The Emergence of Trust

We analyze the phenomenon of gradual increase of stakes in bilateral social interactions in the context of a repeated game with two-sided incomplete information. The underlying stage-game resembles properties of a ”Continuous Prisoner’s Dilemma” with a continuous action space plus the possibility of stealing the opponent’s investment. The continuous investment variable corresponds to cooperation and is interpreted as individual level of trust while the defective action is interpreted as break of trust which terminates the partnership. Players can be of two different types/discount factors. We analyze the structure of efficient equilibria and characterize the Pareto frontier of types’ payoffs. Efficient equilibria are shown to display a typical pattern consisting of three phases. First, in the Communication Phase information about the respective opponent’s type is transmitted, after which in the Adjustment Phase stakes grow over time until in the Established Phase partners behave stationary as under complete information. The efficient adjustment of stakes is governed by the impatience of the low type. Furthermore, we demonstrate that in some equilibria all players do strictly better than in a corresponding game with complete information. JEL Classification: C72, D82, D83