From the Economist: Economics focus / Reality bites

[Guy Berger]

Economics focus

Reality bites

Oct 15th 2009

From The Economist print edition

Elinor Ostrom and Oliver Williamson win this year's Nobel prize for economics

Illustration by Jac Depczyk

BUILDING economic models usually involves stripping the world down to its most essential features. But simple theories often struggle to explain the way things really work. Elinor Ostrom of Indiana University and Oliver Williamson of the University of California at Berkeley, the winners of this year's Nobel prize for economics, have both been honoured for recognising this complexity. Their research provides insights into economic institutions that play crucial roles in the real world, but to which economists have not paid enough attention.

In the case of Mr Williamson, that institution is the company. With hierarchical decision-making processes based on rules and authority, firms ought to be less efficient than decentralised market exchange based on relative prices, which is how standard economic theory assumes that transactions occur. So why do companies exist at all? This question was first addressed in 1937 by Ronald Coase, the winner of the 1991 Nobel prize for economics and the intellectual forefather of both of this year's winners. Mr Coase argued that all economic transactions are costly—even in competitive markets, there are costs associated with figuring out the right price. The most efficient institutional arrangement for carrying out a particular economic activity would be the one that minimised transaction costs. This would often be the market. But using authority and rules within a firm would sometimes prove to be more efficient.

Mr Coase's theory explained why companies existed but it was not specific enough to predict the conditions under which firms, or markets, would be the superior form of organisation. Clarifying this was Mr Williamson's signal contribution. In a series of papers and books written between 1971 and 1985, he argued that the costs of completing transactions on spot markets increase with their complexity, and if they involve assets that are worth more within a relationship between two parties than outside it (a rear-view mirror made to the specifications of a particular car manufacturer, for example).

Both these features make writing and enforcing contracts which take every possible eventuality into consideration difficult, or even impossible. At some point, therefore, it makes sense to conduct the associated transaction within a single legal entity rather than on a market. The car company might prefer to produce its rear-view mirrors in-house, for example, perhaps by buying the mirror company. This would reduce the time and resources spent haggling over profits, because decisions would simply be taken by fiat.

Mr Williamson's theory helpfully specified measurable attributes of transactions that would make them more or less amenable to being conducted on markets. That meant his thinking could be tested against decisions by companies to integrate parts of their supply chain. It has held up remarkably well. Several studies find, for instance, that when an electricity generator can choose between the output of many nearby coalmines that produce coal of a particular quality, it tends to buy its coal on an open market. But if there is only one nearby mine that can be relied upon as a supplier, the electricity generator tends to own it. A transaction that could be done on the market moves into the firm.

According to Mr Williamson, one lesson from organisational theory is the importance of identifying common patterns of behaviour in seemingly disparate situations. That sums up the way Elinor Ostrom has spent her working life. The first woman to win a Nobel prize for economics, she studies the governance of "common resource pools"—such as pastures, fisheries or forests—to which more than one person has access. Unlike pure public goods such as the atmosphere, where one person's use does not reduce the amount available to others, people deplete these resources when they use them. Standard economic models predict that in the absence of clearly defined property rights, such common resources will be overexploited, with individuals acting without regard for the effects of their actions on the overall pool. Overfishing or overgrazing (the "tragedy of the commons") will result. Over time, stocks of the common resource will dwindle.

But in 40 years of studying how common resources—from lobster fisheries in Maine to irrigation systems in Nepal—are actually managed by communities, Ms Ostrom found that people often devise rather sophisticated systems of governance to ensure that these resources are not overused. These systems involve explicit rules about what people can use, what their responsibilities are, and how they will be punished if they break the rules. In particular, she found that self-governance often worked much better than an ill-informed government taking over and imposing sometimes clumsy, and often ineffective, rules. In this, she too shadows Mr Coase, who argued that those who advocated government ownership of common resources ignored the transaction costs associated with collecting taxes.

Tit for tat

One problem with the idea of the tragedy of the commons, Ms Ostrom found, was that it did not account for the fact that people sharing a pool of resources tend to interact repeatedly, making all sorts of clever punishments for wrongdoing feasible. Being able to threaten credible retaliation makes co-operation possible. This is the province of game theory, to which Ms Ostrom has contributed, both through formal modelling of what she found in the field and subsequent laboratory tests of her models.

Both Mr Williamson and Ms Ostrom have built on Mr Coase's idea that all transactions have costs but that these costs will be minimised by different institutional arrangements in different situations. Their work uses methods and insights from fields that many economists are not sufficiently familiar with: detailed case studies, in the case of Ms Ostrom, a political scientist by training, and insights from the law in Mr Williamson's case. Their win reminds economists that borders between disciplines, like those between the firm and the market, can be profitably crossed.

[The Magnificent Goldberg]

Thanks Guy, very interesting.

There's also the case where information inequalities make reaching a bargain difficult, which could be resolved by bringing the unequally informed parties within the same organisation.

MG

[Niko]

building economic models usually involves stripping the world down to its most essential features. But simple theories often struggle to explain the way things really work. Elinor Ostrom of Indiana University and Oliver Williamson of the University of California at Berkeley, the winners of this year's Nobel prize for economics, have both been honoured for recognising this complexity.

whatever they did, i guess most of the prize was awarded because they didn't stop at that observation...

[The Magnificent Goldberg]

whatever they did, i guess most of the prize was awarded because they didn't stop at that observation...

And also, I suspect, because their studies crossed disciplinary divides, having the effect of bringing economics closer to real life.

I've thought frequently that the insight of game theorists that, to keep people playing by the rules, carrots are better than sticks but you can't abandon sticks, is one of the great revelations of human nature and explains much of the world.

MG

[Niko]

whatever they did, i guess most of the prize was awarded because they didn't stop at that observation...

And also, I suspect, because their studies crossed disciplinary divides, having the effect of bringing economics closer to real life.

I've thought frequently that the insight of game theorists that, to keep people playing by the rules, carrots are better than sticks but you can't abandon sticks, is one of the great revelations of human nature and explains much of the world.

MG

whose insight was that? and does one really need (formal) game theory to get there...

[The Magnificent Goldberg]

whatever they did, i guess most of the prize was awarded because they didn't stop at that observation...

And also, I suspect, because their studies crossed disciplinary divides, having the effect of bringing economics closer to real life.

I've thought frequently that the insight of game theorists that, to keep people playing by the rules, carrots are better than sticks but you can't abandon sticks, is one of the great revelations of human nature and explains much of the world.

MG

whose insight was that? and does one really need (formal) game theory to get there...

I can't remember. I've a feeling it was in something Guy posted here a while back.

I think you do need a theory in this case, or all you've got are your own observations and a load of contrary opinions from interested parties such as religions.

MG

[Guy Berger]

Thanks Guy, very interesting.

There's also the case where information inequalities make reaching a bargain difficult, which could be resolved by bringing the unequally informed parties within the same organisation.

MG

Yup. I'm too lazy to dig through the list of econ Nobel laureates, but would bet that the "imperfect markets" wing of microeconomics has won a pretty big share of the prizes handed out in recent decades.

[The Magnificent Goldberg]

whatever they did, i guess most of the prize was awarded because they didn't stop at that observation...

And also, I suspect, because their studies crossed disciplinary divides, having the effect of bringing economics closer to real life.

I've thought frequently that the insight of game theorists that, to keep people playing by the rules, carrots are better than sticks but you can't abandon sticks, is one of the great revelations of human nature and explains much of the world.

MG

whose insight was that? and does one really need (formal) game theory to get there...

I can't remember. I've a feeling it was in something Guy posted here a while back.

No it wasn't - it was in a BBC World Service programme that dealt with comparative religion, or some such related subject. But I don't know the name of the academic who was speaking - he was British, I recall, from his accent.

MG

[ghost of miles]

Lots of attention and B-town pride for Ostrom here since the announcement of this prize.