More Quality, Less Trust?

Michael Dreyfuss, Yahel Giat () and Eran Manes
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Michael Dreyfuss: Department of Industrial Engineering, Jerusalem College of Technology, Jerusalem 9116001, Israel
Yahel Giat: Department of Industrial Engineering, Jerusalem College of Technology, Jerusalem 9116001, Israel
Eran Manes: Department of Business Management, Jerusalem College of Technology, Jerusalem 9116001, Israel

IJFS, 2024, vol. 12, issue 4, 1-18

Abstract: This study investigates how an increase in the quality of business ventures, measured as their success probability, affects trust and return on investment (ROI) in situations where the investor–entrepreneur interaction is affected by moral hazard and asymmetric information. We model a repeated trust problem between investors and entrepreneurs, featuring moral hazard and adverse selection. Hidden Markov techniques and computer simulations are used to derive the main results. We find that trust and ROI may decline as quality improves. Although lenders tend to reduce the requirements for granting initial credit, they nevertheless become less tolerant of current borrowers who fail to pay back. Additionally, we demonstrate a novel substitution effect, where lenders prefer new borrowers over existing borrowers that experienced early failures. The main conclusions of our study are that while impressing early on is effective in gaining first access to credit, it may nevertheless hurt the cause of getting credit in subsequent periods, following an early failure. In business environments plagued with ex post moral hazard, entrepreneurs might do better by gaining trust first and impressing later. Furthermore, our results imply that in a thriving economy, not only are bad loans made, but good loans are lost as well.

Keywords: quality signaling; entrepreneurial finance; trust; micro-lending; moral hazard (search for similar items in EconPapers)
JEL-codes: F2 F3 F41 F42 G1 G2 G3 (search for similar items in EconPapers)
Date: 2024
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