Evolution of Trust in Impersonal Exchange

Prateek Raj∗University College London

June 12, 2017

Abstract

In societies where exchange is limited within familiar contacts, norms of trust andhonest behavior towards strangers may not exist. What are the conditions whenexchange between strangers can emerge and sustain in such societies? My papershows that societies where exchange is limited within familiar contacts are resistant tochange and are punctuated in an equilibrium. For exchange with strangers to sustain,such an exchange should provide a large benefit in comparison to exchanges with fa-miliar contacts, and to possible cost/temptation from cheating. I call the condition,Institutional Condition, where favorable conditions Institutionally Enable the transi-tion. Moreover, for such exchange with strangers to emerge, a minimum threshold oftraders need to adopt standardized codes that reduce partiality in conduct. I call thecondition, Cultural Condition, where presence of Horizontal Communicator(s) cat-alyzes the transition. I look at the cases of seventh century Arabia, twelfth centuryItaly and sixteenth century Northwestern Europe, which were transformative peri-ods in history of global commerce, where exchange opened up beyond familiar andtrusted circles like kinship and guilds. I describe the institutional and cultural condi-tions that enabled the transition.

Keywords: norms, punctuated equilibrium, institutions, trust, Islam, Europe

∗UCL School of Management, p.raj.12@ucl.ac.uk. I thank Center for Economic History and Kellogg School ofManagement at Northwestern University and Stigler Center at University of Chicago Booth School of Business fortheir support. I extend my deep gratitude to Joel Mokyr, Paola Sapienza, Luigi Zingales, Elias Papaioan-nou and Simcha Jong for their continued support, advice and encouragement. I am thankful to RonaldBurt, Raghuram Rajan, Emily Kadens, Avner Greif, Ran Abramitzky, Carola Friedman, Deirdre McCloskey,Jeremiah Dittmar and Sheilagh Ogilvie for their critical feedback at different stages of my project. I amthankful to seminar participants at University College London, London Business School, London School ofEconomics, Northwestern University, University of Chicago and Stanford University for their inputs andto Priyanka Raj, Anjul Khadria and Anuj Karpatne for their assistance during my research. Any errors aremine alone.

1 Introduction: The circle of trust and honesty

Business exchanges are embedded in social relations (Polanyi, 1944; Granovetter, 1985),and social relations are resources that can be tapped by individuals, communities andbusinesses to their advantage (Granovetter, 1973; Coleman, 1988; Greif, 1994; Burt, 1995,2001). But, social relations are based on trust and in some societies it is easier to truststrangers than in others. In societies where social exchange is limited within familiargroups, like family, clan or dense networks like guilds, norms of honest conduct with out-siders, who appear as strangers, may not exist (Banfield, 1967; Platteau, 2000; Fafchamps,2011; Alesina and Giuliano, 2013). Whether the circle of honest conduct is limited or widehas important consequences, for individuals, businesses and economy (Delhey, Newtonand Welzel, 2011). Closely knit groups are valuable, as such networks lower the risksassociated with trust (Coleman, 1988; Greif, Milgrom and Weingast, 1994; Burt, 2001). Yetin closely knit networks there are fewer opportunities (Burt, 1995). With lack of trust inoutsiders, firms may not grow (Bloom et al., 2013), and households may make less invest-ments in stock or receive less credit (Guiso, Sapienza and Zingales, 2004).

In the paper, I explore how impersonal exchanges1 emerge (like between A and Bin Figure 1), in societies where exchanges are limited to familiar contacts, like familiesin case of India (Bloom et al., 2013) or guilds in the case of medieval and early modernEurope (Greif, Milgrom and Weingast, 1994; Ogilvie, 2011). I consider cases of transitionin history where a region became more open to exchanges beyond familiar contacts anddiscuss the feasibility of my proposed theory.

Honest conduct in impersonal settings present two challenges to researchers. Firstly,what enables diffusion of “prosocial” (Tabellini, 2008b; Guiso, Sapienza and Zingales,2008a), “civic” (Ogilvie, 2011) or “bourgeois” (McCloskey, 2015) values, beliefs, norms,ideas or codes that make honest exchanges with strangers possible? Secondly, what sus-tains honest conduct and stops cheating from flourishing in trusting environments, likein impersonal markets made up of unfamiliar traders? Shiller (2017) discussed a for-mal epidemiological approach to study diffusion of narratives. Similarly, Mokyr (2014)proposed an evolutionary “Market of Ideas” where culture can be conceptualized as amenu to which entrepreneurs could add and customers could choose. Using Bisin andVerdier (2001) model of (vertical) cultural transmission between generations, a branch ofliterature has explored the transfer of civic values of good conduct between generations(vertical transmission). In the literature that looks at values, values provide intrinsic ben-efits, like feeling “warm glow” (Tabellini, 2008b) or having “city orientation” (Greif and

1also called arm’s length exchange (Rajan and Zingales, 1998) or generalized exchange (Ogilvie, 2011)

1

Figure 1: The figure represents an example network of individuals where an actor like A, has a trustednetwork. Whenever actors need to make an outward exchange beyond the trusted network (for exampleA exchanging with B), they can either do a relationship based exchange, through trusted intermediaries(brokers), or else they can undertake a risky and arm’s length exchange directly.

Tabellini, 2015), beyond pure monetary gains. The models show that small differencesin initial attitudes can lead to persistent and diverging outcomes on how societies areorganized and the size of circle of honest or cooperative conduct in them (showing in-stitutional and cultural persistence). But, the theories do not explain, how do societiesdevelop different initial attitudes. One possible mechanism through which trust in oth-ers can change is by temporary shocks to the return to being trusting towards strangers(Guiso, Sapienza and Zingales, 2008b). Such a shock increases the beliefs regarding trust-worthiness of others, which then persists. But, honest conduct is itself affected by pre-vailing level of trust. One can expect that a society where people start trusting strangerswould attract cheaters.

Another branch of literature has focused on ways in which cheating can be containedfrom flourishing in cooperative environments. Cooperation can be sustained if there is apossibility of repeat exchange (Greif, 1994; Nowak and Sigmund, 2005) or else if cheatersare threatened by vengeful and costly retaliation (Sethi and Somanathan, 1996; Fehr andGachter, 2000, 2002)2. The methods are considered private mechanisms that individualscan privately use to constrain a partner from cheating. Alternatively, a third party (likeruler) can identify and punish cheaters by improving contract enforcement (or law andorder) (North, 1990; Milgrom, North and Weingast, 1990). Most saliently, Greif (2006)

2Merchant guilds in Europe and kinship networks elsewhere (and Europe) were sustainable economicinstitutions as they provided an effective mechanism for monitoring and punishing opportunism (Greif,Milgrom and Weingast, 1994).

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proposed a community mechanism of community responsibility system that enables imper-sonal exchange between traders as long as their community identities are known. In thecommunity responsibility system cheating behavior by one member of a community fol-lows sanctions on the entire community by the members of the community of the cheatedpartner.

The private, third party or community mechanisms restrict cheating behavior by iden-tifying cheaters and enforcing punishment on them or their communities. Such identifi-cation is imperfect, especially in large economies, and so the risk of cheating can not becompletely negated. For example, the community responsibility system functioned par-ticularly well in small medieval markets of Europe. But, it began to falter as the marketsgrew and identities of traders became more difficult to assess (Greif, 2006). Understand-ing impersonal exchange with a stranger in the absence of repeated exchange, clear knowl-edge of their identity, or in presence of credible third party enforcement becomes importantwhen we are interested in a setting where impartial legal institutions that serve all partiesuniformly are not already well developed and society doesn’t have the prosocial valuesneeded for trust.

I look at the two questions of diffusion and sustenance of trust and honest conductusing an evolutionary model. In my setting trade is impersonal, where identities of un-familiar traders can not be perfectly monitored, trade with them cannot be repeated andthe possibility of cheating always exists. So, I am interested in generalized trust3 whereact of trusting a stranger involves a certain “willingness to be vulnerable” (Mayer, Davis andSchoorman, 1995; Rousseau et al., 1998). In the model traders are of two types of ethicalattitudes, those who extend honest conduct uniformly, and so to all strangers and thoseengage in partiality and so are dishonest to strangers. The traders of different ethical at-titudes (honest or dishonest) get randomly paired and can conduct trade. Traders in themarket with the more economically sound ethical attitude thrive i.e. the market evolu-tionarily selects the economically fitter ethical attitude regarding honest conduct towardsstrangers.

Traders also are either of impersonal or relationship-based orientation (like in Figure1). The trade orientation gets shaped each period by their past exchanges with otherstrangers. In Figure 1, if A conducts outward trade through trusted intermediaries (bro-kers), then A will be considered a relationship based trader. Instead, if A conducts adirect and risky trade with an outsider like B, A will be considered impersonal trader. Ifone of the two partnering traders is impersonal (say A is an impersonal trader in Figure1) while the other is relationship based (say B is relationship based in Figure 1), then A

3Appendix A provides a more comprehensive overview of literature on generalized trust.

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can convince B to trade, by asymmetrically offering them a guarantee (moving first like inan investment game) while not demanding a similar guarantee in return4 Alternatively, Bmay agree to trade with A only if A offers such a guarantee by moving first.

I find, other than relationship based channels (like exchanging through trusted inter-mediaries) which can provide a steady income to traders, there can also exist a reciprocal5

impersonal channel. Cheating behavior is regulated in the impersonal channel when hon-est impersonal traders who get cheated stop being impersonal and instead start relyingon relationship based channels of trade. The relationship based traders demand guar-antees from impersonal traders, if any approach them. So, as the population of honestrelationship-based traders increases they demand more guarantees, and it becomes in-creasingly difficult to cheat.

In the model, two types of equilibrium outcomes exist. In the relationship based equi-librium no trader is impersonal and a significant population of relationship based tradersdo not extend honest conduct to strangers. In contrast, in the impersonal equilibrium, asignificant population of traders extend honest conduct to strangers and they alternatebetween being impersonal and relationship based, depending on their past experiencewith strangers.

I also provide the conditions under which the relationship based equilibrium transi-tions into the impersonal equilibrium. For such a transition to occur, the opportunitiesfrom engaging in risky exchange with strangers, like between A and B in Figure 1, shouldbe high in comparison to loss/temptation from cheating and to traditional opportunitiesavailable from engaging with partners found through relationship based channels. I callsuch opportunities from impersonal exchange the institutional enablers. But, institutionalenablers are not sufficient. Along with the existence of lucrative impersonal opportuni-ties, a critical threshold of traders should initially adopt codes of conduct that allow themto uniformly extend honest conduct impartially to all traders including strangers. In absenceof such a minimum level of adoption, cheating behavior will overwhelm the system, re-gardless of the opportunities available from impersonal exchange. So, in the absence ofsuch a threshold adoption, the system stays in the persistent (punctuated (Gould, 1972;Mokyr, 1990; Romanelli and Tushman, 1994)) relationship based equilibrium where ex-change is limited to familiar circles and nobody conducts exchange with strangers. I callthe mass diffusers of standardized codes as horizontal communicators.

4Asymmetric one sided exchange has been called by Greif (2000) as the fundamental problem of exchangewhere economic exchange is a sequential and one party takes more risk than the other in a given trade.

5The role of reciprocity, especially upstream or pay it forward reciprocity, has a developing literature(Polanyi, 1957; Fowler and Christakis, 2010; Nowak and Sigmund, 2005; Reuben, Sapienza and Zingales,2009; Baker and Bulkley, 2014).

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In the persistent relationship based equilibrium, the state wouldn’t invest in imper-sonal and impartial institutions that lower the costs/temptations of cheating, as the con-ditions sustaining the impersonal equilibrium don’t exist regardless of existence of exis-tence of impersonal institutions. How impersonal and impartial institutions are in de-livery of services is an important metric for measuring quality of government in modernstates (Rothstein, 2011). The key question is, in the historical settings where radius ofexchange expanded beyond familiar contacts, what were the institutional enablers andhorizontal communicators that triggered structural transitions in society?

I look at transformative periods of seventh century Arabia, twelfth century Italy andsixteenth century Northwestern Europe, which were important junctures in the historyof global commerce, where the circle of exchange expanded. Table 1 lists some of theinstitutional enablers and horizontal communicators in the historical settings of transi-tion. Seventh century Arabia was trapped in a punctuated equilibrium of within tribeexchange, and it was only with the rise of Islam that circle of business exchange sig-nificantly expanded and became more (not completely) impersonal and between tribes.Islam was adopted in places of high geographic inequality (e.g. deserts) (Michalopou-los, Naghavi and Prarolo, 2014) where there was uneven distribution of resources andagricultural land. Such high geographic inequality created incentives for trade betweentribes, as two traders from different tribal groups had much to gain from a direct trade.So such geographic inequality acted as an institutional enabler. But, despite the efforts inprevious periods to promote coordination between tribes (e.g. the system of ilaf ), it wasonly after the emergence of a horizontal communicator like Muhammad, who propagatedstandardized norms of generalized morality and the notion of universal brotherhood ofummah (Montgomery, 1961) that tribal barriers loosened in the region. Rise of Islam ledto the rise of Arabia as a major center for commerce in following centuries. In Europe,after a period of relative stagnation during early medieval period, North Italy emergedas a leading center for commerce beginning twelfth century. The region was troubled bya political vacuum during the twelfth century (in contrast to South Italy’s strong state).Such vacuum, of formal intermediaries who could provide reliable exchange beyond tiesof kinship, created incentives for locals different kinship groups to enter in sworn pactsof mutual protection with people outside of their kinship ties, which eventually gave riseto city republics. But, it were cities that had bishops acting as horizontal communica-tors that were better able to coordinate such sworn pacts (Guiso, Sapienza and Zingales,2008b) and establish city republics. In absence of a need to build ties beyond kinship, lo-cals in South Italy continued relying on strong ties of kinship which have been argued tohave persisted till modern times (Putnam, Leonardi and Nanetti, 1994; Guiso, Sapienza

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Table 1: Different cases of transition

Transition Event Radius of Expansion Institutional Enablers Horizontal Communi-cator

7th century: Riseof Arab trade be-tween tribes

Intra-tribal to Inter-tribal trade

Geographic inequalitymade trade lucra-tive (Michalopoulos,Naghavi and Prarolo,2014)

Muhammad promotedgeneralized moralitytowards an ummahacross tribes (Mont-gomery, 1961)

12th century:Rise of non kin-ship associationsin North Italy

Family or Clan associa-tions to City Republicsand Guilds (Guiso,Sapienza and Zin-gales, 2008b; Greif andTabellini, 2015)

Vacuum of traditionalrule in North Italy(unlike in South Italy)(Guiso, Sapienza andZingales, 2008b)

Bishops coordinatedsworn pacts or “pattigiurati” betweencity dwellers (Guiso,Sapienza and Zingales,2008b)

16th century:Emergence of im-personal marketsin Europe

Merchant Guilds toImpersonal Markets(Ogilvie, 2011)

Sea coast, especiallyAtlantic, attractedunfamiliar traders(Gelderblom, 2013)

Printed books diffusedstandardized traderelated informationand business prac-tices like double-entrybookkeeping (Raj,2017)

and Zingales, 2008b). The North Italian city republics formed a unique form of non-kinship based merchant networks, called merchant guilds. The merchant guilds helpedin expansion commerce in Europe (Greif, Milgrom and Weingast, 1994), but with timeespecially beginning the fifteenth century they turned more exclusive and monopolistic(Gelderblom and Grafe, 2010; Ogilvie, 2011). In the sixteenth century, in the northwest-ern region of Europe (Low Countries and England), the guild system began to decline,being replaced by impersonal markets with better institutions. Raj (2017) discusses theperiod of sixteenth century Europe to argue that in the sixteenth century Europe accessto long distance trade, especially the disruptive trade through the Atlantic coast, made acity’s market lucrative and gave traders an incentive to exchange beyond their traditionalnetworks, so acting as an institutional enabler. Also during the same period, Europe wasgoing through a horizontal communication of expanding printing and postal system. Thepresence of such horizontal communication catalyzed transition by better access to traderelated information and diffusion of business practices like double-entry bookkeepingthat promoted standardized codes reducing partiality in conduct. The cities that wereboth close to the sea, especially Atlantic coast, and also adopted printing early (becauseof their closeness to Mainz), underwent institutional changes where impersonal marketsemerged and privileged monopolies declined.

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2 Model: To trust and be honest to a stranger or not

I now develop a model where traders face a dilemma of whether to trust and be honesttowards unfamiliar traders who may be potential partners in trade. Here in any givenperiod traders are randomly paired with an unfamiliar trading partner and the pair canplay a game like prisoner’s dilemma where both parties have incentives to cheat and nothonor promises. Modeling trade in prisoner’s dilemma type settings has been commonin literature (Milgrom, North and Weingast, 1990; Kandori, 1992; Ellison, 1994; Macy andSkvoretz, 1998; Dixit, 2003; Tabellini, 2008b). For example, Milgrom, North and Weingast(1990) modeled trade in cities and fairs of Medieval Europe, in a similar manner andwrote

With the exception of barter transactions, in which physical commodities areexchanged on the spot, virtually all economic transactions leave open the pos-sibility of cheating. In the Champagne Fairs, where merchants brought sam-ples of their goods to trade, the quantities they brought were not always suf-ficient to supply all the potential demand. Then, the merchants sometimesexchanged promises - to deliver goods of like quality at a particular time andplace, or to make payment in a certain form. Promises, however, can be bro-ken. To represent the idea that cheating may be profitable in a simple ex-change, we use the Prisoners’ Dilemma (PD) game as our model of a singleexchange transaction.

Given the temptations to cheat, traders tend to be reluctant to partner with outsiders(like traders until sixteenth century in Europe, or businessmen in developing countries(Bloom et al., 2013)), and prefer the relationship based channels like guild or kinship ties.So, I am interested in modeling the reluctance as well (being matched in the prisoner’sdilemma game is voluntary) and in understanding the mechanism of diffusion and sus-tenance of impersonal honest exchange in such relationship based societies with limitedcircles of trusted and honest exchange.

2.1 Developing an Evolutionary Model

In the model traders can have either an honest or a dishonest ethical attitude towardsstrangers (unfamiliar traders). Traders become honest towards strangers if they adoptstandardized codes that reduce partiality in conduct and make them honest and reliableuniformly irrespective of familiarity with partners. Adopting practices like uniform stan-dards of quality or innovations like double bookkeeping for financial transparency can

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be some of the standardized codes. The standardized codes are sustained in the market,only if adopting the code leads to better payoff than non-adoption. A trader who doesnot adopt the standardized codes continues to favour familiar traders and acts dishon-estly towards strangers.

We would like to capture the idea that ethical attitudes regarding honesty towardsstrangers are replicators that grow or shrink at a rate proportional to their relative “fit-ness” in the market. A simple way to operationalize the idea is to assume that traders oc-casionally review and compare their ethical attitudes regarding honesty towards strangers,described in Section 2.2, and adopt the ethical attitude that leads to better hard payoffs,i.e. payoffs that are actually earned and not just perceived. Unlike models that considervalues like “warm glow” to be of intrinsic utility (Tabellini, 2008b; Greif and Tabellini,2015), in my model traders are interested only in economic utility. But, while traders areconcerned about their hard payoffs, they do not switch between ethical attitudes in eachperiod i.e. ethical attitudes of traders are sticky, and they only review the ethical attitudesoccasionally.

So, consider a unit mass of traders each of whom is either honest or dishonest towardsstrangers depending on whether they adopt the standardized codes or not. An honest(to strangers) trader has invested in standardized codes and has an ethical attitude e =

H , while dishonest (to strangers) trader has an ethical attitude e = D. The aggregatebehavior of the traders is described by a population state p ∈ P , where P = {p ∈ Rn

+ : pH+

pD = 1} is a simplex and pH represents the proportion of traders who adopt standardizedcodes and are honest to strangers. Similarly, pD represents the proportion of traders whodon’t adopt such standardized codes and are dishonest whenever they come across anstranger. Together honest and dishonest traders make up the whole population.

Let in each period traders have the option to approach strangers and engage in animpersonal exchange with them. Such exchange has the potential for high reward butalso the risk of loss because of being cheated6. Alternatively, traders can choose a lessrewarding option where they do not approach strangers and so are insulated from thedishonest behavior of strangers. The safe but less rewarding option could be choosing re-lationship based exchange and exchanging with familiar contacts like intermediaries of amerchant guild. But, relationship based traders can still be approached by strangers whoconduct impersonal trade. As relationship based traders prefer safer but less rewardingoption, they mistrust approaching strangers. So, skepticism drives relationship basedtraders to demand any stranger that approaches them to provide a guarantee of assured

6Impersonal exchange because of its inherent vulnerability and risk resembles the notion of trust as“willingness to be vulnerable” (Mayer, Davis and Schoorman, 1995; Rousseau et al., 1998).

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Table 2: Different types of exchange

Focal Trader (F) Partner Trader (P) Type of Exchange F’s Payoff P’s PayoffHR Type not paired Relationship Based Exchange mDR Type not paired Relationship Based Exchange mHI Type HI Type Simultaneous Exchange c cHI Type DI Type Simultaneous Exchange −h c+ hHI Type HR Type Sequential Exchange c cHI Type DR Type Sequential Exchange −h c+ hDI Type HR Type Sequential / No Exchange 0 mDI Type DR Type Sequential / No Exchange 0 m

return. Traders that are honest are able to provide such guarantees (pre-commit to hon-est conduct), and so are able to approach and exchange with skeptical relationship basedtraders.7 In the setting, the relationship based traders can turn out to be dishonest, andespecially when there are many honest impersonal traders, dishonest conduct becomeslucrative and thrives. So, along with the ethical attitudes regarding honesty (e ∈ {H,D}),in each period the traders also choose an orientation, of being trusting of strangers or not.Traders change their orientation based on their past experiences, described in Section 2.3.

So, traders in each period have an orientation o ∈ {R, I}, where of traders with ethicalattitude e, peR engage in relationship based exchange (o = R) and paI engage in imper-sonal exchange (o = I). Honest relationship based traders (HR type) earn m while dis-honest relationship based traders (DR type) earn g = m+ e if they are not approached byan honest impersonal trader who could offer them a guaranteed return. Impersonal tradersexchange with strangers and they get randomly paired with one of the traders of the population,with uniform probability. Such pairing leads to different types of exchanges summarized inTable 2.

A few notes on the different types of exchange that emerge will be helpful:

• In a relationship-based exchange traders refuse to get paired and trade through rela-tionships.

• In a simultaneous exchange paired traders play a prisoners dilemma.

• In a sequential exchange paired traders play a prisoners dilemma where impersonaltype moves first, i.e. relationship-based type demands a guarantee from impersonaltype.

7In practice such guarantees and one-sided commitment includes activities such as doing business oncredit, which noteworthily became commonplace only after sixteenth-century Europe with the adoption ofmodern accounting techniques.

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If an honest impersonal trader (HI type) gets paired with another honest impersonaltrader both earn c > g > m in a simultaneous trade. If the honest impersonal trader(HI type) gets paired with an honest relationship based trader both earn c > g > m in asequential trade where the impersonal trader moves first as the relationship based traderdemands a guarantee. But, if the honest impersonal trader is paired with a dishonesttrader, impersonal or relationship based, the honest trader loses h while the dishonesttrader earns c+h8. Once again, the impersonal trades are simultaneous while relationshipbased trades are sequential.

If a dishonest impersonal trader (DI type) gets paired with another impersonal traderit earns 0 if the paired trader is dishonest (c+h if the trader is honest), while if it gets pairedwith a relationship based trader, it earns 0, as the relationship based trader refuses toexchange with the dishonest trader that cannot provide a credible guarantee of return. Itis assumed that e = 0 i.e. adopting standardized codes is costless (and similar to choosingan ethical attitude) and g = m9.

A few notes on the interpretation of the payoffs will be helpful:

• m is the payoff from relationship-based trading arrangements, and is high if thearrangements are efficient.

• c is the payoff from impersonal exchange, and is high when such opportunities arelarge.

• h is the temptation/loss from a dishonest exchange, and it decreases as general con-tract enforcement improves.

So at any given time t in a society of population p = 1, pH(t) traders are of honest(e = H) ethical attitude. The honest traders, alternate between orientations o ∈ {R, I}.pHI(t) honest traders behave as HI type that exchange with strangers and have imper-sonal orientation (and earn c on being paired with H type traders and lose h on being

8In Section 4 the value of h is set by a ruler, i.e. ruler can reduce cost/temptation of cheating h, byimproving law and order and probability of detection

9Another way to interpret c and h is, h is the effort required to produce a result that benefits the partnerby c + h. If both partners put the effort h both earn c, but, if one of them doesn’t put in the effort, theeffort-maker loses h, while the partner gains c+ h. If none put any effort, both earn 0. Pre-commitment orguaranteeing an assured return, can mean that in a pairing of relationship based and impersonal traders,the impersonal trader moves first and puts effort h that benefits the relationship based trader, and therelationship based trader moves second and depending on ethical attitude e ∈ {H,D} either puts in effort(honest) or doesn’t (dishonest). The exchange resembles a prisoner’s dilemma when played simultaneouslybetween two paired impersonal traders, while it resembles an investment game when played sequentiallybetween an impersonal trader and then a relationship based trader.

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paired with D type traders) and pHR(t) honest traders behave as HR type that have rela-tionship based orientation (and earn c on being paired with HI type traders and m other-wise). Among dishonest traders the model setup presents Corollary 2.1 on their choice oforientation.

Corollary 1 There are no dishonest traders of impersonal orientation (pDI = 0) as for a dishonesttrader having a relationship based orientation is always preferred over impersonal orientation.

Corollary emerges because the only scenario where dishonest impersonal traders earnis if they are paired with honest impersonal traders. Dishonest impersonal traders aredeclined exchange when partnering with relationship based traders, and they have noparticular advantage over dishonest relationship based traders in exchange with otherimpersonal traders, given the uniform nature of random matching. Even if matchingtechnology of impersonal traders was not uniform and was skewed to favor other imper-sonal traders, dishonest traders would still choose relationship based orientation, unlessthe skew was’t too large10. In an extreme case of skewing where impersonal traders wereonly paired with other impersonal traders, then that would mimic a pure simultaneousprisoner’s dilemma game and honest impersonal exchange cannot sustain in that sce-nario. The importance of uniformity highlights the critical role of interaction betweenimpersonal and relationship based traders which creates the sequential settings for ex-change. In such sequential settings honest and impersonal traders can thrive under alimited set of conditions.

I consider the case of pure random matching where pairing is uniformly random,that doesn’t discriminate between impersonal and relationship based orientation. So,pD(t) = 1− pH(t) traders are of DR type that are dishonest and choose relationship basedorientation (and earn c+h on being paired with HI type traders and g = m otherwise). So,average utility earned by honest (H type) (πH(t)) and dishonest (D type) (πD(t)) tradersat time t is given as:

10Skewed random matching: The payoff of a dishonest relationship based trader is given asP (HIpairsDR)(t)(c+h)+ (1−βP (HIType)(t))m, where P (HIpairsDR) is its probability of being pairedby an HI type agent. The payoff of a dishonest impersonal trader is given as P (HIpairsDI)(t)(c + h)where P (HIpairsDI) is its probability of being paired by an HI type agent. Now, in uniform randommatching, P (HIpairsDR) = P (HIpairsDI) = pHI . If there is a skew where impersonal traders are morelikely to be paired with other impersonal traders, then the condition under which impersonal orientationis favored over relationship based trade by a dishonest agent is if P (HIpairsDR) is quiet low compared toP (HIpairsDI), i.e. P (HIpairsDR)

P (HIpairsDI) <c+h−m/P (HIpairsDI)

c+h−m .

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πH(t) =pHI(t)

pH(t)(pH(t)c− (1− pH(t))h)

+pHR(t)

pH(t)(pHI(t)c+ (1− pHI(t))m)

(1)

πD(t) = pHI(t)(c+ h) + (1− pHI(t))m (2)

2.2 Evolution of ethical attitude

In each period t a fraction w of the population review their ethical attitudes regardinghonesty towards strangers by randomly observing another trader from the populationand comparing their own payoff with the payoff of the observed trader. The probabilitythat the trader changes its ethical attitude i to the ethical attitude j of the observed traderis proportional to the difference in the earned utilities of type j and i traders, at time t,where if type i traders are better off than the observed type j traders, type i traders neverchange their ethical attitude. The the evolutionary dynamics11 is given as:

Evolutionary dynamics:

dpH(t)

dt= −dpD(t)

dt= pD(t)ρDH(t)− pH(t)ρHD(t) =

wpD(t)pH(t)(πH(t)− πD(t))

(3)

Equation 3 captures the idea that ethical attitude is a replicator, i.e. market selects theeconomically “fitter” ethical attitude, unfiltered by any special preferences of the traders.

2.3 Evolution of orientation

Along with traders revising their ethical attitudes regarding honesty towards strangers,honest traders also revise their orientation. Let at period t + 1 an impersonal honesttrader become relationship based with probability ks on being cheated (paired with a U-type trader) in period t12. Similarly, let at period t + 1 a relationship based honest trader

11At the aggregate level the revision protocol can be written as: ρij(t) = wpj(t)(πj(t)− πi(t))+ where ρijis the probability that a trader with ethical attitude i revises to ethical attitude j(T = i → j), and πi(t) andπj(t) is the average payoff of the traders with ethical attitude i and j at time t. When w is small it impliesswitching between honest and dishonest ethical attitudes is uncommon. The pairwise imitation protocolimplies that rate of diffusion of ethical attitudes is proportional to relative payoff. The proportionalityconstant w > 0 can be interpreted to regulate the timescale of imitation.

12Skepticism: Among honest traders, impersonal (HI type) traders become relationship based (HR type)traders if they estimate that the number of dishonest traders in the population is large. Clearly in any

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become impersonal with probability ko on being cooperated (paired with a HI type trader)in period t13. So behavioral dynamics is given as:

Behavioral dynamics:

dpHI(t)

dt= kopHR(t)pHI(t)− kspHI(t)pD(t) +

pHI(t)

pH(t)

dpH(t)

dt(4)

Note that unlike ethical attitude that is modeled as a replicator, orientation of traderswith honest ethical attitude is modeled as a transient choice that traders make based onpast experience. So orientation has been treated as a behavioral rather than an evolu-tionary trait, considering the fact that honest traders would frequently alternate betweenbeing impersonal and relationship based based on their on-the-go estimate of the marketenvironment.

2.4 Equilibrium

The model has several advantages for studying our interest in impersonal exchanges.Firstly, being a one-shot prisoner’s dilemma between strangers, the model is more con-servative and does not consider regulating mechanisms like reputation and punishment.The model focuses on generalized trust in strangers- an important aspect of impersonalmarket exchanges (Fafchamps, 2011; Macy and Skvoretz, 1998). Secondly, unlike exist-ing models my model does not consider values of prosociality (Tabellini, 2008b; Greifand Tabellini, 2015) to be of intrinsic utility that supports cooperation. Accordingly, alltraders, with their ethical attitudes, attempt to maximize their own material payoffs.Thirdly, the voluntary prisoner’s dilemma setup is able to study the choice between re-lationship based and impersonal exchange so highlighting the dynamics of relationshipbased vs. impersonal exchange, an important aspect in understanding structural transi-tions (Fafchamps, 2011; Ogilvie, 2011; Greif and Tabellini, 2015). Fourthly, by using anevolutionary model where traders make decision on-the-go as conditions evolve, I amable to understand the evolution of ethical attitudes in large population more realisticallywhere all traders operate in a market of competing ethical attitudes. In my model, tradersare calibrating both their ethical attitudes as well as their orientation based on the condi-tions available to them, and so we can understand their behavior both in equilibrium and

learning protocol that an honest impersonal trader has, an experience of dishonest exchange increases theestimate and may change impersonal trader’s orientation.

13Optimism: Among honest traders, relationship based (HR type) traders become impersonal (HI type)if they estimate that the number of dishonest traders in population is small. Clearly in any learning protocolthat an honest relationship based trader has, experience of honest exchange decreases the estimate and maychange relationship based trader’s orientation.

13

in phases of transition.Given the dynamics in Equations 3 and 4, we have Proposition 114. The insights from

Proposition 1 are discussed in next Section 3.

Proposition 1 There exist two sets of stable equilibria:

1. Relationship based Equilibrium: pH ∈ [0, pcrH) and pHI = 0, represents a non-asymptoticequilibrium where pcrH = ks

ks+ko.

2. Impersonal Equilibrium: pH = 1 − kohks(c−m)−kom and pHI = 1 − (ko+ks)h

ks(c−m)−kom represents anasymptotic equilibrium if w < w where w = ksc−(ks+ko)m

h(c−fHI(c−m))and fHI = pHI

pH; distinct from (i)

if ksko+ks

> h+mc

.

3. Condition for Transition: If system is close to close to equilibrium (1) i.e. pHI(0) → 0,and pH(0) > pcrH when pcrH > h+m

cand w < w the system converges to the asymptotic

equilibrium (2), and (1) otherwise.

As honest traders make on-the-go decisions regarding their choice of orientation, basedon past experience, common behavioral biases like anecdotal thinking or aversion to mak-ing losses, can affect the choice of orientation. The result of Proposition 1 holds regardlessof nature of ko and ks. I will use the framework of loss aversion to discuss my theoreticalresults15. Let at any given reference frame r, the perceived loss hp = h+ λr(h+ r), whereλr is the degree of loss aversion at reference frame r (Spiegler, 2011). At reference frameof r = m, equilibrium (2) is supported if ks = α(m+ h)(1 + λm)) and ko = α(c−m) whereα is any constant of proportionality16. So, pcrH = (1+λm)(m+h)

c+λmm+(1+λm)h17. To simplify the discus-

sion, reference frame is set at the default payoff of r = m. The discussion isn’t sensitive tochoice of reference frame r ∈ (−h, c).

14The proof of Proposition 1 is given in Appendix B.1. Section C simulates the model, showing a shiftfrom relationship based to impersonal equilibrium, when condition for transition is favorable (Figure 5)

15Loss aversion is not only a common behavioral trait, in my setting it also captures the preference for lessrisky options.

16At the impersonal equilibrium (2), ksko = pHR

pD, and H type traders are indifferent between being imper-

sonal and relationship based, if pHR

pD= m+hp

c−m , as honest traders are indifferent between being impersonalor relationship based if their income from being impersonal (pHc − pDhp) equals the income from beingrelationship based (pHIc+ (1− pHI)m), where hp denotes loss payoff perceived by cautious agents.

17For a general reference frame r, pcr,λr

H is given by

pcr,λr

H =

{m+(1+λr)h+λrrc+λrr+(1+λr)h

, if − h ≤ r < m(1+λr)(m+h)c+λrr+(1+λr)h

, if m ≤ r ≤ c(5)

14

3 Theory: Institutional Enablers and Horizontal Commu-

nicators

The model developed in Section 2 can be viewed as a race between dishonest and hon-est ethical attitudes towards strangers. So, the attitudes evolutionarily compete (Mokyr,2014) and attempt to contagiously diffuse (Shiller, 2017) in a competitive market. Howdo attitudes of honesty and dishonesty fare against each other? Proposition 1 shows thatthere exist two stable equilibria. In the first equilibrium, the population is dominated bytraders who act dishonestly towards strangers and all traders participate in relationshipbased exchange and so population of impersonal traders is 0 (pHI = 0). The relationshipbased equilibrium can be thought of as an equilibrium of amoral familism (Banfield, 1967).Prior to the sixteenth century in Low Countries and England and in rest of Europe untillater, socio-economic exchange resembled the relationship based equilibrium. Here ex-change was confined within exclusionary and relationship based networks, dominatedby merchant guilds that wielded considerable self-serving economic and political power(Ogilvie, 2011). The same way in pre-Islamic Arabia or in Southern parts of Italy, family,tribal or clan exchange superseded pan-regional exchanges.

The second equilibrium is a polymorphic equilibrium where a positive population ofimpersonal traders exists (pHI > 0) and honest traders alternate between impersonal andrelationship based exchange and coexist with dishonest relationship based traders. Theequilibrium can be called the equilibrium of impersonal exchange. In impersonal equilib-rium impersonal exchanges between strangers is possible. In post sixteenth-century, LowCountries and England traders exchanged in impersonal markets outside of their tradi-tional networks, and so resembled the equilibrium of impersonal exchange.

3.1 Institutional Enabler: Relationship Based vs. Impersonal Social

System

Proposition 1 shows the equilibrium of impersonal exchange would not exist unless ben-efits from impersonal exchange (c) considerably outweigh benefits from non-exchange(m) and loss of being cheated (h). It was also found that the polymorphic equilibriumwill fail to sustain itself unless honest traders have a certain behavioral dislike (λr > 0)for making a loss and so overreact to an experience of dishonest behavior and withdrawfrom impersonal exchange and turn skeptical and relationship based. It is assumed fromnow on that rate of revision of ethical attitudes is small enough (w < w) so that multipleequilibria exist. If the rate of revision of ethical attitudes is large and ethical attitudes

15

change rapidly, the impersonal equilibrium does not sustain itself. The conditions sup-porting impersonal equilibrium can be called institutional enablers and can be formalizedin Lemma 1.

Lemma 1 If c > 1+λmλm

h + m (institutional condition), then two equilibria exist. In relationshipbased equilibrium pHI = 0 and in impersonal equilibrium pHI > 0. Otherwise only relationshipbased equilibrium exists18. Institutional condition is not satisfied if λr = 0.

For historical cases some observations from Lemma 1 are useful:

• If general contract enforcement in a society is perfect such that h = 0 then, notsurprisingly, as long as payoff from impersonal exchange (c) is higher than fromtraditional relationship based exchange (m), such an impersonal exchange is sus-tainable.

• If payoff from impersonal exchange (c) is not highly lucrative compared to payoffthrough traditional relationship based arrangements (m) and/or potential loss be-cause of cheating in impersonal setting (h) was considerably high because of poorgeneral contract enforcement then impersonal equilibrium is not sustainable19.

For impersonal equilibrium to be sustainable (i) benefits from impersonal exchange(c) should be highly lucrative (ii) payoff from traditional relationship based arrangements(m) should be relatively low and (iii) loss/temptation because of cheating in impersonalsetting (h) should be relatively low (but not necessarily 0) because of better contract en-forcement or because of large gains from impersonal exchange.

In seventh century Arabia, there were considerable benefits to engage in trade be-tween tribes as traditional tribal arrangements were not well endowed because of highgeographic inequality (Michalopoulos, Naghavi and Prarolo, 2014). Similarly in twelfthcentury North Italy there were benefits from exchanging beyond kinship based ties, asthere was a political vacuum and traditional institutions were weak, which created incen-tives for people to engage in sworn pacts of mutual protection. Such incentives to reachout beyond familial bonds did not exist in South Italy, because the authoritative state en-sured an efficient law and order (Guiso, Sapienza and Zingales, 2008b). Guiso, Sapienzaand Zingales (2008b) commented:

18For a general reference frame institutional condition will be given as c > (h+m)((1+λr)h+λrr)λr(h+r)

if −h ≤r < m and c > 1+λr

λrh + r if m ≤ r ≤ c. Clearly for r = −h or r = c, the institutional condition is not

satisfied. Neither is the institutional condition satisfied if λr = 019Consider the simulation exercise in Figure 7 where a population dominated by honest and impersonal

(HI type) agents, becomes mistrusting and relationship based, as c isn’t significantly larger than m and h.

16

Paradoxically the reason why southern Italy did not develop independentcommunes is because it did not need them: law and order were ensured bythe highly autocratic and efficient Norman kingdom...The Norman kingdombrought peace and prosperity to the South... But its hierarchical form of gov-ernment inhibited the formation of independent city-states and so, accordingto Putnam, prevented the accumulation of civic capital.

During the sixteenth century in Low countries and England trade through the Atlanticcoast was a disruptive opportunity for impersonal trade, which helped create conditionsfor the emergence of impersonal markets (Raj, 2017). But, Low countries and Englandwere not the only countries that benefited from trade through the Atlantic coast duringthe period. Spain and Portugal were other contender countries that also enjoyed similarconditions.

Some pertinent questions emerge: Why didn’t impersonal trade emerge in southernEurope which also had access to Atlantic? Similarly why didn’t circle of commerce ex-pand before the seventh century in Arabia, or non-kinship based associations got formedin most cities of twelfth century North Italy?

3.2 Horizontal Communicator: Punctuated Equilibrium of Amoral Famil-

ism

When institutional conditions are supportive, the model predicts the following cyclic riseand fall of trust:

1. When there are many honest traders who do impersonal exchange, there are oppor-tunities to cheat. So, dishonest traders increase (pD increases) and honest tradersbegin to get cheated.

2. As honest traders get cheated, they become skeptical and withdraw from imper-sonal exchange and become relationship based (pHR increases). Skeptical relation-ship based traders demand guarantees of assured returns.

3. As such demand for guarantee rises, honest traders that engage in impersonal ex-change are able to approach skeptical traders by providing guarantees while dishon-est traders are left out. Demand for guarantees, make honest impersonal exchangelucrative and skeptical traders also switch from relationship based to participate inimpersonal exchange (turn optimistic) (pHI increases).

17

So a contagion of skepticism and withdrawal if coupled with a reverse contagion ofoptimism and participation under favorable institutional conditions keeps dishonest be-havior in check20.

But, critically, if there are too few honest traders in the social system, then the positivecontagion of optimism gets dominated by the negative contagion of withdrawal. So, forany transition from the equilibrium of amoral familism to the equilibrium of impersonalexchange to be feasible, there needs to be a minimum threshold of traders who adoptstandardized codes that reduce partiality in conduct)21. The result can be formalized inthe Lemma 2.

Lemma 2 Conditions for transition are given as:

• When institutional condition of Lemma 1 is satisfied, and number of initial adoptees ofstandardized codes that reduce partiality in conduct pH(0) is greater than a critical thresholdpcrH(λr, c,m, h) given in Equation 5, then social system transitions from relationship basedequilibrium to impersonal equilibrium and pHI > 0. Factors that trigger the initial adoptionwill be called horizontal communicators.

• System stays in a punctuated and relationship based equilibrium of amoral familism other-wise.

So, regardless of external conditions, there is a necessity of mass adoption of standard-ized codes, and in the absence of such mass adoption, social systems stay in the punctu-ated equilibrium of amoral familism. Punctuated equilibria are resistant to incrementalchanges, and so are persistent (Gould, 1972; Mokyr, 1990; Romanelli and Tushman, 1994).

20Contagious Equilibrium (Kandori, 1992) is an equilibrium notion that sustains cooperation in iteratedrandomly matched prisoner’s dilemma games where agents start to defect on coming across an agent withstrategy of defection. Such a switching has a contagious effect over the population and the threat of suchcontagious outbreak of opportunism defers players from not acting dishonestly. While contagious equilib-rium could provide a possible resolution to cooperation, but it is too vulnerable to breakdown. Extensions(Ellison, 1994) that focus on resolution of such vulnerability rely on simultaneity i.e. players stop defect-ing (a form of collective punishment), and start cooperating in tandem. But, here again, achieving such ahigh level of coordination may not be practical in large populations. Looking at mechanisms of sustainingcooperation in loosely knit organizations, Kandori and Obayashi (2014) studied community unions (TokyoManagers’ Union) and found that cooperation was sustained through “simple heuristic reasoning”. Useof heuristics in everyday exchange is well studied (Yamagishi et al., 2007) and heuristics supporting coop-eration often resemble norms of upstream reciprocity which have been shown to work in social networks(Fowler and Christakis, 2010) and organizations (Baker and Bulkley, 2014).

21Consider the simulation in Figures 4 and 5 where in population dominated by distrusting relationshipbased agents, honest and impersonal agents emerge (pHI > 0), as initial population of agents with honestattitude is above the critical threshold. Additionally Figure 6 shows the cycles of trust and mistrust, wherethe population of impersonal agents rises and follows as discussed in the previous paragraph.

18

For the sixteenth century Europe the theory implies that relationship based guild centriceconomic organization of much of Europe was persistent, and transition to impersonalequilibrium was possible only if there was mass adoption of standardized codes thatsupported impersonal trade.

3.2.1 Horizontal communication and mass adoption

Mass adoption of new norms, ideas and codes requires greater horizontal transmission be-tween horizontal contacts like peers and intellectual/cultural leaders, and lesser relianceon vertical transmission by parents, teachers and superiors. Here, horizontal communica-tors like opinion leaders, focal institutions or peer-to-peer groups can act as horizontalcommunicators. But, note that Lemma 1 suggests that horizontal communicators canonly be persuasive in presence of enabling institutional conditions.

When enabling institutional conditions exist significant advances in communicationtechnology - that can enable such a rapid horizontal transmission and adoption of newnorms, ideas and codes - can catalyze transition out of punctuated equilibrium. Duringthe sixteenth century, did Low countries and England develop special characteristics, thatmade such horizontal communication of standardized codes possible? Raj (2017) arguesthat while the postal system enabled horizontal communication between long distancetrading peers, the high penetration of Printing helped mass diffusion of practices promot-ing standardized codes like book-keeping in the region that reduced partiality in businessconduct, and enabled the transition away from relationship based guild equilibrium toimpersonal market equilibrium.

Lemma 2 implies that two social systems (Atlantic traders: Spain and Portugal vs.Low countries and England) with similar initial conditions can have divergent outcomes,because of ability or disability of a critical fraction of traders to adopt standardized codessupporting impersonal trade. Low countries and England were able to reach the thresh-old and so overcame the punctuated equilibrium of relationship based exchange, becauseof higher rates of printing and so high availability to printed books. But, because of lowerprinting penetration in Spain and Portugal, such a mass adoption didn’t occur and rela-tionship based guild equilibrium persisted. The causes of divergence in sixteenth centuryEurope have been examined in detail in (Raj, 2017).

Looking at seventh century Arabia, Michalopoulos, Naghavi and Prarolo (2014) pro-vided an account of the challenges in building stable alliances between tribes before ad-vent of Islam in West Asia’s arid regions with high geographic inequality. With fallingsecurity of long distance trade, and increasing lucrativeness of alliances with differenttribes, efforts were on to build alliances between tribes. But, the efforts were short lived

19

as alliances often changed. There was a rise of an arrangement called ilaf according towhich Meccan merchants would carry commodities produced by other tribes to be soldin markets and fairs. But, ilaf was unsuccessfully enforced, as many tribes were non-committed to the convention. But, rise of Muhammad and his philosophy of Ummahprovided a narrative which allowed for codes of generalized morality to be adopted en-masse. Muhammad coming from a key trading hub of Mecca, became a central figure(a horizontal communicator) who through the narrative of ummah, and promotion of asingle Islamic polity was able to create alliances between several tribes. While previouslymoral codes were to be applied by members within their particular tribes, Ummah pro-moted a sense a community among all adherents of Islam and moral codes were to beapplied generally towards all Muslims Montgomery (1961). Such a diffusion of standard-ized (generalized) moral codes that emphasized honest conduct towards a communitybeyond fellow tribesmen (and allies) had not succeeded earlier in the Arabic region assuch codes arguably failed to breach the threshold that would help them resist oppor-tunism.

Looking at twelfth century North Italy, Guiso, Sapienza and Zingales (2008b) consid-ered the role played by religious institutions (bishops) in facilitating development of trustin medieval North Italy. Guiso, Sapienza and Zingales (2008b) showed that existence ofsuch religious authority made it easier to enforce the “patti giurati” or “sworn pact”, andplayed a key role in coordinating local citizens in their struggle against the Emperor for in-dependence around 12th century22. Cities in the North with bishops before 1000 AD were73% more likely to have become free city-states in preceding centuries. The sworn pactshighlighted the bishops’ trust generating role, where their exchanges with the generalpopulation succeeded in diffusing optimism in a substantial number of citizens to over-come their self-fulfilling mistrust, to engage in a sworn pact with other citizens whosemotives otherwise none were sure of.

3.3 Comparison to existing literature

Papers that consider the evolution of generalized trust (Tabellini, 2008b; Greif and Tabellini,2015) consider traders to be gaining special utility (“warm glow”,“city orientation”) fromhonest conduct. In the theory I develop, traders gain no special utility from being hon-est or trusting. Instead of prosocial preferences, in the model, honest traders should becautious and prudent (λ > 0) in their market exchanges. When λ increases the number of

22Trust anchors are institutions that can lower the critical threshold required for transition, by being un-conditionally honest and trusting of strangers (like charitable and religious institutions). In Appendix B.3,I discuss a mechanism how such anchoring institutions can reduce threshold required for transition.

20

trusting traders reduce, but, there is a larger range of institutional conditions (lower c) forwhich transition is possible. By not giving prosocial preferences to traders, the evolutionof generalized trust does not depend on changing intrinsic preferences, i.e. individualtraders across different equilibria have same intrinsic preferences.

Also, in the model trust is endogenously generated, in contrast to Guiso, Sapienzaand Zingales (2008a) model of transmission of trust between generations, and honest anddishonest traders coexist in a polymorphic equilibrium. Like in the models by Tabellini(2008b); Greif and Tabellini (2015) and Guiso, Sapienza and Zingales (2008a), the presenceof strong traditional relationship based institutions, that make the need for impersonal ex-change less lucrative, makes a transition to impersonal equilibrium less likely. When con-sidering the evolution of cooperation, in contrast to Sethi and Somanathan (1996) wherecooperation is sustained through punishment or to Nowak and Sigmund (2005) where itis sustained by repeated exchange, here trust is sustained by temporary withdrawal fromtrusting strangers when cheaters begin to dominate the system. The mechanism is in thespirit of the voluntary public goods game literature by Hauert et al. (2002) and Semmann,Krambeck and Milinski (2003).

So, trust developed in the model is not an outcome of intrinsic or educated prosocial-ity, nor of private, third party or community regulation. Here honest conduct competeswith dishonest conduct and the equilibria are an outcome of the competition. Also, be-cause of the set up of the model, it is able to capture the intragenerational diffusion ofnorms, ideas and codes within a generation, which are just as important to cultural evo-lution as diffusion (Mokyr, 2014) between generations, as Shiller (2017) shows in his dis-cussion of contagious narratives. So the model compliments the existing work on trustand cooperation (Tabellini, 2008b; Greif and Tabellini, 2015; Guiso, Sapienza and Zin-gales, 2008a; Sethi and Somanathan, 1996; Nowak and Sigmund, 2005), by illuminatingthe previously unexplored facets regarding the evolution of generalized trust. Now thatwe have explored the micro-foundation of honest exchange in impersonal markets, wecan consider the ways in which powerful actors (rulers and elites) will react to it.

4 Endogenous Institutions: Rulers and Elites

We saw how relationship based equilibrium of amoral familism is a punctuated equilib-rium. So conditions before the transition to an impersonal equilibrium can be consideredto be a stasis. In absence of the possible conditions supporting a transition out of thestasis, would rulers/governments support impersonal and impartial institutions like im-personal marketplaces and networking venues?

21

I now consider the specific institutional conditions of medieval and early modern Eu-rope and introduce a ruler and merchant guild elites as actors in the model who can alterthe value of payoffs (m,h) observing population’s initial levels of adoption of standard-ized codes (pmH) and payoff available in impersonal exchange (c). The ruler was interestedin maximizing its tax revenue while merchant guild elites of relationship based systemswere interested in maintaining their monopoly granted to them by the ruler in exchangeof revenue.

A ruler of a relationship based system had a choice of removing monopolies of mer-chant guilds or maintaining them. If ruler maintained merchant guild monopolies thenif at all any impersonal trade occurred, it happened in informal (unsanctioned) markets.Loss from cheating in the informal markets (hi) can be considered higher than the loss inruler sanctioned impersonal markets (hi = βh > h), as in impersonal markets sanctionedby ruler, the ruler will improve law and order while in unsanctioned informal market theruler would attempt to make it worse. At the same time, merchant guilds that were thebeneficiaries of the relationship based system and were at the centre of commerce in theeconomy. Merchant guilds were the intermediaries/brokers in many business exchangesand could endogenously influence the payoff (m) from the relationship based channel. Ifbrokerage charges of the merchant guild elites were expensive, payoff from relationshipbased channel was lower. I assume merchant guild elites could set relationship basedpayoff within a range m ∈ [mmin,mmax]. Under what observed conditions (impersonalpayoff (c) and initial adoption (pmH)) would ruler choose to remove monopolies given thatmerchant guild elites would alter relationship based payoff (m) to block such a transition?

To remove the monopolies granted to merchant guilds, the ruler must have antici-pated impersonal trade beyond relationship based networks would be feasible. As im-personal trade was only supported under special institutional conditions (Lemma 1) andin presence of horizontal communicators (Lemma 2), satisfaction of the two conditionswas a necessary requirement for the ruler to remove monopoly privileges of merchantguilds. In absence of the two conditions, all traders preferred relationship based exchangewhich merchant guilds dominated, and ruler and merchant guilds continued their mutu-ally beneficial nexus where ruler provided monopolies to merchant guilds while in returnmerchant guilds provided ruler with revenue.

Clearly, merchant guilds would alter relationship based payoff (m) to block the pos-sibility of transition to impersonal equilibrium in which merchant guilds lost all power.Also, merchant guilds, especially its dominant elite members, were interested in keepingrelationship based payoffs low so that they did not have to part away with their share ofwealth. How much payoff would guild elites set to block the conditions that made tran-

22

Figure 2: The figure describes conditions in which different systems of exchange emerge.

sition to impersonal equilibrium given that increasing relationship based payoffs makesimpersonal exchange less lucrative?

When payoffs are endogenized, Lemma 3 emerges (see Proof in Appendix B.2).

Lemma 3 Choices of ruler and merchant guild elites are23:

• A necessary condition for ruler to remove merchant guild monopolies is when merchantguild elites have increased relationship based payoff to the maximum (m = mmax) and ifpmH > (1+λm)(mmax+h)

c+λmmmax+(1+λm)hand c > (1+λm)

λmh+mmax. Otherwise ruler maintains monopoly.

• If ruler maintains monopoly, merchant guild elites set minimum relationship based payoffm = mmin if pmH ≤

(1+λm)(mmin+βh)c+λmmmin+(1+λm)βh

or c ≤ (1+λm)βλm

h+mmin. Otherwise merchant guildelites set m ∈ (mmin,mmax).

Figure 2 represents the different conditions.Lemma 3 and Figure 2 implies, if the number of traders who initially adopted stan-

dardized codes that reduced partiality in conduct was small (pmH is small), then unless

23Results are similar for more general r ∈ [−h, c]

23

impersonal exchange (c) was exceptionally lucrative, traders were unable to trigger tran-sition. So merchant guilds could set relationship based payoffs (m) to the minimum (ex-ploit), as regardless of payoff traders would continue to rely on relationship based chan-nels dominated by merchant guilds. But, if payoff from impersonal exchange was highand there was a large population of initial adoptees of standardized codes (pmH is high),conditions could be favourable to transition even if ruler had not removed monopolies astrade could occur in suitable informal settings24. Under the above conditions elites wouldattempt to make impersonal exchange relatively less lucrative by raising the payoffs fromrelationship based exchange (reform traditional institutions) such that conditions becameunfavourable to transition once again. But, there were limits to how much elites couldraise the relationship based payoffs. So, if impersonal exchange became highly lucrativeand if there was large population of initial adoptees of standardized codes, such that eliteswere not having the resources to reform and raise relationship based payoff high enough,the relationship based institutions could be said to have become inefficient, and socialsystem could transition to equilibrium of impersonal exchange. Trade through the At-lantic coast was one of such disruptive opportunities that could have rendered merchantguilds inefficient in regions where there was a mass adoption of standardized codes thatsupported impersonal trade.

As long as elites were efficient, they could block the emergence of impersonal ex-change by introducing reforms. So under such conditions ruler would prefer to grant theelites with monopolies, in return of revenue, and society will have a relationship basedsystem of exchange. But, if elites started losing dominance as impersonal exchange be-came highly lucrative and standardized codes became popular, ruler could promote im-personal and impartial institutions by opening markets and improving law and order.

In sixteeth century Europe closeness to sea was favorable for long distance trade whichmade impersonal exchange lucrative, and so closeness to sea could proxy for higherpayoffs from impersonal exchange (c). Similarly, penetration of printed books increasedhorizontal communication of new norms, ideas and standardized business practices likedouble-entry bookkeeping, and so high printing penetration could proxy for high initialadoption of standardized codes (pmH). Raj (2017) plots in Figure 3 50 largest cities of four-teenth, fifteenth and sixteenth century Europe (81 in total). On the X axis a city’s closenessto sea (which is measured as inverse distance from sea (Oppa)) is plotted. On the Y axisPrinting Penetration in fifteenth century (which is measured as (PrintPentra)) is plotted.The cities had varying types of economic institutions in sixteenth century. Impersonal-

24It could be that informal markets were risky and loss from being cheated hi was high, in which caseimpersonal exchange is not feasible without ruler removing monopoly.

24

ALMERIA

ANGERS

AQUILA

ATHINAI

AUGSBURG

AVIGNON

BARCELONA

BELGRADE

BOLOGNA

BORDEAUX

BOURGES

BURGOS

CAEN

CORDOBA

ERFURT

FERRARA

FIRENZE

GDANSK

GRANADA

JEREZ−DE−LA−FRONTERA

KOBENHAVN

KOELN

LILLE

LISBOA

LUCCA

LUEBECK

LYON

MADRID

MAGDEBURG

MALAGA

MANTUA

MARSEILLEMESSINA

METZ

MURCIA

NAPOLI

NUERNBERG

ORLEANS

PALERMO

PARIS

PIACENZA PISA

PLASENCIA

PLOVDIV

POZNAN

PRAHA

RENNES

ROMA

ROUEN

SALONIKA

SARAJEVO

SEVILLA

SKOPJETIRGOVISTE

TOLEDO, Spain

TOULOUSE

TOURS

VALENCIAVALENCIENNESVALLADOLID

WIEN

WROCLAW

BRESCIA

BRUXELLES

CREMONA GENT

HAARLEM

LEIDEN

LIEGE

MECHELEN

MILANO

PADOVA

TOURNAI

VENEZIA

VERONA

AMSTERDAM

ANTWERPEN

BRUGGE

HAMBURG

LONDON

02

46

Prin

tin

g P

en

etr

atio

n

0 5 10 15 20 25Closeness to Sea

Relationship−based Undergoing Reform

Impersonalizing

Figure 3: The two way plot of cities between variables PrintPentra and SeaPortClosenessa for differenttypes of institutions.

izing cities were those where rulers no longer were granting guild monopolies. Citiesundergoing reform were those where guilds were giving concessions to locals. Relation-ship Based cities were those where guilds or other feudal arrangements continued to holddominance. One observes in Figure 3, as expected in Lemma 3 and Figure 2, that imper-sonalizing markets emerged in places close to sea and with high printing penetration.

The insight provided in Figure 2 is not limited to medieval and early modern Europealone, and can be abstracted to modern economies as well, where societies trapped inpunctuated equilibrium of amoral familism could also have exploitative elites/brokers(like Mafia) in nexus with politicians. Its only when suitable conditions exist that enablesustained impersonal exchange to occur (presence of institutional enablers and horizontalcommunicators), that politicians improve impersonal and impartial institutions and stopfavoring elite brokers who lose dominance in such an impersonal environment25.

25A relevant paper considering nexus between economic elites and and politicians is Rajan and Zingales(2003) that discussed the political economy of financial development, and provided a mechanism for open-ing of financial markets where financial and business elites resisted such development as they would losetheir dominance.

25

5 Conclusion: Persistence and Change

In the paper, I developed a theory of diffusion and sustenance of trust between strangersto answer the following questions. Firstly, what enables diffusion of norms that enableimpersonal exchange? I found when impersonal opportunities are lucrative (institutionalcondition) and a critical threshold of initial adoptees follow standardized codes that re-duce partiality in conduct (popularized by a horizontal communicator), then norms thatenable impersonal exchange diffuse. Secondly, what stops dishonest behavior from flour-ishing in trusting markets? I found that dishonest behavior can be contained in trustingimpersonal markets, even without private, third party or community monitoring and en-forcement, if impersonal traders turn mistrusting of strangers and become relationshipbased on being cheated. As honest impersonal traders turn relationship based, dishon-est behavior becomes less lucrative. With more relationship based traders, demand forguarantees increases, making being honest and impersonal lucrative once again.

Impersonal exchanges help broaden business exchanges, and hinge on trust that oth-ers will fufil promises. If people’s attitudes and sources of information are tightly con-trolled, mass diffusion of new norms supporting impersonal exchanges may be less fea-sible, irrespective of the quality of outside opportunities or law and order. In presenceof horizontal communicators that help people mass adopt new norms, ideas and codesof impersonal honesty, change and reform is possible, where old less efficient institutionsare dismantled and new impersonal ones are created. In light of the fact that historicalevidence suggests mere existence of right institutional conditions (like lucrative oppor-tunities from trade through the Atlantic coast) is not enough for impersonal exchange toemerge and sustain, it seems there is need to support institutions that can act as hori-zontal communicators of codes/norms/practices that promote impartiality in social con-duct. So media (e.g. fifteenth-sixteenth century priting press (Dittmar, 2011)), religiousinstitutions (e.g. Bishops in twelfth century North Italy (Guiso, Sapienza and Zingales,2008b)), opinion leaders (e.g. Muhammad in seventh century (Michalopoulos, Naghaviand Prarolo, 2014)) etc. all become critical players in building and sustaining impersonalsocial systems built on trust.

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A Appendix: Review of Generalized Trust

Trust has become an important area of study in social sciences. Sociologist Edward Ban-field wrote his pioneering book Moral Basis of Backward Society in 1958 and describeda Hobbesian lack of social trust in southern Italy towards people outside of strict familycircles. He attributed the region’s present day underdevelopment to the “amoral famil-ism” that made people act distrustfully towards non-family members expecting othersto do the same. Contrastingly, Tocqueville in his book Democracy in America (1840)(Tocqueville, 1862) gave a flattering description of civic culture in the United States not-ing, “Each American knows when to sacrifice some of his private interests to save therest”. Emphasizing the importance of civic culture he wrote “science of association is themother of science; the progress of all the rest depends upon the progress it has made”.Among economists, Arrow (1969) was among the first to identify the value of trust, andhe wrote “norms of social behavior, including ethical and moral codes” may compensatefor market failure and “in the absence of trust many opportunities for mutually benefi-cial cooperation would have to be, foregone.” Over the last few decades, a considerablemacroeconomic literature has emerged that shows trust has economic significance (Knackand Keefer, 1997; La Porta et al., 1997; Zak and Knack, 2001) and levels of trust are dif-ferent across groups and regions, which are persistent (Putnam, Leonardi and Nanetti,1994; Uslaner, 2002; Guiso, Sapienza and Zingales, 2008b; Tabellini, 2008a; Durante, 2009;Nunn and Wantchekon, 2011) and only gradually change (Alesina and La Ferrara, 2002;Giavazzi, Petkov and Schiantarelli, 2014).

A.1 Theoretical and Empirical literature

Drawing upon influential sociological research being conducted on social capital (Gra-novetter, 1973, 1985; Coleman, 1988), in 1990s two influential sociological works, Putnam,Leonardi and Nanetti (1994) and Fukuyama (1995), emphasized the role of trust on eco-nomic development. But, some economists (e.g. Solow (1995)) pointed at the problems inmeasuring trust as a macroeconomic variable. Some empirical papers (Knack and Keefer,1997; La Porta et al., 1997; Zak and Knack, 2001) began to measure trust using the interna-tional World Values Survey (WVS), that asked respondents “Generally speaking, wouldyou say that most people can be trusted, or that you can’t be too careful in dealing withpeople?” The greater the proportion of people in a country answering yes to the question,the greater the general trust in the country was considered to be. A country’s level of trustwas found to be correlated with its economic growth (Knack and Keefer, 1997), and withefficiency in large organizations (La Porta et al., 1997). Zak and Knack (2001) developed a

34

moral hazard model, where ability of trust in an investment broker increased investmentand income growth and showed that trust and factors that could affect trust (like formaland informal institutions and social homogeneity) were correlated with income growth.

There were also efforts by theorists to define trust. A large literature in sociologyand management (surveyed by Rousseau et al. (1998)) attempted to understand trust be-tween relationships and Mayer, Davis and Schoorman (1995) focused on the aspect ofvulnerability that trusting someone entails in social exchanges. Yamagishi and Yamagishi(1994) made the distinction between impersonal vs. relationship based trust and compar-ing Japan and USA argued that Japanese society relied more on relationship based trustwhile United States had higher levels of generalized trust. Gambetta et al. (2000) con-sidered trust to be a subjective probability and Dasgupta (2000) theorized reputation forhonesty as a sought after but fragile commodity. Dasgupta also argued that expectationsregarding honest and dishonest conduct could be self-fulfilling affecting trust, while Put-nam, Leonardi and Nanetti (1994) found that generalized trust was persistent, and linkedhigh present day generalized trust in North Italy to persistent civic norms that had devel-oped in the region because of existence of medieval city republics.

Persistence of trust (Putnam, Leonardi and Nanetti, 1994) sparked the interest of re-searchers in its origins. Alesina and La Ferrara (2002) using individual level GeneralSocial Survey (GSS) data of US localities, found that generalized trust was lower in in-dividuals who had a history of traumatic experience, who belonged to historically dis-criminated groups, who were economically and educationally unsuccessful, or who wereliving in neighbourhoods that were racially mixed or had high income inequality. Alesinaand La Ferrara (2002) found no significant effect of religion or ethnic origin on trust. Us-laner (2002) argued that trusting others was a persistent moral value in individuals thatwas passed on by parents and was highly correlated with charity and voluntary work.He argued that trusting attitude was unaffected by personal experience or membershipto civic groups (unlike Putnam, Leonardi and Nanetti (1994) who hypothesized that civicgroups generated trust). Guiso, Sapienza and Zingales (2006), using GSS data found astrong positive correlation between generalized trust of US immigrants and the level ofgeneralized trust (measured by WVS) in their country of origin, hinting towards persis-tence. Guiso, Sapienza and Zingales (2008b) found strong empirical evidence of historicalpersistence of trust attitude, as city republic experience during medieval era in North Italywas strongly and positively correlated to present levels of trust and social capital in theregion, as hypothesized by Putnam, Leonardi and Nanetti (1994). Tabellini (2008a) alsoalso found evidence of persistence, with higher levels of trust found in second genera-tion US immigrants originating from countries with more democratic institutions over

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a century ago. Nunn and Wantchekon (2011) similarly found that experience of slaveryhad a persistent effect on mistrust in Africa. Durante (2009) similarly showed that annualvariability of weather conditions during 1500- 1750 stimulated trust in Europe.

Tabellini (2008b) developed a theoretical model to explain the persistence and foundthat impersonal values supporting trust between socially distant individuals could per-sist by creating a strong incentive for parents to invest in such value education, and bygenerating institutions that support such values ((Alesina and La Ferrara, 2002) foundhigh social distance to be a barrier to trust). Guiso, Sapienza and Zingales (2008a) de-veloped a model complimentary to the value based model of Tabellini (2008b), showingthat beliefs transferred between generations regarding honesty of others could be persis-tent. Giavazzi, Petkov and Schiantarelli (2014) using GSS data studied the persistenceof trust attitude (and other cultural traits) among US immigrants in detail, and foundthat trust attitude brought by first generation US immigrants did not persist (unlike someother cultural traits) among fourth generation US immigrants, but second generation USimmigrants showed some persistence. So, body of evidence suggests that values andbeliefs regarding trust passed down by parents do persist among individuals (Putnam,Leonardi and Nanetti, 1994; Uslaner, 2002; Guiso, Sapienza and Zingales, 2008b; Tabellini,2008a; Durante, 2009; Nunn and Wantchekon, 2011), but values and beliefs themselvescan gradually change depending on individual experiences (Alesina and La Ferrara, 2002;Giavazzi, Petkov and Schiantarelli, 2014). Dohmen et al. (2012) looking at German Socio-Economic Panel (SOEP) data find similar results where risk and trust attitudes of childrenwas affected by attitude of parents as well as prevailing attitude in the region.

A.2 Experimental literature

During the time a large body of empirical and theoretical literature was emerging, exper-imental literature was also emerging that highlighted the nature of trust at a micro level.Berg, Dickhaut and McCabe (1995) developed the influential investment game, whichhas become a standard in literature as a means to understand and model (Zak and Knack,2001; Guiso, Sapienza and Zingales, 2008a) trust and honesty (trustworthiness). In thegame an investor decides to invest a particular amount with a trustee which gets multi-plied and the trustee decides how much of money to return to the investor. An investorthat invests a larger amount is considered more trusting, while a trustee that returns alarger amount is considered more honest, where the standard Nash equilibrium outcomeis for investor to not invest, and for trustee to not return. The origins of the investmentgame can be traced to other stage games, like dictator game, ultimatum game, prisoner’s

36

dilemma game, trust game (Kreps, 1996), centipede game (Rosenthal, 1981) and exchangegame (Fehr, Kirchsteiger and Riedl, 1993) each of which have been used by researchers tounderstand behavior that does not match the standard rational framework of economics.

The experimental literature (starting with Berg, Dickhaut and McCabe (1995)) hasfound that unlike the standard game theory equilibrium, investors do invest and trusteesdo return. But, it is not necessarily clear if trusting and honest conduct reflects preferencessuch as altruism or a norm of reciprocity (Cox, 2004), and if the preferences are compo-nents of trust or separate from it. So, researchers have explored the preferences that un-derpin individual behavior to understand trust. Influential set of papers (on inequityaversion by Fehr and Schmidt (1999)); on altruistic punishment by Fehr and Gachter(2000, 2002); on altruism by Fehr and Fischbacher (2003); on betrayal aversion by Bohnetand Zeckhauser (2004); on reciprocity by Falk and Fischbacher (2006)) developed robusttheories of fairness, altruism and reciprocity, and explored the behavioral underpinningsof trust. Classic paper by Fehr and Schmidt (1999) argued that inequity aversion could ex-plain cooperation as individuals get motivated to inflict costly punishment to free riders.Exploring biological underpinnings of trust, Kosfeld et al. (2005) found that higher oxy-tocin increases trusting attitude. Another influential paper Henrich et al. (2001) lookedat 15 small scale societies and showed that in the sampled societies individuals showedother regarding preferences and deviated from the standard “homo-economicus” model.

The social preference based framework is important for understanding human behav-ior and it poses a question whether surveys like WVS measure trust or other preferences.But, the behavior based theories do not convincingly explain why there exists consider-able heterogeneity in trusting behavior across societies and their determinants as mea-sured in WVS surveys or trust games (Johnson and Mislin, 2011). The body of literature(surveyed by Fehr (2009)) has nonetheless convincingly shown that social preferences ofindividuals (which may or may not be universal) are an important component of whatgets observed as trusting or honest conduct, and a narrow focus on economic prefer-ences or beliefs is not enough to understand the topic, but more work needs to be doneto understand how heterogeneity emerges in preferences and beliefs across societies andgroups.

37

B Appendix: Theory

B.1 Appendix: Proof of Stationarity and Stability in Proposition 1

Given the dynamics in Equations 3 and 4 , si is a stationary point s.t. dpH(t)dt

= 0 anddpHI(t)dt

= 0. So:

s1 = (pH = 1, pHI = 1);

s2 ∈ S2 = (pH ∈ [0, 1], pHI = 0);

s3 =

(pH = 1− koh

ks(c−m)−kom ,

pHI = 1− (ko+ks)hks(c−m)−kom

)where pHI > 0 if ks

kHI+ko> h+m

c.

A stationary point si is stable if system of Equations 3 and 4 F (pH , pHI) =

[dpH(t)dt

dpHI(t)dt

]at si has Jacobian matrix JF (pH ,pHI)(si) with Trace tr(JF (pH ,pHI)(si)) < 0 and Determinantdet(JF (pH ,pHI)(si)) ≥ 0.

It is found:

• At point s1 for JF (pH ,pHI)(s1)26, det(JF (pH ,pHI)(S1)) < 0. So s1 is unstable equilibrium.

• At points s2 ∈ S2 for JF (pH ,pHI)(s2)27, det(JF (pH ,pHI)(s2)) = 0. So s2 is stable but not

asymptotically stable if tr(JF (pH ,pHI)(s2)) < 0. tr(JF (pH ,pHI)(s2)) < 0 if at s2 pH <

pcrH = ( ksks+ko

). So, points with pH > pcrH in S2 are unstable.

• At point s3 for JF (pH ,pHI)(s3)28, det(JF (pH ,pHI)(s3)) > 0 and tr(JF (pH ,pHI)(s3)) < 0 when

w < ksc−(ks+ko)mh(c−fHI(c−m))

where fHI = pHI

pH. So, s3 is a stable equilibrium when w is small.

B.2 Appendix: Proof of Lemma 3

Ruler removes monopoly of merchant guilds only if merchant guild elites cannot blocksuch transition by raising relationship based payoff (m). As merchant guild elites canat most set m ≤ mmax, so when Lemma 1 and 2 are satisfied for m = mmax, then tran-sition can occur without being blocked by merchant guild elites. Lemma 1 and 2 are

26JF (pH ,pHI)(s1) =

[wh 0

(ko + ks) + wh −ko

]27JF (pH ,pHI)(s2) =

[0 wpD(cpH − (m+ h))0 kopH − kspD

]28JF (pH ,pHI)(s3) =

[wpDpHIc −wpHpHI(c−m)

(ks + ko)pHI + fHIwpDpHIc −kopHI − fHIwpDpHI(c−m)

]

38

necessary conditions for ruler to remove monopoly of merchant guilds, which are true ifpmH > (1+λm)(mmax+h)

c+λmmmax+(1+λm)hand c > (1+λm)

λmh + mmax (Region 1 of Figure 2). In all other condi-

tions, elites can block such a transition by setting m ∈ [mmin,mmax). When ruler has notremoved monopoly, which is true if pmH ≤

(1+λm)(mmax+h)c+λmmmax+(1+λm)h

or c ≤ (1+λm)λm

h + mmax, thenloss from being cheated hi = βh. If merchant guild elites set m = mmin, traders will nottransition if pmH ≤

(1+λm)(mmin+βh)c+λmmmin+(1+λm)βh

and c ≤ (1+λm)βλm

h + mmin (Region 3 of Figure 2). Ifthere exists a region which lies outside of Region 1 and 3 (Region 2 of Figure 2), then inthe region merchant guild elites set m ∈ (mmin,mmax). The above proves Lemma 3

B.3 Appendix: Trust Anchors

In presence of trust anchors i.e. impersonal and impartial institutions that exchange hon-estly and impersonally (e.g. bishops in North Italy (Guiso, Sapienza and Zingales, 2008a))regardless of past experience in society such that kopHR(t)ε traders are always acting asHI type traders where ε→ 0, evolutionary and behavioral dynamics is given as:

dpH(t)

dt= −dpD(t)

dt= wpD(t)pHI(t)(pH(t)c

−(c−m)pHI(t)− (m+ h))

(6)

dpHI(t)

dt= kopHR(t)(pHI(t) + ε)− kspHI(t)pD(t) +

pHI(t)pH(t)

dpH(t)

dt(7)

Finding stationary points Soi s.t. dpH(t)dt

= 0 and dpHI(t)dt

= 0 where So is stable if system

of equation [5] and [6] F o(pH , pHI) =

[dpH(t)dt

dpHI(t)dt

]at Soi has Jacobian matrix JF o(pH ,pHI)(S

oi )

with Trace tr(JF o(pH ,pHI)(Soi )) < 0 and Determinant det(JF o(pH ,pHI)(S

oi )) ≥ 0.

So there exist two sets of stable equilibria:

1. pH = 0 represents an asymptotic equilibrium.

2. pH = 1− kohks(c−m)−kom and pH = 1− (ko+ks)h

ks(c−m)−kom represents an asymptotic equilibriumif w < w distinct from (i) if ks

ko+ks> h+m

c.

3. If pH(0) > h+mc

and pHI(0) → 0 when ksko+ks

> h+mc

and w < w the system convergesto the asymptotic equilibrium (2) and (1) otherwise.

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C Simulation

I look at conditions of evolution to impersonal equilibrium for a typical simulationscenario. In the following example, a population of 10,000 agents engaged in 1,000exchanges, with a randomly paired agent in each exchange. Of all agents, 5,000 wereagents with honest attitude (pH = 0.5), of which a tiny fraction of 100 were honestand impersonal (pHI = 0.01). Payoffs were set at c = 0.5,m = 0.05 and h = 0.1.Impersonal traders became relationship based on being cheated with probabilityks = 1 and relationship based traders became impersonal traders on being cooper-ated with probability ko = 1. Agents imitate another agent of different attitude witha probability equal to the product of a timescale constant w = 0.1 and difference infitness of paired agents (calculated in variable fitness, and Mode = 0). S = 100 iter-ations of the simulation are run and average population of trusting (HI type) agents(variable meantrust) and of dishonest (D type) agents (variable meandishonesty) iscalculated over time. Figure 4 presents the results of the simulation of variation ofHI type and D type agents.

Note that in the theoretical model agents actually consider average relative fitness oftypes, and not just the relative fitness of the imitated agent. In a simulation modelwhere average fitness is considered (Mode = 1), results exactly match theoreticalpredictions, as is evident in Figure 5, which notes 10 simulations (S = 10). Wheninitial population is pH(0) = 0.49 and pHI(0) = 0.01, at equilibrium pHI = 0 astheoretically expected according to Cultural Condition in Lemma 2.

If rate of imitation is increased (w = 0.5), while other parameters stay equal, thenthe impersonal equilibrium is reached sooner, and the cyclic pattern of trust anddishonesty is more evident, as is evident in Figure 6.

If relationship based payoff is increased to, for examplem = 0.2, while other param-eters stay equal, then even a population completely dominated by HT type agentspH = pHT = 0.99 cannot sustain trust as is evident from Figure 7. Similarly, notrust emerged when initial population of agents with honest attitude was 4,000 i.e.pH = 0.4 (all else being equal or at a higher w = 0.5), as a critical threshold wasn’treached.

A simulation exercise incorporating trust anchors (so that pA > 0) shows that imper-sonal equilibrium can emerge at a lower threshold in presence of a small fraction ofunconditional cooperators (trust anchors). If there were 10 unconditional coopera-tors in a population of 10,000 in our simulation model, and there were 4,000 honest

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Figure 4: Y axis represents number of dishonest (Dtype) and honest and trusting (HI type) agents overtime. The individual trends show results of 100 sim-ulations, while thick Black line shows average pop-ulation of HI type honest and trusting agents over-time, while thick Red line shows average popula-tion of D type dishonest agents. The simulationsmatch theoretical expectations. c = 0.5,m = 0.05,h = 0.1, w = 0.1, ks = 1, ko = 1. Total population is10,000, pH(0) = 0.5 and pHI(0) = 0.01. Mode = 0.

Figure 5: Y axis represents number of dishonest (Dtype) and honest and trusting (HI type) agents overtime when Mode = 1. The individual trends show re-sults of 10 simulations, while thick Black line showsaverage population of HI type honest and trustingagents overtime, while thick Red line shows averagepopulation of D type dishonest agents. The simu-lations match theoretical expectations of equilibriumpHI = 0.5 and pD = 0.25. c = 0.5,m = 0.05,h = 0.1, w = 0.1, ks = 1, ko = 1. Total populationis 10,000, pH(0) = 0.51 and pHI(0) = 0.01.

Figure 6: Y axis represents number of dishonest (Dtype) and honest and trusting (HI type) agents overtime. The individual trends show results of 10 sim-ulations, where thick Black line shows population ofHI type honest and trusting agents overtime for oneparticular iteration, while thick Red line shows pop-ulation of D type dishonest agents of the same itera-tion. The simulations match theoretical expectations.c = 0.5,m = 0.05, h = 0.1, w = 0.5, ks = 1, ko = 1.Total population is 10,000, pH(0) = 0.5 and pHI(0) =0.01. Mode = 0.

Figure 7: Y axis represents number of dishonest (Dtype) and honest and trusting (HI type) agents overtime. The individual trends show results of 10 simu-lations, while thick Black line shows average popula-tion of HI type honest and trusting agents overtime,while thick Red line shows average population of Dtype dishonest agents. The simulations match theo-retical expectations that pHI = 0 as Institutional Con-dition in Lemma 1 is not satisfied. c = 0.5,m = 0.2,h = 0.1, w = 0.1, ks = 1, ko = 1. Total population is10,000, pH(0) = 0.99 and pHI(0) = 0.99. Mode = 0.

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Figure 8: Y axis represents number of dishonest (D type) and honest and trusting (HI type) agents overtime in presence of 10 trust anchors. The individual trends show results of 10 simulations. The simulationsmatch theoretical expectations. c = 0.5,m = 0.05, h = 0.1, w = 0.5, ks = 1, ko = 1. Total population is10,000, pH(0) = 0.4 and pHI(0) = 0.01, and there are 10 trust anchors. Mode = 0

agents (pH = 0.4) impersonal exchange can still emerge especially when imitationrate (w = 0.5) is high, as shown in Figure 8

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