Trust, regulation, and market efficiency

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.