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 prisoner's 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.