Researching the transactions of Jewish diamond dealers in New York City, Professor Lisa Bernstein found that dealers relied on a private ordering system—a set of extralegal rules determined internally—supported in large part by their shared religion and cultural identity.
“Jewish diamond dealers in the New York bourse [trading center] in the early 1990s were able to exchange millions of dollars of diamonds simply by shaking hands and intoning the [Hebrew] phrase mazal u'bracha,” Bernstein said during the 2020 Coase Lecture, which she delivered last month to a packed audience.
Much of the research on private ordering has focused on these types of small, ethnically homogenous communities, including Chinese rubber dealers in Malaysia, as well as Bernstein’s work on the Jewish diamond dealers of New York and cotton merchants in the old South. But such a narrow focus has led to misconceptions about the circumstances under which private ordering can thrive, Bernstein said during the lecture, titled “Re-examining Ethnically Homogeneous Trade: A Social Network Approach.”
“I want to take the occasion of the Coase Lecture to follow the words of my colleague Richard Epstein, who says that after five years a good scholar should attack her work with the same vigor that she attacks the work with others,” Bernstein, the Wilson-Dickinson Professor of Law, told the audience, drawing chuckles.
To correct these misconceptions, Bernstein suggested that viewing private ordering systems through the lens of social network analysis can be helpful because it reveals that it is the existence and structure of ties among people and institutions (regardless of whether the ties arise from bowling leagues, ethnic or cultural bonds, or just past transactions) that can help to support exchange. Recognizing this allows for a much wider view of when successful private ordering might be possible.
The cases of cotton in the South, rubber in Malaysia, and diamonds in New York—“are not wrong,” Bernstein said. “Rather they're just very special cases of a much more general phenomenon.”
A social network approach—a term that has nothing to do with Facebook, she added—can be used to understand when private ordering is likely to work. It suggests that reputation-based forces can support exchange when two conditions are met: First, that bad behavior is unlikely to go undetected, and second, that the ties among people and institutions are structured in such a way that information about that bad behavior is easily transmitted or can be obtained by going through only one or two intermediaries. Bernstein referred to the collective force of these reputation-based, non-legal sanctions as “network governance,” adding that while ethnic ties may reinforce this type of governance, they are by no means necessary.
Bernstein referred back to the New York diamond dealers’ trading center. If anyone within that center exhibited truly unacceptable behavior, she said, every member would know. The same goes for the Belgian diamond bourse, where information about fellow dealers is also readily available. If a dealer from the New York center is looking to work with a dealer from the Belgian bourse, then he or she could tap any connection with the Belgian bourse, whether personal or professional, to get information about any Belgian trader. Those relationships help relevant information travel despite geographic or ethnic divides, Bernstein said.
There are also broader international organizations that connect these different trading centers, which can further extend the network and help spread information about which dealers are trustworthy, she added.
“Both the New York diamond club as the Brussels bourse have trading rules,” Bernstein said. “And if a transactor is found to have violated these rules or engaged in any of the long list of commercial misbehaviors, that person is kicked out of the bourse—[and] that information is then sent to the World Federation of Diamond Bourses, which sends it out over the wire to all of the diamond trading centers in the world.”
Bernstein also referenced a recent study published in the Journal of Law and Economics that examined the strategic alliances made between large pharmaceutical companies and small biotech firms. The study offers empirical evidence of the ability of network governance to substitute for more formal types of governance in a setting with no ethnic connections.
“When the small biotech company was very central in the network—meaning it had connections to tons of different other players in the industry—the large pharmaceutical company was less likely take a seat on the board or an equity stake to control it,” Bernstein said. “Rather, they were content to rely on the force of network governance to [substitute for these governance devices, to] ensure that the small [biotech] company would behave. But when the small [biotech] company was all the way out on the periphery, sort of connected to no one, the large pharma companies dealing with them would insist on taking a seat on the board and/or an equity stake.”
It isn’t just the pharmaceutical industry, Bernstein said. Other studies—including those on industrial procurement, the reinsurance industry, the textile industry, and more—have suggested that network governance is a powerful force in commercial relationships, even in the absence of strong social or ethnic ties. Acknowledging this force can have useful implications for development economists and lawyers alike, Bernstein added.
“For lawyers, it means something pretty straightforward,” Bernstein said. “If you draft a contract for a client and you don't know where your client is in the network of firms, or where your client's contracting partner is in the network of firms, there's a good chance that you might put in extensive contact governance provisions that really are not needed to benefit your client.”
In response to a student question about mechanisms designed to encourage truths and discourage untruths, Bernstein explained that many trading organizations have set up arbitration tribunals to resolve internal disputes. Her research, however, suggests that few dealers actually use them.
“Although great care was taken to create them, to put very clear rules in place, and to amend those rules as various things about the industries changed, they weren't used all that often,” Bernstein said. “They would decide maybe three to ten cases per year, which seemed rather low. And so I've come to think that maybe they're there as sort of a backstop to help prevent the spread of bad information.”
As she later explained, “If I go out and badmouth you without foundation, you can point out that if you really did something wrong I should have taken you to arbitration and proved it. The fact that I did not do this will provide a strong indication to others that I might not be telling the truth.”