The fundamental problem of exchange can be diagrammatically explained using game theory, simplified by the one-sided prisoner’s dilemma game (OSPD), also known as the game of trust. In this game there are two individuals, one of whom can initiate beneficial exchange, and the other has the option of fulfilling his side of the deal (cooperating) or gaining even more by not cooperating. If the second individual decides to not fulfil his side of the deal, the initiator of cooperation is worse off than if he had not initiated cooperation.
This is shown in the following diagram:
Player I can either initiate exchange or not. When he does not, both players get their reservation payoff of 0, i.e. nothing is achieved or lost. If player I initiates exchange, player II can decide whether or not to also exchange, or cooperate by fulfilling his contractual obligations. Exchange is efficient, yielding a payoff that is allocated among the parties in a way that makes both of them better off than if they did not partake in exchange. Player I receives Y - W > 0 and player II receives W > 0. But player II can gain even more (α > W) by not cooperating, leaving player I with δ < 0 which makes him worse off than had he not exchanged to begin with. By understanding this basic game theory it is clear that despite the clear benefit of exchange, it will most likely not take place. If player I initiates exchange, the best thing player II can do under the circumstances is not exchange. Player I will eventually anticipate this outcome and will find it best not to initiate exchange to begin with. Therefore the final outcome here will be no exchange, and neither player will gain. However there is an opportunity cost here as both players are missing out on a potential gain. This is a clear problem that had to be fixed in order for the trading states to prosper, and those that solved it successfully (for example Portugal and Venice) were able to gain significantly from trade, and give them a leading position in Europe.
Clearly the ability to benefit from exchange will therefore be governed by a nation’s ability to moderate this fundamental exchange problem. The most important institutional change was the emergence of the merchant guild, whose ambition was to ensure the coordination and internal enforcement needed to maintain collective trading and its credibility, and protect themselves from feudal governments. Because merchants belonged to an organization which could act in their collective interest and which had the power to enforce compliance by each individual member, the commitment problem could be solved. In particular, the merchant organization could threaten a trade boycott if the ruler of a nation state acted opportunistically, and this credible threat could induce the ruler to act responsibly. Merchant guilds sometimes acted by providing insurance schemes to cover members engaged in long-distance trade, allowing merchants to take more risks with long-distance routes. In addition, repeated trade between merchants builds up reputation and information between states, consequently anyone who acts opportunistically would lose a valuable trade network, thus dissuading this type of behaviour even further. Another important factor was that merchants could operate independent of any states, thus if a state treated its merchants badly they could move to an adjacent state, competition between these states therefore ensured that merchants would be treated well.
The guilds were also involved in making sure that the customers were not cheated: they checked weights and measures of goods and insisted upon a standard quality. To allow only a legitimate profit, the guild fixed a "just price," which was fair to both producer and customer, further avoiding any opportunistic trade.
In addition to the merchant guilds, the state played a key role in solving the fundamental problem of exchange, thus further boosting their prosperity. The prime example here is the rise of the Venetian Republic as a result of the revival of merchant trade after the collapse of the merchant empire from the 11th century onwards. This started with the growth of the Venetian maritime navy, whose expertise in shipbuilding gave them an opportunity to defend their merchants and maintain trade routes. This was important in medieval times as war was common, making it important for a state to defend its merchants in order to maintain beneficial exchange, and provide a credible threat against any opportunistic behaviour. A strong army presence allowed Venice to expand its empire as well, acquiring colonies such as Crete, and expansion on the Italian mainland giving more opportunities to trade within the same state without intervention of foreign rulers.
The Venetian state further aided merchants by laying the foundations of modern day institutional framework important to capitalist trade. Political and legal institutions were set up to maintain property rights and contracts, thus regulating the exchange of private property. An efficient fiscal system was created thus regulating the flow of merchant profits and capital accumulation. Furthermore a democratic system of governance that allowed foreign merchants to operate freely and be responsive to the needs of the merchant guilds allowed even more secure trade.
The final part of the question asks how important long distance trade was to the prosperity of the Venetian Republic and Portugal. Venice is believed to have prospered more as a result of this revival in trade, as commercialisation spread deeply across the economy, trading heavily in glass, silk and woollen textiles and sugar, the GDP per capita is believed to have risen to $1,100 by 1500A.D. while Portugal had only $632 per capita. Most of the trade between Asia and Europe at this time passed through Venice, thus giving them a vital monopoly until 1498 when the Portuguese explorer Vasco de Gama managed to sail round Africa to India and establish a new trade route, bypassing the Venetian bottleneck. From this stage there was a relatively gentle decline in the dominance of the Venetian republic and a slow rise in Portuguese importance in Europe, particularly in the import of spice from India and Africa to the rest of Europe. It is important to note that GDP figures are a rough estimate as a result of the lack of economic information from medieval times, and are determined by the relative sizes of agriculture and industry which are not strictly synonymous with the amount of trade that is carried out, particularly in Portugal where agriculture and industry were believed to be largely backward.
The fundamental problem of exchange and the rise of merchant trade are important factors in the rise of mercantilism and eventually capitalism. They laid the foundations of international trade after the collapse of the Roman Empire and continued the trend of rising per capita growth, as opposed to the Malthusian trap of population crowding out, allowing rising prosperity to be maintained.
Bibliography
Maddison, A (2001) The World Economy: A Millennial Perspective
Carew Hazlitt, W. (1915) The Venetian Republic Its Rise, its Growth, and its Fall (Volume I and II) 4th edn
Grief, A. (2000) The Fundamental Problem of Exchange: A Research Agenda in Historical Institutional Analysis
