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Contract Enforceability and Economic

Institutions in Early Trade:

The Maghribi Trader’s Coalition

By Avner Grief

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Objective

Knowledge about the historical institutional developments that enabled exchange relations to expand can throw light on nature and evolution of modern institutions and facilitate the understanding of the institutional transitions that developing economies still face

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Paper Outline

• Economic Institution of 11th century traders: Maghribi Traders

• Coalition, which governed relations between merchants and traders

• It operated on a reputation mechanism• Analyzed based on historical records• Study highlights:

– Interaction between social and economic institution– Determinants of business practices– Merchants Law

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Maghribi Traders

In the 10th century, as the social and political environment in Baghdad became increasingly hostile to Jews, some Jewish traders emigrated to the Maghreb. Over the following two or three centuries, such Jewish traders became known as the Maghribis, a distinctive social group who traveled throughout the Mediterranean World. They passed this identification on from father to son. Their tight-knit pan-Maghreb community had the ability to use social sanctions as a credible alternative to legal recourse, which was anyway weak at the time. This unique institutional alternative permitted the Maghribis to very successfully participate in Mediterranean trade.

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Economic Trade Environment

• Trade was free, private and competitive

• Merchants: who want to trade( receiver of residual revenue)

• Overseas Agent : (compensated) to handle goods abroad, involved in decision making as well

• Saves merchant time and risk of traveling

• Trust Problem- agents can act opportunistically and embezzle the merchants goods

• Need for supporting institution to establish agency relations and attain efficient cooperation (qualitative assessment) by overcoming commitment problem

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Historical Data

• Geniza (“deposit place”)

• Maghribi Traders had the custom of depositing in the geniza every document that was written in Hebrew characters

• It contains thousands of contracts, price list, trader’s letters, accounts.

• It is assumed to contain a representative sample of their commercial correspondence

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Commitment Problem: Reasons

• Complexity and Uncertainty of long distance commerce- eg: prices and weather condition not verifiable ex-post, bribes given, goods stolen, cost of delivery etc.

• Slow technology leading to untimely communication and non verifiable data generation

• Possibly Legal system not of much help due to asymmetric information, limitations of applicability of law, time consuming and delayed justice

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Solution Evolved: CoalitionPaper Hypothesis• Coalition: Defined as a group of traders whose member merchants are

expected to hire only member agents, and these agency relations are governed by Multilateral Punishment Strategy(MPS).

• Internal informal information transmission mechanism enables merchants to monitor agents and makes cheating known to all.

Geniza Document Suggest that:• That a reputation mechanism governed agency relations and in particular

that merchants conditioned future employment on the past conduct, practiced community punishment and ostracized agents who were considered cheaters until they compensated the injured

• An agent who has been accused of cheating were to receive agency services from another Maghribi traders, they could cheat him free from community retaliation

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Model Description• Perfect and complete information economy• M merchants , A agents , living for infinite no. of periods• Agents have time discount factor δ• Each unemployed agent could be hired by only one merchant• A merchant who does not hire any agent receives a payoff of κ >0• If agent is honest, the merchants payoff is γ-w and agents payoff is w • If the agent cheats his payoff is α and the merchants payoff is 0.• Probability of merchant terminating agents services due to exogenous variable is

τ• Unemployed agent receives the reservation utility of ϖ >=0• Assumption γ> κ + ϖ : cooperation is efficient• Assumption γ> α > ϖ : cheating entails a loss, agent prefers cheating over

receiving his reservation utility.• Assumption κ > γ- α : merchant prefers to operate by himself if the agent is to

cheat him or to receive a wage α• the probability that unemployed honest agent(when last employed) will be

rehired• the probability that unemployed cheater agent(when last employed) will be

rehired

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Proposition 1

• Assume that ,

The optimal wage, the lowest wage for which it is an agent’s best response to play honest, is

and w is monotonically decreasing in and monotonically increasing in

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Proposition 1 : Proof

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Multilateral Punishment Strategy - MPS

A merchant offers an agent a wage W*, rehires the same agent if he has been honest (unless forced separation has occurred), fires the agent if he has cheated, never hires an agent who has ever cheated any merchant, and (randomly) chooses an agent from among the unemployed agents who never have cheated if forced separation has occurred.

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Why MPS Works

• An agent is motivated to be honest by the carrot of a premium over his reservation utility and the stick of firing.

• The optimal wage decreases as the honest agent is more likely to receive future wage premiums (higher ) can gain less by cheating (lower α) , is more likely to remain employed if

he is honest (lower τ), has worse opportunities elsewhere

(lower ϖ ), and has a smaller chance of being hired if he is cheater (lower ) and as agent values his future income more (higher δ)

• Merchant find it optimal to hire agent if wages are low enough

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Proposition 2

Assume the δ ϵ (0,1) and under MPS

merchant strictly prefers to hire a honest agent

So it is not the compulsion of MPS due to which

he can not hire the cheat agent (socially labeled)

rather a individual rationality.

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Proposition 2: Proof

• We know

• Also, w* is monotonically increasing in and monotonically decreasing in

• Under MPS

• Under MPS

• Proposition 1 implies that

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Bilateral Punishment Strategy - BPS

Identical to MPS but merchants do not condition hiring decision on agents past behavior (because such information is not gathered, given that nobody is expected to use it)

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Why MPS preferred to BPS

• History and theory lend support to the main hypothesis that coalition relations are governed by MPS

• Why MPS is self enforcing • Why two different coalitions do not merge• Because MPS is more efficient that BPS

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Proposition 3

MPS supports cooperation when BPS fails.

Take the limits of W* as δ goes to 1 using the fact that

Under BPS

Under MPS

Plug these in proposition 1

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Sustainability of Coalition

• MPS enhances its efficiency compared to BPS

• Efficiency gains generated by coalition encourage its emergence

• MPS not applied in intercoalition due to nature of the network of information transmission and strategic considerations

• Intracoalition preferred to intercoalition, intracoalition is self enforcing.

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Merchants Law

• To bring in coordination and threat of collective punishment credible, consensus should be reached what is considered as cheating

• Detailed contracts were not possible since they require high negotiation costs.

• Instruction list was shared by the merchant with the agent

• Set of cultural rules of behavior were employed for circumstances not mentioned in instruction list sent by merchant

• Failing to follow instructions or set of cultural rules lead to agent being considered cheater.

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Conclusion

• The evidence suggests that the coalition was a response to problems of contract enforceability, although not optimal response

• Intergenerational transfers ensured the horizon long enough to support the operation of a reputation mechanism

• Original social structure lead to economic institution which in turn preserved initial social structure.

• The factors which ensured the sustainability of coalition prevented the coalition from expanding in response to welfare enhancing opportunities

• Economic growth in different economies may be diverse due to distinct institutional framework of historical origin

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Thanks!