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adopt grim and that C would adopt grim if A and B adopt grim. The
interesting exercise is to determine A™s incentives to cooperate if B
and C adopt grim. As both clients would terminate their
relationship with him if he behaved opportunistically with either, A
would defect from both relationships if he defects at all. What
remains is to calculate A™s gains and losses if he defects from both
relationships in year 0. If he does, he gains $7,000 now ($4,000
from his partnership with B; $3,000 from his partnership with C).
Set against that is the value of all the future bene¬ts from
cooperation he will have to forgo. That loss is $(1,000 + 1,000)/r. It
follows that A can™t do better than to adopt grim himself if $7,000
is less than $2,000/r; which is to say, if r is less than 2/7. Since 2/7
exceeds 1/4 (it lies between 1/4 and 1/3), the condition under which
Economics




A and B are able to cooperate is weaker. Suppose r is less than 2/7
(per year), but greater than 1/4 (per year). By tying the relationships,
both can be created; whereas, if they are kept separate, only the one
between A and C can form. The intuition behind the ¬nding is
clear. A faces greater temptation to defect from his agreement with
B than the one with C, which is why the circumstances under
which a relationship could form with B are more restricted than
they are with C (1/4 is less than 1/3). By tying the two relationships,
A™s temptation to break his relationship with B is reduced
(2/7 exceeds 1/4).

While C doesn™t lose from the move to tie the partnerships, she
doesn™t gain either. Only A and B gain. So B has every reason to offer
solidarity to C, whom she now regards as a professional comrade. B
may even offer a small compensation to C, so as to give her a
positive incentive to agree to having the two partnerships tied. In
return, C promises to stick by B should A mistreat her. He doesn™t do
that, of course, but only because he is smart enough to know that C
would break up their relationship if he did.

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Further re¬nements are needed when people who wish to trade
with one another are separated by distance. Community
responsibility systems in Italy during the 12th and 13th centuries
helped people to obtain credit and insurance. Transgressions by a
party were met in a collective way: the group to which the injured
party belonged imposed sanctions on the group of which the
transgressor was a member. In such arrangements it is
communities, not individuals, that acquire a reputation for
honesty. Tying relationships in this manner creates incentives for
members of a peer group to keep an eye on one another. The
institution reduces the costs people incur in keeping an eye on
one another.

The drawback of tied relationships among people having different
interests is that they require further coordination. If, in our
numerical example, B possessed not only her own skills but those of
C as well, and if she had the time to work for A in both ventures, it




Communities
would be simpler for A to offer both partnerships to B, with the
proposal that they be tied. The relationship would involve only A
and B, requiring less coordination.


Networks
The distinction between personal and impersonal transactions is
not sharp. Even in a sophisticated market (modern banking),
reputation plays a part (credit rating of the borrower). But the
distinction is real. Meeting new people in Becky™s world is often
accidental, but people spend resources in order to make new
acquaintances. Why? One reason is that new acquaintances may
be in a position to provide information.

One can think of interpersonal networks as systems of
communication channels linking people to one another. Networks
include as tightly-woven a unit as a nuclear family or kinship group,
and one as extensive as a voluntary organization, such as Amnesty
International. We are born into certain networks and enter new

67
ones. Personal relationships, whether or not they are long-term, are
emergent features within networks.

The clause ˜personal relationships™ in the notion of networks is
central. It involves trust without recourse to an external enforcer of
agreements. Scholars have argued that civic engagements in Becky™s
world and communal activities in Desta™s world heighten the
disposition to cooperate. The idea is that trust begets trust and that
this gives rise to a positive feedback between civic and communal
activities and a disposition to be so engaged. That positive feedback
is, however, tempered by the cost of additional engagements (time),
which, typically, rises with increasing engagements. The economist
Albert Hirschman has observed that trust is a moral good, in that it
grows with use but decays with disuse; which means that we don™t
need to ˜economize™ on trust, in the way we need to with ˜bread and
butter goods™ like bread and butter. Trust shares this feature with
skills: the more one practises a skill, the better one gets at it.
Economics




Weak ties
Relationships can be strong or weak. One can be misled by this into
thinking that weak ties are not valuable. In fact they can be very
valuable. While working at his previous job, Becky™s father learnt
through word of mouth that the ¬rm he now works for was looking
to hire someone with his quali¬cations. There is much empirical
evidence that weak ties are useful because they connect people to a
wide variety of other people, and so, to a large information base.
Engagements among people with weak ties in Becky™s world are
untied. Becky™s father has little to do with the Parent-Teacher
Association (PTA), of which her mother is an active member.
Similarly, Becky™s mother has nothing to do with the association of
lawyers to which Becky™s father belongs. Moreover, neither the PTA
nor the Bar Association play any role in their social life.

Strong ties
In Desta™s world ties are mostly strong because they involve tied
engagements in long-term relationships. As this sort of

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arrangement sets limits on the range of people with whom people
are able to do business, it offers few opportunities for material
advancement. In Chapter 6 we will con¬rm that strong ties among
kinship hinder economic progress in the contemporary world, by
limiting the amount of insurance coverage households are able to
obtain, by maintaining a low rate of return on investment, and by
stimulating fertility. But if used wisely, strong ties can be of help in
seeking economic opportunities in the outside world. Consider
migration. One enterprising member of the rural community moves
to the city, supported by those with whom he has strong ties at
home while he searches for work. He is followed by others in a
chain-like fashion, as information is sent home of job prospects.
Migrant workers even recommend village relations to their bosses.
Bosses in turn favour their employees™ kin, because doing so reduces
the risks involved in hiring people they don™t know. This would
explain why city mills in poor countries have been found to employ
disproportionate numbers of workers from the same village.




Communities
Markets and communities are capable of functioning in such ways
as to offer mutual bene¬ts.

Why do networks in Desta™s world operate along ethnic or kinship
lines and why are they multi-purpose and dense, unlike the
specialized professional networks such as those of academic
economists and psychotherapists in Becky™s world? Our previous
analysis offers an answer. As membership is de¬ned by birth, entry
into ethnic or kinship networks is impossible, nor is exit possible.
Moreover, membership is easily veri¬able. Proximity within the
village enables individuals to know one another™s characteristics
and dispositions well. Consequently people there don™t suffer much
from a problem known in the insurance industry as adverse
selection. In the insurance context, ¬rms are said to face a problem
of ˜adverse selection™ when people who are bad risks are
indistinguishable from people who are good risks and are able to
displace the latter. Proximity within the village also enables people
to observe one another and see what they are about. Consequently
people there don™t suffer much from a problem known in the

69
insurance industry as moral hazard. In the insurance context, ¬rms
are said to face a problem of ˜moral hazard™ when insurees don™t take
those precautions against bad outcomes that may have been agreed
upon. Tied long-term relationships make the networks multi-
purpose and dense. In contrast, people enter and exit professional
networks out of choice, with the result that the networks have
sharp, limited goals. Membership doesn™t impose constraints on
what people can do with other aspects of their lives, such as where
to shop, what to eat, which school to send their children.

We shouldn™t be surprised that the networks people bequeath their
children in Desta™s world frequently amount to ethnic or kinship
networks, for who else is there in rural societies with whom one can
form links? However, even though it is true that exit from one™s
ethnicity or kinship is literally impossible, children do have a choice
of not using the networks they have inherited. Why then do people
Economics




7. Teff threshing in Ethiopia

70
maintain so many inherited networks even in Becky™s world? The
reason they do is that one can™t costlessly re-direct relationships
once they have been established. Such investments are speci¬c to
the relationships. Moreover, as trust begets trust, the cost of
maintaining a relationship declines with repeated use (witness that
we often take our closest friends and relatives for granted). The
bene¬ts from creating new relationships are low if one has inherited
a rich network of relationships, which is another way of saying that
the cost of not using inherited networks is high. Outside
opportunities have to be especially good before it is in someone™s
interest to cease making use of inherited links. This explains why we
maintain so many of the relationships we have inherited from our
family and kinship, and why norms of conduct pass down the
generations. We are, so to speak, locked in from birth.




Communities




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Chapter 4
Markets




Just as communities differ from one another, markets differ from
one another. Markets come in so many varieties, that it makes good
sense to determine their ideal form and examine why and how
actual markets differ from the ideal.


Ideal markets
Economists refer to departures of markets from their ideal form as
˜market failure™. Each kind of market failure offers society a reason
to explore how other institutions, such as households, communities,
and government, could improve matters. The argument works the
other way too. Understanding ideal markets enables us to uncover
clues as to how markets could improve matters in situations where
households, communities, and government don™t work so well. Of
course, all this presupposes that ideal markets are a good thing. One
of our tasks here is to explore the sense in which they are a good
thing.

A single market
It helps to begin the formal study of markets by isolating a
commodity and developing the account of an ideal market for it. Let
us denote the commodity as X. For concreteness, we will suppose
that X is a non-durable consumption good, meant for consumption
now. As we are studying ideal markets, I assume that X is a private

72
good, implying that there are no externalities associated with its
consumption or production. For convenience I will use X also to
denote its quantity.

Imagine that there are many ¬rms that could potentially supply X
and many households that are potential consumers of X. Firms are
owned by households. By a market for X we mean a clearing house
for X. Firms bring their supplies of X to the market and households
arrive there to make their purchases of X. As the markets for goods
and services are interconnected (the demand for tea would be
expected to increase if the price of coffee was to increase), we would
be justi¬ed in studying the market for X in isolation only if (i) the
resources devoted to the production of X are small compared to the
resources devoted to the production of all the other goods and
services in the economy, and (ii) the expenditure on X by each
household is but a small fraction of its total budget. We make both
assumptions here and suppose in addition that all other goods and




Markets
services are transacted in their own markets. Assumptions (i) and
(ii) imply that the prices of all other goods and services are pretty
much unin¬‚uenced by what happens in the market for X. That
being so, we can value the remaining goods and services in the
economy in terms of their prices and sum them so as to create an
aggregate index in terms of which X is priced. Let us call that index
wealth, expressed in, say, dollars. In the language of economics,
wealth is our numeraire. Purchases and sales of X take place at the
price quoted in the market for X.

You will no doubt have noticed the circularity in the reasoning I
have deployed here. How can we justify assuming in advance of any
analysis of the market for X that the production and purchases of X
involve, respectively, only a small proportion of the economy™s
resources and only a small proportion of each household™s budget?
By now though, you will have grown used to circular reasoning in
economics (Chapter 2). Our previous discussions have shown us
that it is a powerful method of analysis. Here we have begun by
assuming (i) and (ii). If we now were to discover empirically that

73
near an equilibrium of the market for X (de¬ned below) the
assumptions are correct, the basis for the analysis will have been
justi¬ed.

In an ideal market households and ¬rms are all price-takers. We
may imagine that an auctioneer cries out the price of X and that
¬rms and households make their respective decisions on the basis of
that price. The quantities purchased by each household and sold by
each ¬rm are assumed to be veri¬able, as is the quality of X.
Payments are enforced by an external agency (government). People
neither steal X nor renege on their payments for X. If they tried to
do either, they would be caught and punished by the enforcer
(Chapter 2).

Suppose the price of X is P. By a household™s demand for X we mean
the quantity of the good it would wish to purchase at P. If a
household™s willingness to pay for each unit of X declines as the
Economics




number of units it purchases increases, it would demand the good
to the point where its willingness to pay for the marginal unit of X
equals P. (If it demanded more, the household would have to pay
more than it was willing to pay for the last unit demanded, meaning
that the household would reduce its demand; whereas, if it
demanded less, the household would be paying less than it was
willing to pay for the last unit demanded, meaning that it would
demand still more.) As X is a private good, the market demand for
X at price P is the sum of all household demands at P. We have just
argued that if P were ˜high™, market demand would be ˜low™; if it
were ˜low™, market demand would be ˜high™. This feature gives rise to
a downward sloping market demand curve, drawn hypothetically as
DD′ in Figure 8. Market demand for X is measured along the
horizontal axis, while P is measured along the vertical axis.

It can be that ¬rms own different technologies for producing X. We
suppose, though, that all technologies display diminishing returns
in production, by which I mean that the cost of producing an
additional unit of X (the cost being computed at the prices that

74
Markets
8. Demand and supply curves


prevail for all the inputs required to produce X) increases if the
quantity produced was to increase. As ¬rms are owned by
households, the objective of every ¬rm is to maximize its pro¬t in
the market for X. By a ¬rm™s supply of X at P we mean the quantity
it would be willing to sell at P. A ¬rm would produce the good to
the point where the cost it incurs for the last unit produced “ its
marginal cost of production “ equals P. (If the ¬rm produced more,
it would make a loss on the last unit it produced, which means that
it ought to reduce production; whereas, if it produced less, the ¬rm
could increase its pro¬t by producing a bit more.) In short, each
¬rm would plan to produce to the point where its marginal cost
of production equals P. The market supply of X at P is the total
quantity of X that all the ¬rms in the economy are willing to supply
at P. We have just argued that if P were ˜high™, market supply would
be ˜high™; if it were ˜low™, market supply would be ˜low™. This feature
gives rise to the upward sloping market supply curve, drawn

75
hypothetically as SS′ in Figure 8. Market supply of X is measured
along the horizontal axis, while P is measured along the vertical
axis.

Figure 8, which was the creation of the economist Alfred Marshall,
brings together what is probably the most famous pair of curves in
all of economics: the demand and supply curves. The curves
intersect at a unique point (XE units of the good, at price PE), which is
an equilibrium of the market for X. It is an equilibrium, because at
PE, market demand equals market supply, implying that the market
for X clears. Economists frequently add the adjective ˜competitive™
to the word ˜equilibrium™, because, as the market being studied
involves many ¬rms, they are all price-takers. Which is why we say
that PE supports a competitive equilibrium in the market for X.

Notice how closely the concept of a competitive equilibrium
resembles the notion of an equilibrium in the communities we
Economics




studied earlier. At PE, those who wished to be active participants in
the market for X “ whether as suppliers or purchasers “ discover
that their intentions can be carried out. Those who chose not to
enter the market at that price discover that they were right not to
have entered: the market clears at PE, leaving nothing over which
anyone could bargain. PE enables a set of expectations on the part of
households and ¬rms to be ful¬lled. Notice too the parsimony of
information that households and ¬rms need to have in order to
participate effectively in the market for X. A household needs to
know its own ˜mind™ (that is, what it is willing to pay for the good)
and the price P. It doesn™t need to know anything about other
households, nor about the cost conditions facing ¬rms. Similarly, a
¬rm needs only to know the technology available to it, the prices it
has to pay for its inputs in production, and the price of X. It doesn™t
need to know anything about households™ willingness to pay, nor
anything about the technologies of rival ¬rms. The equilibrium
price, PE, acts as a coordinating device for allocating X and the
resources needed to produce X. PE is an emergent feature of the
market for X.

76
In what sense is the market I have just described ˜ideal™? It is ideal
in the sense that the equilibrium supplies and demands would

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