Trust and Law in Credit Markets

This study examines the coevolution of trust and legal institutions in a model of competitive credit markets plagued by asymmetric information. When entrepreneurs' relative payoff to productive activities versus cheating is private information, uncivic ones, who intend to cheat, can enter credit markets and be cross-subsidized by civic ones, who engage in productive activities. To exploit this benefit, uncivic entrepreneurs demand weak legal enforcement through the political process. This rent-seeking behavior interacts with the formation of trust, generating an underdevelopment trap with weak enforcement and distrust. Technological advancement may encourage entrepreneurs' rent-seeking and aggravate distrust.