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B regards the proposal as fair, but is worried about one thing: why
should she trust A not to renege on the agreement by keeping the
entire $8,000 for himself?

External enforcement
Here is one possible way to ensure that B could trust A: the
agreement is enforced by an established structure of power and
authority. In many societies, tribal chieftains, village or clan elders,
and warlords enforce agreements and rule on disputes. Here we
imagine that the external enforcer is the state and that the

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agreement is drawn up as a legal contract. We include on this list
the implicit ˜social contract™ among citizens not to break the law.
However, if contracts are to offer a viable means of doing things,
breaches must be veri¬able; otherwise, the external enforcer would
have nothing to go by if asked to rule on it. To be sure, lawyers, like
Becky™s father, make a handsome living precisely because
veri¬cation is fraught with dif¬culties. Rough estimates suggest
that in the US, expenditure on the legal profession (lawyers, judges,
investigators), on people who work in insurance (loss adjusters,
insurance agents), and on those in law enforcement (the police)
make up $245 billion a year, which is about 2% of the US™s GDP;
and I haven™t included the defensive measures people take against
possible litigations, burglary, and theft.

We leave aside the problems that arise in verifying breach of
contract (but see Chapters 4“5) and note that if the punishment the
state imposes for a violation is known to be severe relative to the
temptation A faces to violate, A will be deterred from going that




Trust
route. If B is aware of the force of that deterrence, she will trust A
not to renege. And A will trust B not to renege, because he knows B
doesn™t fear that he will renege. In Becky™s world, the rules
governing transactions in the market place are embodied in the law
of contracts. Becky™s father™s ¬rm is a legal entity, as are the ¬nancial
institutions through which he is able to accumulate his retirement
pension, save for Becky™s and Sam™s education, and so on. He has an
employment contract with his ¬rm. The agreements he has reached
with the saving and pension institutions are legal contracts. Even
when someone in the family goes to the grocery store, the purchases
(paid in cash or by card) involve the law, which provides protection
for both parties (the grocer, in case the cash is counterfeit or the
card is void; the purchaser, in case the product turns out on
inspection to be substandard). Formal markets, from which people
enter and exit when they need to or wish to, are able to function
only because there is an elaborate legal structure that enforces the
agreements known as ˜purchases™ and ˜sales™. Moreover, it is because
Becky™s family, the grocery store™s owner, and the credit card

37
company are con¬dent that the government has the ability and
willingness to enforce contracts that they do business together.

Given that enforcing contracts involves resources, what is the basis
of that con¬dence? After all, the contemporary world has shown
that there are states and there are states. One answer “ in a
functioning democracy “ is that the government worries about its
reputation. A free and inquisitive press helps to sober the
government into believing that incompetence or corruption would
mean an end to its rule, come the next election. Notice how this
involves a system of interlocking beliefs about one another™s
abilities and intentions. The millions of households in Becky™s
country trust their government (more or less!) to enforce contracts,
because they know that government leaders know that not to
enforce contracts ef¬ciently would mean being thrown out of of¬ce.
In their turn, each side of a contract trusts the other not to renege
(again, more or less!), because each knows that the other knows
Economics




that the government can be trusted to enforce contracts. And so on.
Trust is maintained by the threat of punishment (a ¬ne, a jail term,
dismissal, or whatever) for anyone who breaks a contract, be the
contract legal (Becky™s father™s employment contract) or social (the
contract between the voters and the government in Becky™s world to
maintain law and order). We are in the realm of beliefs that are held
together by their own bootstraps (our earlier condition (2) ).

What I have presented is only the sketch of an argument. The
complete argument is similar to the one which shows that social
norms also offer a way to enforce agreements. So I turn to that for
details.

Mutual enforcement
Although the law of contracts exists in Desta™s country, her family
can™t depend on it. The nearest courts are far away and there are no
lawyers in sight. As transport is very costly, her village is something
of an enclave. Economic life is shaped outside a formal legal system.
Nevertheless, Desta™s parents do business with others. Saving for

38
funerals involves saying, ˜I accept the terms and conditions of the
iddir™. As there are no formal credit markets where they live,
villagers practise reciprocity so as to smooth consumption. A recent
study has found that in a sample of villages in Nigeria nearly all
credit transactions were either between relatives or between
households in the same village. No written contracts were involved,
nor did the agreements specify the date of repayment or the amount
repaid. Social codes were implicitly followed. Less than 10% of the
loans were in default.

Why do the villagers trust one another? They do, because
agreements are mutually enforced: a threat by members of a
community that stiff sanctions will be imposed on anyone breaking
an agreement would deter everyone from breaking it. This is a
common basis for doing business in the poor world. Among the
Kofyar farmers in Nigeria, for example, agricultural land is
privatized, but free-range grazing is permitted once the crops have
been harvested. Like Desta™s household, Kofyar households are




Trust
engaged in subsistence farming, so labour isn™t paid a wage.
However, unlike Desta™s village, where household farms manage on
their own labour, the Kofyars have instituted communal work on
individual farms. Although some of this is organized in clubs of
eight to ten individuals, there are also community-wide work
parties. A household that doesn™t provide the required quota of
labour without good excuse is ¬ned (as it happens, in jars of beer). If
¬nes aren™t paid, errant households are punished by being denied
communal labour and subjected to social ostracism. In a different
context, systems of codes have served to protect ¬sheries in coastal
villages of northern Brazil. Violations are met with a range of
sanctions that include both shunning and sabotaging ¬shing
equipment. And so on.

How is mutual enforcement able to support agreements? It is all
well and good to say that sanctions will be imposed on opportunists,
but why should the threats be believed? They would be believed if
sanctions were an aspect of social norms of behaviour. To see why,

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assume for the moment that whether an agreement has been kept
by each party is observable by all parties. No doubt this is a strong
assumption, but as with ˜veri¬ability™, it is a useful starting point.
Once we draw conclusions from it, we will be able to infer how
communities could modify their institutions in situations where the
assumption doesn™t hold even approximately. That said, anyone
who has visited villages in poor countries will know that privacy is
not a fundamental right there. In tropical villages that I have
visited, cottages are designed and clustered in such a fashion that it
must be hard for anyone to prevent others from observing what
they are about.

By a social norm we mean an accepted rule of behaviour. A rule of
behaviour reads like: ˜I will do X if you do Y™; ˜I will do P if Q
happens™; and so forth. For a rule of behaviour to be a social norm, it
must be in the interest of each person to act in accordance with the
rule if all others act in accordance with it; that is, the rule should
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correspond to a Nash equilibrium. To see how social norms work,
let us return to our numerical example to study whether
cooperation based on a long-term relationship can be sustained
between A (we now call him the patron) and B (we now call her the
client).

Imagine that the opportunity for A and B to do business with each
other is expected to arise over and over again; say, annually. The
time taken for B to produce her output is assumed to be well within
a year. Let t denote time. So t assumes the values 0, 1, 2, . . . , and so
on, ad in¬nitum; with 0 standing for the current year, 1 standing
for the following year, 2 standing for the year following that, and so
on, ad in¬nitum. Although the future bene¬ts from cooperation are
important to both A and B, they will typically be less important than
present bene¬ts. After all, there is always the chance that one of the
parties will not be around in the future to continue the relationship,
or that circumstances may change in such ways that A does not have
access to his capital ¬‚ow. To formalize this idea, we introduce a
positive number r, which measures the rate at which either party

40
discounts the future bene¬ts from cooperation. (We will see that in
the present example, it doesn™t matter what B™s discount rate is. For
expositional ease, though, I assume that both individuals discount
their future costs and bene¬ts at the rate r.) The assumption is that,
when making calculations in the current year (which is t = 0), each
divides his or her bene¬ts in any future year t by a factor (1 + r)t .
(The term (1 + r)t denotes (1 + r) multiplied to itself t times.) So, if r
is positive, (1 + r)t exceeds unity for all future t; and since bene¬ts in
year t are divided by (1 + r)t when making calculations in the
current year, the importance of those bene¬ts decays by a ¬xed
percentage r each year when viewed from today. The smaller is r,
the greater is the weight placed on the bene¬ts of future
cooperation. We now show that, provided r is small, the pair could
in principle enter a successful long-term relationship, where each
year A advances $4,000 to B, sells the goods B has produced for
$8,000, and pays her $3,000. The formal theory of long-term
relationships was developed by the mathematicians Robert
Aumann and Lloyd Shapley, and extended by the economists Drew




Trust
Fudenberg, Eric Maskin, Ariel Rubinstein, and others. What I
present here is an illustration of how the theory works.

Consider the following rule of behaviour that A might adopt: (i)
begin by advancing $4,000 to B, (ii) sell the goods if she produces
them during the year, (iii) share the proceeds according to the
agreement, and (iv) continue doing so every year so long as neither
party has broken the agreement; but (v) end the relationship
permanently the year following the ¬rst defection by either party.
Similarly, consider the following rule of behaviour that B might
adopt: so long as neither party has reneged on the agreement, work
faithfully for A each year; but refuse ever to work for him the year
following the ¬rst violation of the agreement by either party.

The two rules embody a common idea: begin by cooperating and
continue to cooperate so long as neither party has broken their
word, but withdraw cooperation permanently following the ¬rst
defection from the agreement by either party. Withdrawal of

41
cooperation is the sanction. Game theorists have christened this
most unforgiving of rules the ˜grim strategy™, or simply grim. We
show next that grim is capable of supporting the long-term
relationship if r is not too large.

First consider B. Suppose A has adopted grim and B believes that he
has. He will advance her the capital at the beginning of year 0. B™s
best course of action is clear: keep to the agreement. For suppose
she reneges on the agreement. She would lose $1,000 (her share of
$3,000 minus the $2,000 she would earn producing home goods),
but gain nothing in any future year (remember, A has adopted
grim). This means that no matter what B™s discount rate is, she
couldn™t do better than to adopt grim if A has adopted grim.

The harder piece of reasoning is A™s. Suppose B has adopted grim
and A believes she has. If he has advanced the working capital to
her, she will have worked faithfully for him in year 0. A now
Economics




wonders what to do. If he reneges on the agreement, he would make
a $4,000 pro¬t ($8,000 minus the $4,000 he could have earned
with his capital even if he had not entered into the relationship with
B). But since he believes B to have adopted grim; he must also
believe that B will retaliate by never working for him again. So, set
against a single year™s gain of $4,000 is a net loss of $1,000 (the
forgone pro¬t from the partnership) every year, starting in year 1.
That loss, calculated in year 0, is the sum, $(1,000/(1 + r) + 1,000/
(1 + r)2 + 1,000/(1 + r)3 + . . . ad in¬nitum), which can be shown to
add up to $1,000/r. If $1,000/r exceeds $4,000, it isn™t in A™s
interest to break the agreement, which means that he can™t do better
than to adopt grim himself. But $1,000/r exceeds $4,000 if and
only if r is less than ¼, or 25% (per year). We have therefore proved
that if r is less than 25%, it is in each party™s interest to adopt grim if
the other party adopts grim. But if both adopt grim, neither would
be the ¬rst to defect, which implies that the agreement would be
kept. We have therefore proved that grim can serve as a social norm
to maintain a long-term relationship between the patron (A) and
the client (B).

42
Economists have found evidence of grim in social interchanges, but
it would appear to be in force mostly where people also have access
to formal markets. In Desta™s world, though, grim is not in evidence.
Sanctions are graduated, the ¬rst misdemeanour being met by a
small punishment, subsequent ones by a stiffer punishment,
persistent ones by a punishment that is stiffer still, and so forth.
How are we to explain this?

Where formal markets and long-term relationships co-exist, grim
could be expected to be in operation. Grim involves permanent
sanctions, which is a needed device for preventing people from
engaging in opportunistic behaviour when good short-term
opportunities appear nearby from time to time. But if, as in Desta™s
village, there are few alternatives to long-term relationships,
communitarian arrangements would be of high value to all.
Adopting grim would be an overkill in a world where people
discount the future bene¬ts from cooperation at a low rate. For that
reason, the norms that are adopted involve less draconian sanctions




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than grim. A single misdemeanour is interpreted as an error on the
part of the defector, or as ˜testing the water™ (to check if others were
watching). This is why graduated sanctions are frequently observed.

Here then is our general ¬nding: social norms of behaviour are able
to sustain cooperation if people care suf¬ciently about the future
bene¬ts of cooperation. The precise terms and conditions will be
expected to vary across time and place; what is common to them all
is that cooperation is mutually enforced, it isn™t based on external
enforcement.

There is, however, a piece of bad news: people could end up not
cooperating even if they care a lot about the future bene¬ts of
cooperation. To see how, imagine that each party believes that all
others will renege on the agreement. It would then be in each one™s
interest to renege at once, meaning that there would be no
cooperation. Even if r is less than 25% in our numerical example,
behaviour amounting to non-cooperation is also a Nash

43
equilibrium: A doesn™t advance the $4,000 worth of raw material to
B, because he knows that B won™t work for him; she would refuse
because of the fear that A won™t keep his promise to share the
proceeds; a fear that is justi¬ed, given that A intends not to share
the $8,000 with her once she has produced those goods; and so on.
Failure to cooperate could be due simply to an unfortunate pair of
self-con¬rming beliefs, nothing else. No doubt it is mutual
suspicion that ruins their chance to cooperate, but the suspicions
are internally self-consistent. In short, even when appropriate
institutions are in place to enable people to cooperate, they may not
do so. Whether they cooperate depends on mutual beliefs, nothing
more. I have known this result for many years, but still ¬nd it a
surprising and disturbing fact about social life.

Could the pair form a partnership if r exceeds 25%? The answer is
˜no™. As grim is totally unforgiving, no other rule could in¬‚ict a
heavier sanction for a single misdemeanour. The temptation A
Economics




faces to defect is less if B adopts grim than if she were to adopt any
other rule of behaviour; which implies that no rule of behaviour
could support a partnership if r exceeds 25%. Studying grim is
useful, because it allows us in many examples, such as the present
one, to determine the largest value of r for which cooperation is
possible.

We now have in hand a tool to explain how a community can skid
from cooperation to non-cooperation. Ecological stress “ caused,
for example, by increasing population and prolonged droughts “
often results in people ¬ghting over land and natural resources
(Chapter 7). Political instability “ in the extreme, civil war “ could in
turn be a reason why both A and B become concerned that A™s
source of capital will be destroyed or con¬scated. A would now
discount the future bene¬ts of cooperation with B at a higher rate.
Similarly, if the two fear that their government is now more than
ever bent on destroying communitarian institutions in order to
strengthen its own authority, r would rise. For whatever reason, if r
were to rise beyond 25%, the relationship would break down.

44
Mathematicians call the points at which those switches occur
bifurcations. Sociologists call them tipping points. Social norms
work only when people have reasons to value the future bene¬ts of
cooperation.

Contemporary examples illustrate this. Local institutions have been
observed to deteriorate in the unsettled regions of sub-Saharan
Africa. Communal management systems that once protected
Sahelian forests from unsustainable use were destroyed by
governments keen to establish their authority over rural people. But
Sahelian of¬cials had no expertise at forestry, nor did they have the
resources to observe who took what from the forests. Many were
corrupt. Rural communities were unable to switch from communal
governance to governance based on the law: the former was
destroyed and the latter didn™t really get going. The collective
vacuum has had a terrible impact on people whose lives had been
built round their forests and woodlands.




Trust
Ominously, there are subtler pathways by which societies can tip
from a state of mutual trust to one of mutual distrust. Our model of
the partnership between A and B has shown that when r is less than
25%, both cooperation and non-cooperation are equilibrium
outcomes. The example therefore tells us that a society could tip
over from cooperation to non-cooperation owing merely to a change
in beliefs. The tipping may have nothing to do with any discernible
change in circumstances; the entire shift in behaviour could be
triggered in people™s minds. The switch could occur quickly and
unexpectedly, which is why it would be impossible to predict and
why it would cause surprise and dismay. People who woke up in the
morning as friends would discover at noon that they are at war with
one another. Of course, in practice there are usually cues to be
found. False rumours and propaganda create pathways by which
people™s beliefs can so alter that they tip a society where people trust
one another to one where they don™t.

The reverse can happen too, but it takes a lot longer. Rebuilding a

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community that was previously racked by civil strife involves

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