The Role of Institutions in the Revival of Trade - The Law Merchant, Private Judges and The Champagne Fairs Pt. 2

• North's 1977 Study: Markets and Other Allocation Systems in History - The Challenge of Karl Polanyi explores different market systems.
• Price-mediated markets rely on prices to allocate resources.
• Reciprocity and distribution involve non-market exchanges.
• Non-market forms of economic organization exist outside traditional markets.
• Milgrom, North, and Weingast's 1990 study examines the role of institutions in trade revival, including the Law Merchant, private judges, and Champagne Fairs.

Medieval Law Merchant

• The central question explores how trade developed over long distances in the medieval ages, preventing cheating among traders.
• Addresses how trust could develop in "honest merchants" despite the short-term incentives to cheat.
• Continuing relationships ensured honest behavior because reputation was a valuable asset.
• Information costs for evaluating traders' reputations increase with community size and trade distance.
• The Law Merchant (Lex Mercatoria) emerged as traders' customary law for cross-border transactions, absent state-protected commercial law.
• The Law Merchant can be compared to modern private international arbitration.
• The Law Merchant emerged due to increasing specialization along with trade over longer distances.
• Law Merchant emerged when markets became larger and more anonymous.
• Because markets became more anonymous, information costs increased.
• Problems arose because other parties' behavior was harder to observe in larger groups.
• Market exit became simpler in case of opportunism ("hit and run").

Cooperation Game: Static Case

• A medieval trader's one-shot decision is modeled as a Prisoner's Dilemma (PD).
• In this game, there exist two players, each with two options: to be honest or to cheat.
• The game assumes α > 1 and α − β < 2.
• If the Prisoner's Dilemma is played once, the only Nash Equilibrium is for both players to cheat.
• Both players are worse-off if they both cheat compared to if they both were honest.

Cooperation Game: Dynamic Case

• Players trade repeatedly, allowing them to condition their behavior on past interactions.
• Players can reward previous honest behavior and punish cheating.
• The dynamic situation is modeled as an infinitely repeated game with discounting.
• The number of stages in the game is unknown.
• The last step of the game isn't relevant for the players.
• Players believe the game will continue for a few more stages at every stage.
• Players discount the next-period payoff by δ ∈ [0, 1) at each time t ∈ N0.
• δ is the probability or frequency that traders will meet again in the next period.
• 1 − δ is the probability that the game will end.
• If δ is close to 1, then trade occurs frequently.
• If δ is close to 0, then trade occurs infrequently or only once.
• Cooperation may emerge in bilateral trade for a large value of δ.
• Grim Strategy: Play Honest if the other player has always played Honest in the past, and play Cheat if the other player ever cheated.
• Tit-for-Tat: Play Honest at t = 0, and in each following turn (t > 0), play whatever the other player played at t - 1.
• The Tit-for-Tat Equilibrium can extend to scenarios with more than two merchants if they belong to a common community.
• Adjusted Tit-for-Tat Strategy (ATFT): If a player cheats, the next merchant they deal with punishes them, even if they weren't the original victim.
• This is effective because it is profitable to cheat a cheater, motivating merchants to punish those who cheat others.
• If a player doesn't punish cheaters, the community punishes them.

Institutional Implications

• ATFT needs common knowledge of past trade history among traders.
• ATFT is not adequate for medieval merchants because trading partners engage in long-distance trade making punishment too costly or impossible.
• Traders may not punish if they expect a profitable deal.
• The Law Merchant Enforcement System overcomes informational barriers and motivates merchants.
• A core component of the Law Merchant Enforcement System is presence of a specialized actor who serves as a repository and adjudicator of disputes: the Law Merchant.
• The Law Merchant Enforcement System involves an accusation of cheating, which then prompts an appeal to the Law Merchant.
• Any dispute is honestly and perfectly adjudicated at cost C to the plaintiff.
• Law Merchant pronouncements award damages if a cheating defendant is found, although payment is voluntary because there is no state to enforce it.
• Parties can visit the Law Merchant prior to finalizing a contract to query the LM records for a cost of Q.
• There is no information about trading history without querying the Law Merchant.
• Traders contact the Law Merchant if they don't have unpaid judgements and if their per-period payoff from honest behavior is 1 − Q.
• Complete Information Equilibria may occur, but may break down given the high cost of information about transaction history.
• The Law Merchant Enforcement System provides information to merchants so they can recognize cheaters.
• The Law Merchant Enforcement System also motivates traders to provide information 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 establish the attractiveness of honest behavior on the market.
• Examples of the Law Merchant Enforcement System are pillories in the medieval ages, review systems like Jameda and TripAdvisor, online trading platforms like eBay, international fruits trade, and credit ratings like Schufa.