest unless something significant Induces them to be dishonest Buyer-Seller relationship waiter provides service quality q buyer/diner pays tip
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ECOS3003 Lecture 3 2
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ECOS3003 Lecture 3 3 Solve by backwards induction What do we observe in reality? Why? - reputation? - what about trust? Disutility from breaking implicit contract (social norm) Utility for buyer B – P if pay for the good U = B – k if cheat – don’t pay k is the disutility from breaking implicit contract P is the implicit price for a quality good
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ECOS3003 Lecture 3 4
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ECOS3003 Lecture 3 5 Break implicit contract if k < P Keep the implicit contract if k > P If k {k1,k2} k1 < P < k2 What will the seller do – provide quality or not? - if most buyers have k1, do not provide quality - if most buyers have k2, provide quality good
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ECOS3003 Lecture 3 6
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ECOS3003 Lecture 3 7 More explicit: Buyer γ prob k = k1 (1 – γ) prob k = k2 P implicit price, C cost of supplying quality good The choice for the seller is π(q=H) = γ(-c) + (1 – γ)(P – c) = (1 –γ)P - c π (q = L) = 0
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ECOS3003 Lecture 3 8
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ECOS3003 Lecture 3 9 Provide quality when: (1 – γ)P – c ≥ 0 P – γP ≥ c - γP ≥ c – P - γ ≥ (c – P)/P γ ≤ (P - c)/P Provision of quality when: - more trustworthy people - ‘mark-up’ higher (more profit on each sale to honest person)
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ECOS3003 Lecture 3 10
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ECOS3003 Lecture 3 11 What about contracting? - cost of writing a contract on quality Contract between buyer and seller - if seller does not provide quality qH, penalty will apply of price will be 0 - cost of contracting could be M When will contract be used? - when temptation to cheat is large; that is P – k is large
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ECOS3003 Lecture 3 12
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ECOS3003 Lecture 3 13 Say k1 = k2 = k < P - everyone will cheat (supplier will not provide the quality good at all without any protection) - assume the cost of contract needs to be paid for by the buyer Buyer willing to write contract on quality when: U = B – P – M > 0 or that B – P > M - more likely to write a contract when M is small; easy to contract on quality - when B – P is large; that is, the benefit of getting quality is very high
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ECOS3003 Lecture 3 14
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ECOS3003 Lecture 3 15 Can think of problem other way around Seller wants to contract to ensure payment - assume both quality options better than no supply - again if k1 < P< k2 Then: P – c – M > γ(-c) + (1 – γ)[P - c] or that γP > M Expected loss without contract loss from writing a contract Again, write a contract when easy to do so and the potential loss from not having a contract is large
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ECOS3003 Lecture 3 16
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ECOS3003 Lecture 3 17 Decision rights: level of empowerment - focus on a single decision right - where should it be located in the firm? Assigning tasks and decision rights
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lecture_3_tab - Trust Reference: Chen (2000) Promises,...

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