Can intermediaries assure contracts? Experimental evidence

Abstract

We model economic transactions as prisoner's dilemma games with an outside option played by randomly matched pairs drawn from an anonymous population. In this environment, two intermediary institutions are studied who punish their customers for cheating. One institution does so by enforcing payment of a fine, while the other inflicts a bad reputation on the customer. By voluntarily becoming a customer of an intermediary institution, a player can signal her pre-commitment to honest action to the transaction party. The paper reports experimental results, which show that such a pre-commitment practice fosters cooperation and improves efficiency relative to the setting without intermediation. The results show that when the intermediary imposes a fine on customers for cheating, behavior moves towards the social optimum. In contrast, when the intermediary has only a mandate to impose a bad reputation score on cheating customers, efficiency gains are small compared to a situation without any intermediary.