The Evolution of Trust under Institutional Moral Hazard

TL;DR

This paper models how reputation systems in for-profit platforms influence trust, moral hazard, and platform incentives, revealing a tension between reputation accuracy and profit-driven distortion.

Contribution

It introduces a theoretical model showing how platforms balance reputation accuracy and profit motives, highlighting the potential for rating inflation and its effects on trust.

Findings

Platforms have incentives for rating inflation to increase commissions.

Reputation distortion is self-limited by the need for accuracy to sustain trust.

Optimal reputation investment depends on the platform's ability to set fees and the trade-off between accuracy and profit.

Abstract

We study the behavior of for-profit institutions that broadcast reputations to foster trust among market participants. We develop a theoretical model in which buyers and sellers are matched on a platform to engage in transactions involving a moral hazard: sellers can either faithfully deliver goods after receiving payment, or not. Although the buyer does not know a seller's true type, the platform maintains a reputation system that probabilistically assigns binary reputation signals. Buyers make purchase decisions based on reputation signals, which influence the payoffs to sellers who then adapt their type over time. These market dynamics ultimately shape the platform's profit from commissions on sales. Our analysis reveals that platforms inherently have an incentive for rating inflation, driven by the desire to increase commission. This introduces a second layer of moral hazard: the platform's incentive to distort reputations for its own profit. Such distortion is self-limited by the platform's need to maintain enough accuracy that trustworthy sellers remain in the market, without which rational buyers would refrain from purchases altogether. Nonetheless, the optimal strategy for the platform can be to invest in order to reduce signal accuracy. When the platform can freely set commission fees, however, maximum profit may be achieved by costly investment in an accurate reputation system. These findings highlight the intricate tensions between platform incentives and resulting social utility for marketplace participants.