The Fundamental Problem Of Exchange In Long Distance Trade Essay Example for Free

The Fundamental Problem Of Exchange In Long Distance Trade Essay How did medieval merchants solve the fundamental problem of exchange in long distance trade? What light does this shed on the prosperity of the Venetian Republic and Portugal before 1700? Trading has been an elementary part of economies since the advantages of it were discovered. The ability to exchange goods greatly contributes to economic efficiency as it enables us to capture gains from natural comparative advantage and division of labour. There are evident gains from trade when a country has an absolute advantage in the production of a good. A country is said to have absolute advantage in production if it can produce the same amount of output with less inputs relative to other countries. This brings about a stronger economy, as there is greater specialisation and technical innovation, which has positive impact on the economy in the long run. There are also gains in trade when a country has a comparative advantage in the production of a good. This is when the opportunity cost for producing a good is lower than that of another country. This results in a higher aggregate output, which means that gains can be split between both countries. The fundamental problem of exchange has existed since the advantages of trade were discovered. It says that even if there are potential gains from trade, trade may still not occur as the lender will not want to lend without being assured that the borrower will not invest the money in a hopeless venture, or take the money and run. It is very difficult to be sure that the person on the other end of a deal will fulfil their contractual obligation. In short, in the absence of commitment, an exchange will not take place. The arguments against trade, if the other side of the bargain wants the maximum gain for him or herself, can be seen very clearly by using the one-sided prisoners dilemma. Player I has the choice of either conducting an exchange or not. If no exchange is conducted, then both player I and II realise no gain. If player I does decide to exchange, player II has the choice to either cooperate or to renege. Both sides gain if player II cooperates, but if we are assuming that player II wants to maximise their own self interest then player II will decide to renege, in which case player I will be worse off. It is possible however that player I will anticipate this happening and so decide not to exchange in the first place. This leaves us in the initial position of both sides not realising any gains from trade and no one being any better or worse off. For the trade to therefore take place, it is essential that player II can guarantee that they will keep to their side of the bargain and not renege. A way for this to successfully occur arose in Europe, as institutions were developed through the formation of merchant guilds. Economic institutions are defined here as a system of social factors, such as rules, beliefs, norms and organisations, that guide, enable and constrain the actions of individuals; thereby generating regularities of behaviour. Merchant guilds were formed in order to act as a deterrent of opportunistic behaviour, both between merchants themselves and between merchants and the state. Within the merchant community itself, the majority of merchants traded through networks of kinship and the exchange of hostages. Networks worked extremely well in deterring opportunistic behaviour, as those with good reputations would carry out many trades, as they were trusted in the community. The fact that reputations also took a long time to build up and could be quickly erased made them of extreme value to people. It was also possible to use strategic marriages and trade through families if you wanted to be sure both sides of a trade were secure. As a medieval ruler would have a local monopoly of the area he ruled, he would be faced with the temptation of abusing his power and appropriating merchants. Merchants therefore devised a solution to combat this problem, which was by organising a boycott of a state that abused the rights of a merchant. This deters predatory behaviour by the ruler, as it is not desirable to deprive the population, the ruler and the merchants the benefits of trade. It therefore has the potential to work very well, but the problem is that it can be very difficult to sustain as some merchants may see ways of maximising their personal gains by renegotiating with the ruler, causing the boycott to deteriorate. It was therefore vital if planning a state boycott to ensure rules were set out to prevent this from happening. Venice played a major role in re-opening the Mediterranean economy to western European commerce after the post-Roman Empire collapse, and the establishment of effective protection for merchants was crucial in this. Venice was very different to other economies of its time as the state was able to create an institutional framework that was favourable to merchant capitalism. It did many things, including the creation of political and legal institutions that guaranteed property rights and enforced contracts; it created a government bonds market, a fiscal system and a democratic system of governance. The creation of the government bonds market was one of the earliest financial markets created. It formed ways of raising funds for the government through compulsory loans on which interest was regularly paid, which is directly comparable to modern day government bonds. It is possible to see just how prosperous the Venetian Republic was in comparison to other European countries by looking at the GDP per Capita it had. In 1500, it had a GDP of $1100, which was far larger than other countries; the UK had a GDP of $714, Spain $698 and the second highest GDP per capita was Belgium with $875. This shows just how prosperous the Venetian Republic really was. Between 1147 and 1249, Portugal emerged from Arab rule. It did so with a significantly different political regime in comparison with that of Venice, as military aristocracy and the church became major landowners, and the interests of the church and the state became very closely linked. The fact that it was placed very well geographically meant that it was able to develop a strong empire through its unearthing of new trade routes and voyages of discovery. The Portuguese state was willing to give Jewish merchants and scholars refuge after they were driven out of Spain, as they recognised the value they had to society through the skills they were able to bring. They were able to provide scientific development, as well as being providing valuable links in trading with the Islamic world. This allowed important networks to be built up, which increased the volume of trade that Portugal came into contact with and so built up its strength as an empire. Although Portugal was extremely successful in its core business areas of shipping and trade, this success did not lead to successful wider development. This can be seen when looking at figures for per capita income before the nineteenth century, which gives an estimate of the per capita income of Portugal of $632. This is far lower than other relatively similarly dominant economies, such as Italy and Belgium, who had per capita incomes of $1100 and $875 respectively. The reason for this can be given by the fact that in general, agriculture and industry were the determining factors when analysing the per capita incomes, and in Portugal these industries were quite underdeveloped relative to other countries. In comparison to Portugal, Venice was far more prosperous. Not only when looking at the per capita incomes, but also when seeing how much more developed the Venetian institutional framework was. It was formed to be favourable to merchant capitalism, which vastly strengthened its trading platform as a country, and therefore the amount of money it was able to make. Trading was only possible through solving the fundamental problem of exchange. Over time, ways of solving the problem became more sophisticated; from using boycotts and networks of trust, to legal frameworks and courts of law. We have been able to become more affluent as economies due to the advantages that trade brings us, as can be seen looking at examples of economies from hundreds of years ago that first experienced the prosperity that trade brought. We have also been able to see the importance that institutions hold in nurturing and maintaining an environment that is favourable to trade, namely in Venice. References: The Fundamental Problem of Exchange: A research agenda in Historical Institutional Analysis Avner Greif, 2000 Cambridge University Press Maryam Shakiba L100