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Trust, regulation, and market efficiency

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Abstract

Building from the interest-group theory of regulation, we posit that trust alters the payoff from regulatory rent-seeking relative to profit-seeking. Trust reduces the costs of productive economic exchange by lowering transaction costs, thus raising the cost of rent-seeking behavior. In addition, trust increases political accountability, discouraging politicians from creating regulatory rents. We therefore hypothesize that trust reduces the extent of business regulation while simultaneously facilitating market efficiency. To test that hypothesis, we construct an overall business regulation index measuring procedures, time, and cost along eight dimensions of doing business in a country. The empirical results reveal that trust negatively relates to business regulation but positively relates to market efficiency. Interaction and split-sample results further indicate that trust and business regulation are substitutes. Collectively, the findings reported herein suggest that business regulation itself is not the root cause of market inefficiency, but rather lack of trust is the dominant factor.

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Notes

  1. The loadings for each eigenvector are presented in Panel A, Appendix 2. The higher the loading, the larger the contribution to the variation in each principal component. The results reveal that the loadings on five of eight individual regulation indices examined approximately are the same, with Debt having the largest contribution (with a loading of 0.53) to the first principal component (PC1), followed by Business entry (0.45), Utility (0.43), Court (0.42), Tax (0.38), and so on.

  2. This scatterplot is based on the regression estimation presented in Table 2, Panel B, column (2).

  3. In a prior draft of the manuscript, we also entered rule of law from the Worldwide Governance Indicators as a measure of market efficiency. However, as pointed out by Langbein and Knack (2010), rule of law and corruption control measure the same broad concept. Given that correlation and the empirical evidence indicating that the results are qualitatively similar, we chose to drop rule of law as a measure of market efficiency to avoid redundancy.

  4. Appendix 3 reports estimates from regressing each individual regulation measure on trust for a total of 30 OLS regressions. The results support the findings of Table 2, wherein trust is negative and significantly associated with almost all measures of business regulation (trust is significant in 25 of the 30 specifications).

  5. We replicate Table 2 on a sample of democratic countries. We define a country as democratic if its Polity2 score exceeds the full sample mean. We recreate each business regulation index from that subsample to avoid data biases that can result from reporting errors in autocratic countries. The principal component eigenvalues are presented in Appendix 2, Panel B. The results from the democracy subsample are presented in Appendix 4 and are consistent with the findings for the full country sample.

  6. The results are not tabulated to save space but are available upon request.

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Acknowledgements

We thank the editors and two anonymous referees for valuable comments and suggestions. We also thank participants of the Trust & Regulatory Governance in an Age of Crisis, TiGRE Research Seminar and the 2021 Financial Management Association Conference.

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Authors and Affiliations

  1. Department of Finance and Economics, Mississippi State University, P.O. Box 9580, Starkville, MS, 39762, USA

    Brandon N. Cline & Haoyang Xiong

  2. Department of Finance and Economics, Gary W. Rollins College of Business, University of Tennessee at Chattanooga, 434-D Fletcher Hall, 615 McCallie Ave, Chattanooga, TN, 37403, USA

    Claudia R. Williamson

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  1. Brandon N. Cline
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Appendices

Appendix 1

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Table 8 Data description
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8.

Appendix 2

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Table 9 Principal component analysis, eigenanalysis of the correlation matrix
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Appendix 3

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Table 10 Trust and regulation, individual regulation components
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Appendix 4

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Table 11 Trust and regulation, democracy sample
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11.

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Cline, B.N., Williamson, C.R. & Xiong, H. Trust, regulation, and market efficiency. Public Choice 190, 427–456 (2022). https://doi.org/10.1007/s11127-021-00945-3

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