4.2 The Formal Model
The theoretical modeling is kept simple and directed to analyzing the potential of various plausible mechanisms for overcoming the ruler's commitment problem.25 Each of the mechanisms examined explicitly captures a particular intertransactional linkage and might feasibly permit commitment by the ruler at some level of trade. The focus is on the growing need for more sophisticated mechanisms as the level of trade rises and approaches the efficient level.
The environment in which trade takes place has two kinds of players, a city and individual merchants. The merchants, identical and large in number, are identified with the points on the interval [0, xA ]. The city—a potential trading center—has the following trading technology: if the number of traders passing through the city in a single period is x, the gross value of trade in that period is f(x). In addition, suppose that there is a cost of c > 0 per unit of value traded incurred by the city for the services it provides and a cost T > 0 per unit of value incurred by each trader, so that the net value of trade is f(x)(1!c!T). Assume that trade is profitable, that is, c + T < 1. Also assume that f is nonnegative and differentiable, that f(0) = 0, and that f achieves a maximum at some unique value x* > 0, which is referred to as the efficient volume of trade. In this model the city funds its services and earns additional revenues by charging a toll or tax of t $ c per unit of value passing through its ports, so that its total tax revenues are tf(x). If it provides the services contracted for, its net revenue for the period is f(x)(t!c). If the city breaches its contract by failing to provide services to a fraction D of the traders, it saves Dcf(x), so its payoff for the trading period is f(x)(t!c(1!D)).26 Traders who are not cheated each earn profits, net of costs, tolls, and taxes, of (1!t!T)f(x)/x. Traders who are cheated pay taxes and incur costs T but receive no revenues; each earns !(t+T)f(x)/x.
This game is repeated period after period. The players' payoffs from the repeated game are the discounted sum of the periodic payoffs using a discount factor of B. Thus the city's payoff when the trading volume is xt in period t is given by:
94 Btf(x)(t!c(1!D)). (1)