Milgrom (1)

Milgrom (1) - ECONOMICS AND POLITICS Volume 2 0954- 1985...

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ECONOMICS AND POLITICS Volume 2 March 1990 0954- 1985 No. I THE ROLE OF INSTITUTIONS IN THE REVIVAL OF TRADE: THE LAW MERCHANT, PRIVATE JUDGES, AND THE CHAMPAGNE FAIRS PAUL R. MILGROM, DOUGLASS c. NORTH AND BARRY R. WEINGAST* A good reputation can be an effective bond for honest behavior in a community of traders if members of the community know how others have behaved in the past - even if any particular pair of traders meets only infrequently. In a large community, it would be impossibly costly for traders to be perfectly informed about each other's behavior, but there exist institutions that can restore the effectiveness of a reputation system using much less extensive information. The system of judges used to enforce commercial law before the rise of the state was such an institution, and it successfully encouraged merchants (1) to behave honestly, (2) to impose sanctions on violators, (3) to become adequately informed about how others had behaved, (4) to provide evidence against violators of the code, and (5) to pay any judgments assessed against them, even though each of these behaviors might be personally costly. How can people promote the trust necessary for efficient exchange when indivi- duals have short run temptations to cheat? The same question arises whether the traders are legislators swapping votes, medieval merchants exchanging goods, or modern businesspeople trading promises about future deliveries. In each of these situations, one of the important ways in which individuals ensure one another's honest behavior is by establishing a continuing relationship. In the language of economics, if the relationship itself is a valuable asset that a party could lose by dishonest behavior, then the relationship serves as a bond: a trader would be unwilling to surrender this bond unless the gain from dishonest behavior was large. Variants on this basic idea are found throughout the literatures of economics (Klein and Leffler, 1981; Shapiro, 1983; Shapiro and Stiglitz, 1984), politics (Axelrod, 1984, 1986; Calvert, 1986) and game theory (Abreu, 1988; Aumann, 1985; and Fudenberg and Maskin, 1986). Even in a community in which any particular pair of people meet rarely, it is still possible (as we show) for an individual's reputation in the group as a whole to serve as a bond for his good and honest behavior toward each individual member. This illustrates the important fact that a reputation system may sometimes work only when it encompasses *Department of Economics, Stanford University: Department of Economics. Washington University; Hoover Institution. Stanford University. The authors thank Robert Aumann, Gary Becker, Peter DeMarzo. Avner Greif. Michihiro Kandori, Bart Lipson. Uwe Schimack and the participants at numerous workshops for helpful conversations. Mr Milgrom and Mr Weingast thank the National Science Foundation for partial support.
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This note was uploaded on 02/21/2010 for the course ECON 330 taught by Professor Iorio during the Spring '10 term at USC.

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Milgrom (1) - ECONOMICS AND POLITICS Volume 2 0954- 1985...

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