Disclaimer. Don't rely on these old notes in lieu of reading the literature, but they can jog your memory. As a grad student long ago, my peers and I collaborated to write and exchange summaries of political science research. I posted them to a wiki-style website. "Wikisum" is now dead but archived here. I cannot vouch for these notes' accuracy, nor can I say who wrote them.
Fearon and Laitin. 1996. Explaining interethnic cooperation. American Political Science Review 90 (December): 715-35.
This article addresses three main questions:
"Though both journalists and the academic literature on ethnic conflict give the opposite impression, peaceful and even cooperative relations between ethnic groups are far more common than is large-scale violence. We seek to explain this norm of interethnic peace and how it occasionally breaks down, arguing that formal and informal institutions usually work to contain or 'cauterize' disputes between individual members of different groups. Using a social matching game model, we show that local-level interethnic cooperation can be supported in essentially two ways. In spiral equilibria, disputes between individuals are correctly expected to spiral rapidly beyond the two parties, and fear of this induces cooperation 'on the equilibrium path.' In in-group policing equilibria, individuals ignore transgressions by members of the other group, correctly expecting that the culprits will be identified and sanctioned by their own ethnic brethren. A range of examples suggests that both equilibria occur empirically and have properties expected from the theoretical analysis."
Ethnic groups are a response to the possibility of opportunitism, and they therefore serve a purpose similar to that of the Law Merchant: They allow for trust and reputation to be communicated among a group of people, even if they haven't met, allowing people to cooperate in tit-for-tat prisoner's dilemmas. Having an ethnicity allows you to trust others of your ethnic group (or at least to be able to ask around about him before making a deal), whereas you give only the "lemon price" to outsiders.
This is a similar idea as Akerlof's market for lemons: if you can easily determine whether somebody is a "lemon" (that is, somebody likely to cheat you), then you can avoid Akerlof's "lemons problem," resulting in much higher individual and social welfare. When you deal with people in your ethnic group, you have a means to do this.
The puzzle they solve next is, under what circumstances can people from different ethnic groups exchange at better terms than the lemon price? The two answers are the spiral equilibiria and the in-group policing equilibria. (See p 722 for details about the equilibria.)
For more details, read the authors' conclusion on p 730.
Is this an overly stylized view of ethnicity? Varshney argues that both inter- and intraethnic social capital exist, and that these interethnic social and business networks can prevent ethnic conflict. By contrast, Laitin and Fearon claim (it seems) that ethnicity is definied by networks; if you are part of the network, you are part of the ethnic group, so only intraethnic social capital can exist (by definition). Perhaps, though, from a different perspective, the arguments are reconcilable: Varshney is saying that when the sorts of intragroup mechanisms that Laitin and Fearon describe on 721 begin to cross ethnic lines, then you get ethnic peace.
Also, Fearon and Laitin assume (explicitly) that you have full information about all members of your ethnic group, but no information about others (other than which group they belong to. They admit the implausibility of this assumption and discuss on 721. But without this assumption, can their model still stand?
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