Sad news today arrives, as we hear that Douglass North has passed away, living only just longer than his two great compatriots in Cliometrics (Robert Fogel) and New Institutional Economics (Ronald Coase). There will be many lovely pieces today, I’m sure, on North’s qualitative and empirical exploration of the rise of institutions as solutions to agency and transaction cost problems, a series of ideas that continues to be enormously influential. No economist today denies the importance of institutions. If economics is the study of the aggregation of rational choice under constraints, as it is sometimes thought to be, then North focused our mind on the origin of the constraints rather the choice or its aggregation. Why do states develop? Why do guilds, and trade laws, and merchant organizations, and courts, appear, and when? How does organizational persistence negatively affect the economy over time, a question pursued at great length by Daron Acemoglu and his coauthors? All important questions, and it is not clear that there are better answers than the ones North provided.
But North was not, first and foremost, a historian. His PhD is in economics, and even late in life he continued to apply the very most cutting edge economic tools to his studies of institutions. I want to discuss today a beautiful piece of his, “The Role of Institutions in the Revival of Trade”, written jointly with Barry Weingast and Paul Milgrom in 1990. This is one of the fundamental papers in “Analytic Narratives”, as it would later be called, a school which applied formal economic theory to historical questions; I have previously discussed here a series of papers by Avner Greif and his coauthors which are the canonical examples.
Here is the essential idea. In the late middle ages, long distance trade, particularly at “Fairs” held in specific places at specific times, arose again in Western Europe. Agency problems must have been severe: how do you keep people from cheating you, from stealing, from selling defective goods, or from reneging on granted credit? A harmonized body of rules, the Merchant Law, appeared across many parts of Western Europe, with local courts granting judgments on the basis of this Law. In the absence of nation-states, someone with a negative judgment could simply leave the local city where the verdict was given. The threat of not being able to sell in the future may have been sufficient to keep merchants fair, but if the threat of future lost business was the only credible punishment, then why were laws and courts needed at all? Surely merchants could simply let it be known that Johann or Giuseppe is a cheat, and that one shouldn’t deal with them? There is a puzzle here, then: it appears that the set of punishments the Merchant Law could give are identical to the set of “punishments” one receives for having a bad reputation, so why then did anybody bother with courts and formal rules? In terms of modern theory, if relational contracts and formal contracts can offer identical punishments for deviating from cooperation, and formal contracts are costly, then why doesn’t everyone simply rely on relational contracts?
Milgrom, North and Weingast consider a simple repeated Prisoner’s Dilemma. Two agents with a sufficiently high discount rate can sustain cooperation in a Prisoner’s Dilemma using tit-for-tat: if you cheat me today, I cheat you tomorrow. Of course, the Folk Theorem tells us that cooperation can be sustained using potentially more complex punishment strategies in infinitely repeated games with any number of players, although a fundamental idea in the repeated games literature is that it may be necessary to punish people who do not themselves punish when they are meant to do so. In a repeated prisoner’s dilemma with an arbitrary number of players who randomly match each period, cooperation can be sustained in a simple way: you cheat anyone you match with if they cheated their previous trading partner and their previous trading partner did not themselves cheat their partner two rounds ago, and otherwise cooperate.
The trick, though, is that you need to know the two-periods-back history of your current trading partner and their last trading partner. Particularly with long-distance trade, you might frequently encounter traders you don’t know even indirectly. Imagine that every period you trade with someone you have never met before, and who you will never meet again (the “Townsend turnpike”, with two infinite lines of traders moving in opposite directions), and imagine that you do not know the trading history of anyone you match with. In this incomplete information game, there is no punishment for cheating: you cheat the person you match with today, and no one you meet with tomorrow will ever directly or indirectly learn about this. Hence cooperation is not sustained.
What we need, then, is an institution that first collects a sufficient statistic for the honesty of traders you might deal with, that incentivizes merchants to bother to check this sufficient statistic and punish people who have cheated, and that encourages people to report if they have been cheated even if this reporting is personally costly. That is, “institutions must be designed both to keep the traders adequately informed of their responsibilities and to motivate them to do their duties.”
Consider an institution LM. When you are matched with a trading partner, you can query LM at cost Q to find out if there are any “unpaid judgments” against your trading partner, and this query is common knowledge to you and your partner. You and your partner then play a trading game which is a Prisoner’s Dilemma. After trading, and only if you paid the query cost Q, when you have been cheated you can pay another cost C to take your trading partner to trial. If your partner cheated you in the Prisoner’s Dilemma and you took them to trial, you win a judgment penalty of J which the cheater can either voluntarily pay you at cost c(J) or which the cheater can ignore. If the cheater doesn’t pay a judgment, LM lists them as having “unpaid judgments”.
Milgrom, North and Weingast show that, under certain conditions, the following is an equilibrium where everyone always cooperates: if you have no unpaid judgments, you always query LM. If no one queries LM, or if there are unpaid judgments against your trading partner, you defect in the Prisoner’s Dilemma, else you cooperate. If both parties queried LM and only one defects in the Prisoner’s Dilemma, the other trader pays cost C and takes the cheater to the LM for judgment. The conditions needed for this to be an equilibrium are that penalties for cheating are high enough, but not so high that cheaters prefer to retire to the countryside rather than pay them, and that the cost of querying LM is not too high. Note how the LM equilibrium encourages anyone to pay the personal cost of checking their trading partner’s history: if you don’t check, then you can’t go to LM for judgment if you are cheated, hence you will definitely be cheated. The LM also encourages people to pay the personal cost of putting a cheater on trial, because that is the only way to get a judgment decision, and that judgment is actually paid in equilibrium. Relying on reputation in the absence of an institution may not work if communicating reputation of someone who cheated you is personally costly: if you need to print up posters that Giuseppe cheated you, but can otherwise get no money back from Giuseppe, you are simply “throwing good money after bad” and won’t bother. The LM institution provides you an incentive to narc on the cheats.
Note also that in equilibrium, the only cost of the system is the cost of querying, since no one cheats. That is, in the sense of transactions costs, the Law Merchant may be a very low-cost institution: it generates cooperation even though only one piece of information, the existence of unpaid judgments, needs to be aggregated and communicated, and it generates cooperation among a large set of traders that never personally interact by using a single centralized “record-keeper”. Any system that induces cooperation must, at a minimum, inform a player whether their partner has cheated in the past. The Law Merchant system does this with no other costs in equilibrium, since in equilibrium, no one cheats, no one goes for judgment, and no resources are destroyed paying fines.
That historical institutions develop largely to limit transactions costs is a major theme in North’s work, and this paper is a beautiful, highly formal, explication of that broad Coasean idea. Our motivating puzzle – why use formal institutions when reputation provides precisely the same potential for punishment? – can be answered simply by noting that reputation requires information, and the cost-minimizing incentive-compatible way to aggregate and share that information may require an institution. The Law Merchant arises not because we need a way to punish offenders, since in the absence of the nation-state the Law Merchant offers no method for involuntary punishment beyond those that exist in its absence; and yet, in its role reducing costs in the aggregation of information, the Law proves indispensable. What a beautiful example of how theory can clarify our observations!
“The Role of Institutions in the Revival of Trade” appeared in Economics and Politics 1.2, March 1990, and extensions of these ideas to long distance trade with many centers are considered in the papers by Avner Greif and his coauthors linked at the beginning of this post. A broad philosophical defense of the importance of transaction costs to economic history is North’s 1984 essay in the Journal of Institutional and Theoretical Economics. Two other titans of economics have also recently passed away, I’m afraid. Herbert Scarf, the mathematician whose work is of fundamental importance to modern market design, was eulogized by Ricky Vohra and Al Roth. Nate Rosenberg, who with Zvi Griliches was the most important thinker on the economics of invention, was memorialized by Joshua Gans and Joel West.