Milgrom, North, and Weingast: The role of institutions in the revival of trade

Milgrom, North, and Weingast. 1990. The role of institutions in the revival of trade: The medieval law merchant, private judges, and [...]. Economics and Politics 1: 1-23.

In Brief

In medieval times, how could one merchant trust other merchants to deal honestly?

The Law Merchant system was a private code of laws among merchants, with disputes adjudicated by a local official or a private merchant, that became widespread by end of 11th century. These judges had no police power and could not enforce judgments, nor was there a state to do so. Yet somehow this system was sufficient to make trade possible. This article seeks to explain why.

The Problem and a Formal Model to Solve It

Without institutions like the Law Merchant system, any interaction between two merchants would be a prisoner's dilemma. Each merchant has strong incentives to cheat the other.

• If they will interact with each other only once, both merchants can be sure to try to cheat (based on the prisoner's dilemma);
• If they will have repeated interaction, honest dealings might be possible if both players adopt a tit-for-tat strategy of doing whatever their opponent did in the previous round.

This tit-for-tat equilibrium can also be reached even among constantly changing opponents if all the opponents (i.e. merchants) belong to a common community. Tit-for-tat becomes adjusted tit-for-tat (ATFT): If you cheat a merchant, you will be punished by the next merchant you deal with, even if he wasn't the one you cheated.

ATFT works for two reasons:

1. It's profitable to cheat the cheater, so you have an incentive to punish somebody who cheated somebody else, and
2. If you fail to punish the cheater, the community will punish you instead.

Of course, this model assumes everyones knows what happens in each trade. This assumption is plausible within a small community of merchants using the reputation system.

The Law Merchant

ATFT wasn't enough to make trade possible among medieval merchants, though. They belonged to a large, dispersed community of merchants, so even if they wanted to use the ATFT strategy, it would be difficult to know whom to punish.

To play ATFT, merchants had two problems to solve.

1. Merchants must be sufficiently motivated to impose sanctions when required, and
2. They must be motivated to stay informed about when sanctions are required.

The Law Merchant (LM) institution solved this problems. The Law Merchant could

• settle disputes between merchants (for a cost);
• impose fines and grant awards, which are paid voluntarily by guilty merchants;
• tell a merchant whether another merchant (whom he presumably wants to trade with) has any complaints against him (for a cost).

Seen as a formal game, this is the sequence of play:

1. Players may query the LM (at cost Q) to see whether opponent (i.e. potential trade partner) has any unpaid judgments;
2. Players play prisoner's dilemma;
3. Either may appeal to LM at cost C (but only if he has queried the LM beforehand);
4. If there's an appeal, LM makes a judgment;
5. Defendant may pay the judgment J or refuse;
6. Unpaid judgments are recorded and become part of LM's permanent record.

As it usually worked out, traders would only query the LM in advance if they themselves had no unpaid judgments. Usually, the payoff from honest behavior would be 1 - Q (where 1 is the payoff of honesty, Q is transaction cost of query, 0 is payoff from not trading at all, and the cost of being cheated is negative)

Why Can't you Bribe the LM?

The LM has an incentive to remain honest to protect his income flow from merchants who trust him. Merchants would be unwilling to pay him for future queries and judgments if word got out that he were corrupt.

Conclusion

LM's make reputation system work better. Queries allow you to know one's reputation (or at least enough of it). Unpaid judgments hurt your reputation. Paying judgments costs more than being honest in the first place. So merchants should be honest.

Related ideas you may encounter: Public stocks, the "scarlet letter," and similar mechanisms also were used to tell you who has violated the community norms.

Comments and Criticism

Should we really believe that the LM has incentives not to take bribes? While it may be true that each trader "expects that if he pays a bribe he will be subjected to repeated attempts at extortion in the future," isn't it also true that each trader fears the costs of being the only trader not paying the bribe? It seems that this is another prisoner's dilemma.