Private Order Institutions: The case of the Maghribi Traders

1. Private Order Institutions:The case of the Maghribi Traders UBC - Econ 334 Mauricio Drelichman

2. Last lecture recap The Manorial system was the set of institutional arrangements that structure rural economic life in the Middle Ages. Its key elements were: Open fields. Serfdom. Input sharing (labor dues). North and Thomas argued that these institutional arrangements were efficient in the absence of a monetary market economy. Fenoaltea contended that the problems of the Manorial economy could be easily (and more efficiently) solved without resorting to serfdom and input sharing.

3. Bibliography Greif, A. Reputation and Coalitions in Medieval Trade: Evidence on the Maghribi Traders. Journal of Economic History.

4. Impersonal trade We all conduct transactions - trade - with people we know and trust. We do so because we are reasonably certain that they will live up to their end of the bargain. This type of trade - personal trade - is sustained by: Trust relationships. Natural groups (tribes / clans). Kinship ties (family). Fear of God. The development of a market economy, however, relies on impersonal trade - a large number of transactions with people we never met before and will likely never meet again. What are the problems of impersonal trade?

5. The prisoner�s dilemma In any economic transaction, at least one party will have the option to cheat. After enjoying a meal at a restaurant, you could walk out without paying the bill (failure to deliver payment). You might advertise a product in an online auction, collect the winning bid and never ship the item (failure to deliver goods). If there is no way to enforce the completion of the transaction or to punish a cheater, trade will not take place. In game theory, this problem is known as the prisoner�s dilemma.

6. The prisoner�s dilemma Two prisoners are accused of a crime. If both of them stay silent, each of them will receive a one year sentence. If both of them betray each other, each of them will receive a five year sentence. If one stays silent but the other betrays him, the prisoner who stayed silent receives a ten year sentence while the one who betrayed him will walk free. Each prisoner wants to minimize the time he serves, and does not care about the other prisoner.

7. Payoffs of the game for player 1

8. Payoffs of the game for player 2

9. One-shot Nash equilibrium If the game is played only once, no matter what prisoner 2 does, prisoner 1 is always better off betraying. Similarly, prisoner 2 is always better off betraying, no matter what prisoner 1 does. That means that both will betray and each will get 5 years. But if they both could agree to cooperate, they would only serve 1 year each! This is called a Nash equilibrium - both parties end up in a suboptimal situation because they cannot commit to play cooperatively.

10. Nash equilibrium vs. social optimum

11. Breaking the Nash equilibrium If the two players play the same game repeatedly, it is possible to break the Nash equilibrium. Each has an incentive to cooperate today so that their opponent will continue to cooperate in future periods. If the game is played only once, the only way to escape from the Nash equilibrium is to adopt a commitment device. Impersonal trade resembles the prisoner�s dilemma. You most likely meet your counterparty only once, and you only care about your gains. Institutions are commitment devices that allow traders to commit not to cheat on each other, therefore avoiding the Nash equilibrium and allowing impersonal trade to take place.

12. Agency problems One particular type of Nash equilibrium arises when agents are employed to oversee part of a business operation. The use of agents allowed capitalists and traders to realize efficiency gains. The use of traveling agents enabled capitalists to trade with different locations simultaneously. The use of agents residing in remote locations allowed for better knowledge of local conditions and saved on traveling costs. Agency, however, had its own problems: The agent could run away with the capital or lie about the circumstances of a loss. The agent could lie about market conditions in remote locations.

13. Solving agency problems In the absence of a commitment device, agents would have always had an incentive to cheat on their principals. Some trading companies, particularly Italian ones, employed only family members as agents. Created a repeated game. Had a potentially large punishment if the agent was caught cheating. Greif examines a different type of commitment device: private-order institutions. Public institutions are sustained and enforced by the state. Private-order institutions must be self-enforcing.

14. Early Mediterranean Trade Encompassed a closely knit trading area from Southern Spain to Arabia. There were few trade barriers and rulers were generally supportive. Goods and transportation markets were competitive. There were many sources of uncertainty: Market volatility. Transit time volatility. Information could only move as fast as ships. Risk of �sea and people.�

15. The Geniza Documents How can we learn about the particularities of Medieval trade? Greif finds a valuable source in the Geniza documents. In the Jewish tradition, documents containing the name of God could not be destroyed. A Geniza was a room in a synagogue where such documents were deposited. The Fustat (Old Cairo) Geniza documents have survived to the present, and contain a plethora of trading contracts. Among the Geniza documents, Greif exploits those pertaining to the Maghribi traders.

17. The Maghribi Traders The Maghribi traders were a group of Jewish traders spread throughout the Mediterranean basin in the eleventh century. They were largely middle-class, and engaged in small and mid-sized trading ventures. They were not ethnically or religiously different from other Jewish groups (which they could join). Their trading relationships were supported exclusively through an economic, private-order institution: the coalition.

18. Trading relationships The Maghribi traders were sedentary. They acted alternatively as principals or agents in different ventures. If the trader risked his own capital, he acted as the principal. If the trader managed another trader�s capital and charged for the service, he acted as an agent. The legal system did not provide a framework to enforce contracts, as virtually all ventures spanned more than one sovereign territory. Trading relationships were based on �trust.�

19. Reputation mechanisms Kinship, religious and group mechanisms enable an agent to signal his honesty or fear of God. The Maghribi traders shared a religious faith. Greif argues that their ventures did not rely on this. Commitment mechanisms enable an agent to establish ex-ante that his most profitable course of action is to be honest. The Maghribi traders developed an economic institutions - the �coalition� - that enabled them to commit ex ante not to cheat on their business associates.

20. The coalition Every coalition member agrees to employ only other coalition members as his agents. This limits the supply of available agents, thus generating a premium compensation. All members agree to never employ a member who has cheated on any other coalition member. In addition, if a member cheats, all other members can cheat back on him without being penalized in turn (this is called a �cheat the cheater� strategy).

21. Enforcing the coalition Coalition members kept a fluid correspondence with other coalition members as part of their trading relationships. This ensured that each trader was timely informed of local market conditions in virtually every location where the coalition operated. The Maghribi traders used a �per-venture� accounting system, detailing the profit or loss of each individual trade. The abundant flow of information combined with the per-trade accounting system made it easy to spot cheaters.

22. Contractual forms in Medieval trade Italian merchants relied mostly on the commenda and the sea loan: In a commenda, one partner supplies the capital, while the other travels. If the venture is successful, they split the gains. If unsuccessful, the capitalist bears most of the losses. A sea loan is a standard loan where the borrower bears all the risk, with the exception of some insurance provisions (for example, for shipwreck or piracy). Wealthy capitalists minimized the risk of cheating by hiring young partners with low outside options. The Magrhibi traders relied on partnerships, formal friendships, and factor relations: These contractual forms are much more flexible, allowing the partners to alternatively fulfill the role of principal or agent. The penalty for cheating is external to the contractual relationship.

23. Life of the relationship Italian merchants created family firms, and sons inherited the liabilities of their fathers. Creating �infinitely-lived� firms increased the incentives to be honest with your firm (family). The Maghribi traders continuously entered and left short-lived partnerships with many other members of the coalition. Repeated games among the same individuals were not necessary to generate �trust.� Traders in the same family were normally not in partnership with each other.

24. The limits of the coalition The Maghribi traders retained their separate social identity within local Jewish groups only as long as they were engaged in long distance trade. They did not engage in partnership with other Jewish, Christian or Muslim members. Coalitions tend to be closed: The cost of maintaining the flow of information increases with the size of the coalition. Outsiders require a higher premium; if they cheat, they cannot by punished by the coalition.