Incentives Are Everything

Mr. Matouschek, as an economist you deal with optimal decisions every day. How do you yourself decide whether to trust someone?

In the best case, I already know the person. Then I know how they think and can assess whether they will actually keep their promise. For instance, one of my colleagues never goes back on his word because that would literally give him a guilty conscience. It’s easy to trust someone like that.

But we often deal with people we’ve never met before.

That makes everything more difficult. Particularly when a stranger is also pursuing their own business interests or is working for a company that by definition is trying to maximize its own profits.

So you can trust someone like that?

In most cases, yes. Otherwise our everyday lives would never work at all. But I always ask myself two questions beforehand. First: Does my counterpart have a long-term interest in keeping a promise although it might be more advantageous to break it over the short term? And second: Would other people find out if this person cheated me? The higher the long-term interest of my counterpart and the more transpar­ency there is, the more likely I am to trust the person.

 

How often have you been correct using this method?

It usually works pretty well. But sometimes it doesn’t, of course. When I moved into a new house with my family a few years ago, my wife and I hired an interior decorator and paid in advance. That was admittedly somewhat naive. The decorator did a good job for a while, but then he was suddenly gone. Just vanished off the face of the earth.

 

Did you research the decorator beforehand?

Friends recommended him to us. And we were certain that he would be interested in our recommending him later as well. But apparently we were wrong about that. There were also no online reviews of him. To that extent, there was a certain lack of transparency.

You research trust as an economist. Have your findings helped you?
Yes, there is always overlap. In the specific case of the interior decorator, for instance, it was interesting because he should have had a strong theoretical interest in our recommending him to others. So much business in his branch comes from personal references. But sometimes things in real life work differ­ently than they do in theory. As an economist and game theorist, I also look at trust through a very special set of glasses.

 

And what do you see?

Incentive systems above all else. I’m interested in whether a person keeps their word and what types of incentives support that even though there’s no benefit over the short term. Incentives are everything.

Can you provide an example?

Let’s say that I am taking a business trip and pick a hotel because it advertises an absolutely gourmet breakfast. It is interesting to see whether the hotelier actually serves me breakfast of the promised quality after I’ve checked into the hotel. Once I’ve paid, the hotel is faced with the increasing temptation to serve me a more mediocre breakfast to save on costs. In my definition, the hotel would be trustworthy when it has the will to prepare me the promised breakfast despite this temptation.

Why would they do that?

Because alongside the short-term temptation to maximize profits is the long-term incentive. As long as the hotel isn’t planning to close anytime soon, it’s also dependent on paying guests in the future. For instance on me, the next time I’m in that city. Or on other guests who decide to book the hotel on my recommendation.

But they might also gamble that you’ll never come back to that city anyhow and other guests won’t find out about your dissatisfaction.

That’s exactly the trade-off the hotel has to consider. How they decide depends strongly on the circumstances. Taking a game theory approach, we’d argue that it depends on how often the game—in this case my choice of a hotel—will be repeated and how high the level of transparency for this decision is. Online rating portals, for example, increase the chance that other guests would find out about my experience. The transpar­ency increases. And with it, the incentives for the hotel to keep its promise.

So you’re saying whether we can trust someone simply depends on whether they expect long-term benefits from it?
It’s not quite that simple. For instance there is an experiment in which two people who have never met before play a unique game. The rules are that person A receives 10 euros. This person may then decide whether they give person B some of the money. If person A shares the money, the money person B receives gets tripled. Afterwards, person B can decide whether or not and how much of the tripled amount goes back to person A. And after that, they never see each other again.

Theoretically, person A would keep all the money and the game would be over.
And that’s exactly what doesn’t happen in practice. Instead what we see is that people trust one another. On average, person A gives about half of the ­mo­ney away, and person B returns about the same amount. People reciprocate nice behavior by acting cooperatively themselves. In purely economic terms, it’s absolutely irrational behavior.

So why does it happen?
I personally believe that we simply all have a certain basic level of trust within ourselves. Some researchers explain this basic trust as providing an evolutionary advantage. It would be very difficult to imagine us living together in large societies with divisions of labor without us mutually trusting one another in advance.

On the other hand, there’s all sorts of fibbing going on in real life.
This is also reflected in the experiment. As soon as the stakes are increased, the shared contribution decreases. So there are limits to our basic trust.

And that brings us back to incentive systems?
Exactly. If for instance you modify the rules so that there are more rounds of game play, you see that the mutual trust increases or decreases depending on the behavior in the first round.

Couldn’t you just draw up a contract in this type of situation that defines exactly what is to be done? I’m happy to share my money with you, but only when I get back 70 percent of the trip­led winnings?
That would be a possibility. And that’s how it’s done in all kinds of businesses in real life.

So we don’t actually need trust if there are watertight contracts?
As long as I clearly define the quality of a service or a product in a contract, fully verify it afterwards and, when in doubt, can sue, then I don’t really need trust. However, the point is that the exact definition and immediate testing of a service ends up being difficult and is often quite expensive in huge sections of the economy. What exactly does a gourmet breakfast entail? And what are the precise details of what you expect from an interior decorator?

You could define it.
In this quite simple example, possibly. But what about digital services? Or software? At some point it becomes infinitely complex and therefore quite expensive. I would even go so far as to claim that trust is what matters most in the majority of cases in today’s economic system.

Why is that?
Because markets without trust wouldn’t work ­nearly as well as they actually could. If you as a customer don’t trust me, then you’ll stop buying from me even if we both profit from the business. And if you’re an investor and don’t trust that I’ll pay back the money, then you won’t loan me any even if I have an extremely good business idea. Many deals wouldn’t take place without trust. There would be less value creation. The market economy would wither on the vine.

At the same time, this trust can always be taken advantage of.
That’s true. Fortunately, our experiments show that taking advantage of someone’s trust doesn’t pay off over the long term. Instead what is rewarded is a good reputation. Acting in a trustworthy manner in modern market economies is good for the soul and also good for the bottom line.

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Niko Matouschek Niko Matouschek is a Professor of Management and Strategy at the Kellogg School of Management at Northwestern University in Chicago. In the interdisciplinary research project “The Trust Project,” he analyzes why people trust one another and what role trust plays in a functioning national economy.