Schelling Points and Self-enforcing Contracts Is it possible for individuals to contract their way out of a Hobbesian world, a society

where nobody has any rights recognized or enforced by anyone else? That question was raised in a series of articles contained in two books1 edited by Gordon Tullock in the early 1970s. Tullock himself, in his contribution to the second book, argued that it was not possible, that in such a world there was nothing to enforce a contract, hence making a contract would have no effect. On the face of it, the argument seems obviously correct. It is both obvious and false. 2 Even in a Hobbesian world with no external mechanism to enforce contracts, signing a contract can affect the behavior of the parties in a way that makes it more likely that they will act as specified in the contract than if they had not signed it. In that sense, it is possible for contracts to be self-enforcing. Parties in a Hobbesian world would gain by agreeing to some division of property and definition of rights between (or among3) themselves, with different divisions and definitions affecting both the size of the gain and how it is distributed. They are in a form of the game bilateral monopoly; the parties can produce a gain, provided they can agree on how to divide it. Possible outcomes all divisions that leave both parties at least as well off as they started, as well as bargaining breakdown, in which there is no agreement and no gain. Here bargaining breakdown means that the parties fail to contract their way to some form of civil order and so remain in the Hobbesian world where they started. What makes a self-enforcing contract possible is the fact that making the contract changes the equilibrium outcome of the game. To explain why first requires a long digression on the subject of Schelling points. Schelling Points4

2, 5, 9, 25, 69, 73, 82, 96, 100, 126, 150 Two people are separately confronted with the list of numbers shown above and offered a reward if they independently choose the same number. If the two are mathematicians, it is likely that they will both choose 2the only even prime. Non1 2 3

Explorations in the Theory of Anarchy (1972) and Further Explorations in the Theory of Anarchy (1974). A claim originally made in my review of Tullock 1974, Published in Public Choice in 1976.

For simplicity I will work out the logic in a two person world; the generalization should be reasonably obvious.
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Thomas C. Schelling, The Strategy of Conflict, (Oxford: Oxford University Press, 1960), Ch. 3. While I am using Schelling's concept, my analysis of it, in particular my grounds for applying it to games with communication, is somewhat different from his.

-2mathematicians are likely to choose 100a number which seems, to the mathematicians, no more unique than the other two exact squares. Illiterates might agree on 69, because of its peculiar symmetryas would, for a different reason, those whose interest in numbers is more prurient than mathematical. There are three things worth noting about this simple problem in coordination without communication. The first is that each pair of players is looking for a number that is in some way unique. To a mathematician, all three squares are special numbers, as are the three primes. But if they try to coordinate on a square or a prime, they have only one chance in three of successand besides, one may be trying primes and the other squares. 2 is unique. If the set of numbers did not contain 2 but did contain only one prime (or only one square, or one perfect number) they would choose that. The second thing to note is that there is no single right answer; the number chosen by one player, hence the number that ought to be chosen by the other, depends on the categories that the person choosing uses to classify the alternatives. The right strategy is to find some classification in terms of which there is a unique number, then choose that numbera strategy whose implementation depends on the particular classifications that pair of players uses. Thus the right answer depends on subjective characteristics of the players. The third point, which follows from this, is that it is possible to succeed in the game because of, not in spite of, the bounded rationality of the players. To a mind of sufficient scope every number is unique.5 It is only because the players are limited to a small number of the possible classification schemes for numbers, and because the two players may be limited to the same schemes, that a correct choice may exist. In this respect the theory of this game is radically different from conventional game theory, which assumes players with unlimited ability to examine alternatives and so abstracts away from all subjective characteristics of the players except those embodied in their utility functions.6 Consider now two players playing bilateral monopoly.7 They have a dollar to divide between them, provided they can agree how to divide it. Superficially there is no

5There is a semi-serious theorem according to which all integers are interesting. The proof is by induction. If some positive integers are uninteresting, then there must be a smallest positive uninteresting integer. But this unique characteristic makes that number interesting. So there can be no smallest uninteresting positive integer, so there can be no uninteresting positive integers. Similarly, mutatis mutandis, for negative integers. 6 Game theory sometimes smuggles subjective characteristics back into the argument in the process of choosing a particular strategy set. A famous example of this problem is the analysis of oligopoly. The assumption that the firms strategy is defined as a choice of quantity and the assumption that it is defined as a choice of price lead to very different conclusions. See David Friedman, Price Theory: An Intermediate Text, (Cincinnati: South-Western Publishing Co. , 1990), ch. 11. So called because it corresponds to a situation where there is only one buyer and one seller, and they must agree on a price.
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-3resemblance between this game and that discussed above; the players are free to talk with each other as much as they want. But while they can talk freely, there is an important sense in which they cannot communicate at all. It is in my interest to persuade you that I will only be satisfied with a large fraction of the dollar; if I am really unwilling to accept anything less than ninety cents, you are better off agreeing to accept ten cents than holding out for more and getting nothing. Since each of us wants to persuade the other of his resolve, statements to that effect can be ignored; they would be made whether true or not. What each player has to do is to guess what the other's real demand is, what the fraction of the dollar is without which he will refuse to agree. The situation is therefore similar to that in the previous game; the players must coordinate their demands (so that they add up to a dollar) without communication. It seems likely that they will do so by agreeing to split the dollar fiftyfifty, that being the one outcome that appears unique. To put the same point a little differently,8 Consider a situation in which the process of bargaining is itself costly, either because it consumes time or because each player bears costs (such as staying out on strike) in trying to validate his threats. As long as the players are faced with a choice among a large number of comparable alternatives, each proposal by one player is likely to call forth a competing proposal from another, slanted a little more in his own interest. But suppose there is one outcome that is seen as unique. A player who proposes that outcome may be perceived as offering, not a choice between that outcome, another slightly different, another different still, . . . but a choice between that outcome and continued bargaining. A player who says that he insists on the unique outcome and will not settle for anything less may be believable, where a similar statement about a different outcome would not be. He can convincingly argue that he will stand by his proposed outcome because, once he gives it up, he has no idea where he will end up or how high the costs of getting there will be. To see that the solution depends on the particular categories used by the players, imagine that both have been brought up to believe that utility, not money, is the relevant payoff, and suppose further that both believe the marginal utility of a dollar to be inversely proportional to the recipient's income. In that case, the solution to the game is not a fifty-fifty split of money but a fifty-fifty split of utilityimplying a division of the dollar into shares proportional to the two players' incomes.9

8 This approach is discussed in Friedman (1980). 9 I have discussed this point, and the game of bilateral monopoly, at greater length in David Friedman, Bilateral Monopoly: A Solution, Fels Discussion Paper #52, University of Pennsylvania, (March 1974), webbed at: http://www.daviddfriedman.com/Academic/Bilateral_Monopoly_%C4/Bilateral_Monopoly.html

-4Just as in the earlier game of guessing a number, the players are looking for a unique solution; if I decide that the natural split is one third-two thirds and you agree, both of us reasoning from a mystic belief in the significance of the number three, there is still the risk that each will decide he is entitled to the two-thirds. Such an outcome, chosen because of its uniqueness, is called a focal point or Schelling point, after Thomas Schelling who originated the idea. It provides a possible solution to the problem of coordination without communication. As this example shows, it is relevant both to situations where communication is physically impossible and to situations where communication is impossible because there is no way that either party can provide the other with a reason to believe that what he says is true. Even if players cannot communicate their real demands, it may still be possible for them to affect the outcome by what they say by altering the other players categories, the ways in which he organizes the alternatives of the game. In the example just discussed, one player (presumably the richer) might remind the other of their shared belief in the importance of utility in order to make sure the equi-utility Schelling point would be chosen. If, in the first game I described, the players were allowed to talk before seeing the numbers, a conversation on the interesting properties of primes or the special uniqueness of the lowest of a series of numbers might well alter the Schelling point and so the outcome. One can interpret a good deal of bargaining behaviour in this lightas an attempt by one party to make the other see the situation in a way that generates a Schelling point favorable to the first party. In order for a Schelling point to provide a peaceful resolution to a conflict of interest, both parties must conceptualize the alternatives in similar wayssimilar enough so that they can agree about which possible outcomes are unique, and thus attractive as potential Schelling points. So one implication of the argument is that conflict is especially likely to occur on the boundary between cultures, where people with very different ways of viewing the world interact. Escaping Hobbes Consider two people of roughly comparable physical ability alone in a Hobbesian world containing land and a stream. One proposes to the other that they divide the world between them. If such an agreement is made and kept, it will no longer be necessary for each of them to spend time and effort protecting the roots he has gathered and the animals he has hunted down and slain from pilfering by the other, nor for each to sleep hidden far up a tree for fear that the other will eliminate the future risk of conflict by killing him in his sleep. Each would prefer an agreement giving him as much land as possible. Each can threaten violence against the other if he does not get what he wants. Each knows that a fight to the death, or even close, is on average a losing game for both parties, hence both

-5want to avoid violent conflict. Each knows that the other also wants to avoid it, and is tempted to use the threat of conflict to his own benefit. In bargaining over the initial division, they are in a bilateral monopoly game. This bilateral monopoly, however, has a Schelling point provided by the stream. One of them proposes a division defined by the stream, with either free to attack the other if he trespasses without permission on the wrong side. The other, realizing that this is the only available Schelling point, sees the choice not as one among a multitude, but as a choice between a unique solution and continued bargainingand many more uncomfortable nights up a tree. He agrees How has their agreement changed the outcome of their mutual threat game? Each realizes that enforcing the agreement requires him to be willing to attack the other if he crosses the stream without permission. Since maintaining the agreement is valuable, he has a strong incentive to do so. Each also realizes that, if he does cross the stream and get attacked, he can end the attack by retreating back to his own territory. To put it differently, attack trespassers, retreat if caught trespassing and attacked is another Schelling point. There are lots of other strategies each party could select. But that one, abiding by the terms of the contract, is unique in a sense in which no other strategy, or at least no reasonably attractive one, is. It is a Schelling point created by the contract. Hence the contract is, to at least some degree, self-enforcing. It may occur to readers familiar with the literature on ethology, the science of animal behavior, that the behavior I have described is not limited to humans. It corresponds fairly closely to territorial behavior in various species of animals, especially birds and fishes. In that case there is not, so far as we know, any initial contract, but there is property enforced by a commitment strategy. One individual marks what he claims and somehow commits himself to fight a trespasser of his own species, more and more desperately the deeper the trespasser penetrates into the territory. A fight to the death is usually a loss for the winner as well as the loser, so once the defenders commitment is clear, it is usually in the interest of the trespasser to retreat. Now fast forward twenty years. Norris, who owns the land north of the creek, has planted an apple orchard and the trees are now fully grown and bearing. Unfortunately, a large oak tree has also grown up and is shading the orchard. Also unfortunately, Norris has no way of cutting down the oak at a reasonable cost in time and effort. Southey, however, Norriss neighbor, has spent many hours learning and applying the skill of flint knapping, produced an axe, and has been using it to cut down trees that shade the field where he is cultivating crops. Norris proposes a deal. Southey is to cut down the oak tree and Norris will provide him fifty apples a year from his orchard. Southey agrees and carries out his side of the contract. A few months later, the apples are ripe. Will Norris deliver, and if so why? One reason he will is that Southey, while fulfilling his side of the bargain, also made it clear that if the apples were not delivered when due, he would wait until the next time

-6Norris was off hunting, cross the stream, and apply his axe to Norris treasured apple trees. Why wouldnt that threat get Southey his apples if he had made it a year earlier, without offering to cut down the oak tree? Because it would have been an attempt to push the outcome of the threat game away from the one available Schelling point (each party respects the property of the other, as initially agreed to) into one of a continuous range of outcomes (next harvest Southey might ask for sixty apples), with large costs in potential conflict as the parties fought or bargained over that range. Why does the threat work now? Because acting on it pushes the outcome towards the Schelling point defined by the second contract, just as attacking a trespasser pushed the outcome towards the Schelling point defined by the initial agreement dividing up the property. Hence we again have a self-enforcing contract in a world where there is no external enforcement. By using such contracts, individuals starting in a Hobbesian world could, in principle, bargain their way up to a civil order. Does This Have Anything to Do With the Real World? So far I have been applying the idea of self-enforcement via Schelling points to an imaginary world of Hobbesian anarchy. To see why it is more broadly relevant, the first step is to ask in what sense we are ever out of such a world. What do we have that the world Hobbes described lacks that explains how much safer and more orderly ours is? We have police, judges, courts, law codes, but why do any of those matter? Police and judges are people, and like the people Hobbes world they will act on their own selfinterest. Law codes are written on paper, and paper is not proof to steelwhat compels individuals considering the use of violence to get what they want to pay attention to the code? Police compel them? What compels the police to do so? One possible answer is morality, that what we have is a set of internalized codes which make police feel that they are bad people if they use their position to rob, good people if they use it to enforce the law, and similarly for everyone else. That is a possible answer, but not the one that interests me. My answer is that what we have is an elaborate network of mutually consistent Schelling points.10 Each of us has the ability to injure others, whether by violent force, gossip, legal action, or whatever. Each of us has committed himself to use that ability against anyone who violates what he considers his rightssubject to reasonable prudence

This approach is discussed and defended at greater length in D. Friedman, "A Positive Account of Property Rights," Social Philosophy and Policy 11 No. 2 (Summer 1994) pp. 1-16, webbed at http://www.daviddfriedman.com/Academic/Property/Property.html.

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-7when dealing with a violator with an overwhelming advantage over us.11 Just like Norris, Southey, or a territorial bird, each of us is willing to bear costs large relative to what appears to be immediately at stake in defending what is ours. And each of us, recognizing that commitment in our neighbor, has good reason not to violate what our neighbor sees as his rights. The system only works if our beliefs about rights and the associated commitment strategies are reasonably consistent. If I believe I have a right to walk across your lawn and you believe, with equal confidence, that I dont, we may be in for trouble. What makes civil order possible is that we have acquired a set of Schelling points, a set of commitment strategies, that are for the most part mutually consistent. One implication, again, is that conflict is most likely to arise on the interface between cultures sufficiently different so that, in the same situation, they see different and inconsistent Schelling points.

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This way of understanding civil order provides a possible answer to the question of defining government, distinguishing it from other forms of organization. A government is an organization against which people have dropped the commitment strategies that protect what they view as their rights against violation by other individuals and organizations.