Theorists and policy analysts have convincingly argued that greater trust makes a more efficient society by reducing the need for costly contracts. At the same time, some experiments have suggested that reciprocity is a potent substitute for law when compliance with contracts is imperfectly enforced. This paper examines these issues within the context of a common trust-building contract device: satisfaction guaranteed. We find that this mechanism does indeed build trust and improve efficiency, but only if it is externally enforced. Paradoxically, only one side of the transaction needs the assurance of external enforcement. Offering a satisfaction guarantee always increases trustworthiness of sellers, even when honoring it is fully voluntary, but only elicits the trust of buyers when it is legally enforced.

In a world of incomplete, unenforceable contracts, both reputation effects and fairness concerns have been suggested as mechanisms capable of avoiding or mitigating market failure. Existing experiments show that labor market failure can be avoided in the absence of individual reputations, apparently due to subjects’ other-regarding preferences. This paper introduces a reputation equilibrium with stereotyping (modeled as a belief of type correlation) that predicts cooperation when individual reputations effects are weak. New experiments show that cooperation emerges when such equilibria are likely to exist, but not when existence is unlikely.

Fehr, Kirchsteiger and Riedl [12] experimentally test a labor market in which worker e#ort levels are chosen after wages are set. They observe high wages and e#ort levels in the repeated game, contrary to the equilibrium prediction. In a similar experimental test of lemons markets, Lynch Miller, Plott and Porter [23] find support for the equilibrium prediction. The current paper finds more evidence of repeated game e#ects than in previous studies. In a model of incomplete information regarding the reciprocal nature of other players, the FKR design is shown to be conducive to reputation e#ects while the LMPP design is not.

Tax Liability Side Equivalence (tax LSE) claims that the statutory incidence of a tax is irrelevant for its economic incidence. Tax LSE is predicted to hold in gift-exchange labor markets if workers ’ effort choices exclusively depend on the net wage, but breaks down if they partially depend on the gross wage paid to workers. This is the case if the tax is perceived to be external to the gift-exchange relationship. We experimentally test tax LSE in a giftexchange labor market and find that it holds very well.

We study differently framed incentives in dynamic laboratory buyerseller relationships with multi-tasking and endogenous matching. The experimental design tries to mitigate the role of social preferences and intrinsic motivation. Absent explicit incentives, effort is low in both tasks. Their introduction boosts efficiency substantially increasing effort in the contractible task, mildly crowding it out in the non-contractible one, and increasing buyer surplus. Bonuses and penalties are equivalent for efficiency and crowding-out, but different in distributional effects: sellers’ surplus increases with bonuses as buyers ’ offers become more generous. Buyers tend to prefer penalties, which may explain why they are dominant in procurement.