The Role of Institutions in the Revival of Trade - The Law Merchant, Private Judges and The Champagne Fairs Pt. 3

• North's 1977 publication explores markets and allocation systems in history, addressing Karl Polanyi's challenge.
• The study covers price-mediated markets, reciprocity and distribution, and non-market forms of economic organization.
• Milgrom, North & Weingast's 1990 study examines the role of institutions in the revival of trade, focusing on the Law Merchant, private judges, and Champagne Fairs.
• The study investigates the medieval Law Merchant, cooperation games, and institutional implications.

Medieval Law Merchant

• A central question is how trade developed over long distances in the medieval ages, considering the risk of cheating.
• The issue of how trust in "honest merchants" grew despite short-term incentives to cheat is explored.
• Honest behavior is ensured by establishing continuing relationships.
• Reputation serves as an asset that can be lost through dishonest behavior.
• Information costs for evaluating traders' reputations increase with community size and trade distance which is due to lower contact frequency.
• Even with infrequent interactions, trade functions well.
• The Law Merchant (Lex Mercatoria) developed in the medieval ages in the absence of state-protected commercial law.
• Law Merchant (Lex Mercatoria) served as traders' customary law for cross-border transactions, similar to today's private international arbitration.
• Increasing specialization and trade over longer distances marked the starting point of Law Merchant.
• Markets became larger and more anonymous, increasing information costs.
• Observing other parties' behavior became more difficult in larger groups.
• Market exit in case of opportunism became simpler, which is characterised as "hit and run."

Cooperation Game: Static Case

• A medieval trader makes one-shot decsions which can be modeled as a Prisoner's Dilemma (PD).
• If the Prisoner's Dilemma is played once, both players will choose to cheat.
• Both players would be better off if they agreed to cooperate.

Cooperation Game: Dynamic Case

• When players participate in repeated trade, they can condition their behavior on past actions, rewarding honesty and punishing cheating.
• This dynamic is modeled as an infinitely repeated game with discounting.
• The number of stages in this model is unknown.
• The last step holds no relevance for the players.
• At each stage, players believe that the game will continue.
• Players discount future payoffs by a factor δ between 0 and 1.
• δ represents the probability or frequency of future meetings between traders along with the probability that the game will end
• δ close to 1 means that trade occurs frequently.
• δ close to 0 means that trade occurs infrequently or only once.
• Cooperation may emerge in bilateral trade for large δ through strategies like Grim or Tit-for-Tat.
• Grim: If the other player has always been honest, continue to play Honest; if the other player ever cheated, play Cheat.
• Tit-for-Tat: Start by playing Honest, and in each subsequent round, play whatever the other player played in the previous round.
• Tit-for-Tat Equilibrium: Merchants 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.
• Merchants are incentivized to punish cheaters since it's profitable to cheat a cheater.
• If a player doesn't punish, she gets punished by the community.

Institutional Implications

• ATFT requires common knowledge of trade history among all traders which can be inadequate for medieval merchants due to long-distance trade making punishment costly or impossible.
• Traders may not want to punish if they anticipate a profitable deal.
• The Law Merchant Enforcement System addresses merchants' lack of knowledge to motivate them to fulfill duties.
• A Law Merchant serves as a specialized actor, repository of information, and adjudicator of disputes.
• The Law Merchant Enforcement System involves each party being able to accuse the other of cheating after any exchange.
• A dispute appealed to the Law Merchant (LM) is perfectly and honestly adjudicated at a cost to the plaintiff.
• LM pronouncements can award damages to the plaintiff if the defendant cheated
• Payment of the damage award is voluntary since there's no state to enforce payment.
• A party can visit the LM prior to finalizing a contract, and for a cost Q, query the LM for records of previous judgments about any other player.
• Without consulting the LM, players have no information about their current partners’ trading history.
• Traders would contact LM if they don’t have unpaid judgments and their per-period payoff from honest behavior is 1 − Q.
• Complete Information Equilibria may occur (e.g., tit-for-tat), but can break down if information about trading counterparts is too costly.
• The Law Merchant Enforcement System provides information to merchants so they can recognize cheaters.
• The Law Merchant Enforcement System motivates merchants to provide information on their injuries to expand the case database.
• The Law Merchant Enforcement System sets incentives for honest behavior and enforces punishment for rule violations.
• Both reputation and institutions are needed to establish the attractiveness of honest behavior.

Examples

• The pillory in medieval ages, jameda, and TripAdvisor today are examples.
• Ebay and other online trading platforms are examples.
• International fruits trade are examples.
• Schufa (credit ratings) is an example.