The Role of Institutions in the Revival of Trade - The Law Merchant, Private Judges and The Champagne Fairs

• Roadmap for Foundations of Institutional Economics

North (1977): Markets and Other Allocation Systems in History - The Challenge of Karl Polanyi

• Focuses on price-mediated markets.
• Discusses reciprocity and distribution in economics.
• Explores non-market forms of economic organization.

Milgrom, North & Weingast (1990): The Role of Institutions in the Revival of Trade - The Law Merchant, Private Judges and The Champagne Fairs

• Examines the medieval law merchant
• Covers cooperation games in trade.
• Considers institutional implications.

Medieval Law Merchant

• Addresses how trade developed over long distances in the medieval ages without constant cheating.
• Examines how trust in the "honest merchant" grew despite short-term incentives to cheat.
• Establishment of continuing relationships ensures honest behavior.
• Reputation is a valuable asset that can be lost through dishonesty.
• Information cost increases with community size and lower contact frequency but trade still functions well.
• The Law Merchant (Lex Mercatoria) developed in the medieval ages as traders' customary law for cross-border transactions due to the absence of state-protected commercial law.
• The Law Merchant is comparable to today's private international arbitration.
• There was increasing specialisation and trade over longer distances.
• Markets became larger and increasingly anonymous.
• Information costs increased.
• Observation of other parties' behavior became more difficult in larger groups.
• Market exit in case of opportunism became simpler, described as "hit and run".

Cooperation Game: Static Case

• A medieval trader's one-shot decision is modeled as a Prisoner's Dilemma (PD).
• If the Prisoner's Dilemma is played only once, the only Nash Equilibrium is to play Cheat for both players which makes them worse-off than if they agreed to play Honest.

Cooperation Game: Dynamic Case

• Players trade repeatedly and can condition their behavior based on past interactions, rewarding honesty and punishing cheating.
• The dynamic situation is modeled as an infinitely repeated game with discounting.
• The number of stages is unknown.
• The last step of the game is not specially relevant for the players.
• Players believe the play will continue for a few more stages at every stage of the game.
• Players discount the next-period payoff by δ ∈ [0, 1).
• \delta δ represents the probability or frequency that traders will meet again.
• 1 - \delta δ is interpreted as the probability that the game will end.
• δ close to 1 indicates frequent trade.
• δ close to 0 indicates infrequent trade or only one transaction.

Cooperation in Bilateral Trade

• In bilateral trade, cooperation might emerge for large d by adopting Grim or Tit-for-Tat strategies.
• Grim: Play Honest if the other player always played Honest in the past and play Cheat if the other player cheated once.
• Tit-for-Tat: Play Honest at t = 0, and at each t > 0 play whatever the other player played at t - 1
• Tit-for-Tat Equilibrium can be extended to the case of n > 2 merchants as soon as they belong to a common community.
• Adjusted Tit-for-Tat strategy (ATFT): if a player cheats someone, she will be punished by the next merchant she deals with.
• It is profitable to cheat a cheater, so a merchant has an incentive to punish someone who cheated somebody else.
• If a player abstains from punishing, she gets punished herself by the community.

Institutional Implications

• ATFT requires common knowledge of previous trade history among all traders, which might be inadequate for medieval merchants engaged in long-distance trade.
• Punishment can become too costly or impossible in long-distance trade.
• Traders may not find it in their own interest to participate in punishing if they expect a profitable deal.
• Law Merchant Enforcement System is designed to overcome merchants' lack of knowledge and "to motivate them to do their duties".
• The core component is a specialized actor, Law Merchant, who serves as repository of information and as an adjudicator of disputes.
• Law Merchant Enforcement System involves each party accusing the other of cheating and appealing to the LM after an exchange.
• Any dispute appealed to the LM is perfectly and honestly adjudicated at cost C to the plaintiff.
• LM's pronouncements include the ability to award damages if the defendant is found to have cheated the plaintiff.
• Payment of the damage award is voluntary with no state to enforce payment.
• Parties can visit the LM prior to finalizing a contract to query records of previous judgments at a cost of Q.
• Without querying the LM, players have no information about their current partners' trading history.
• Traders would only contact LM if they don't have any unpaid judgments and their per-period payoff from honest behavior is 1 - Q.
• Complete Information Equilibria may occur (e.g., tit-for-tat) even with infrequent meetings, but might break down if information about trade history is costly.
• Law Merchant Enforcement System provides information to merchants to recognize cheating traders.
• It motivates merchants to provide information and expands the case database.
• It sets incentives for honest behavior and enforces punishment of those who violated rules.
• Reputation and institutions both matter to establish the attractiveness of honest behavior on the considered market.

Examples

• The pillory in the medieval ages, jameda, tripadvisor etc. today
• Ebay and other online trading platforms
• International fruits trade
• Schufa (credit ratings)