The bigger picture
Oct 12th 2009
From Economist.com
This year’s Nobel prize has rewarded the use of economics to answer wider questions
NEITHER Oliver Williamson of the University of California at Berkeley nor Elinor Ostrom of Indiana University at Bloomington was widely tipped to win this year’s Nobel prize for economics. This may be because their work sits at the boundary of economics, law and political science, and tackles different questions to the ones that economists have traditionally studied. Ms Ostrom is also notable as the first woman to win the economics prize in its 40-year history.
Mr Williamson and Ms Ostrom work independently of each other but both have contributed plenty to economists’ understanding of which institutions—firms, markets, governments, or informal systems of social norms, for example—are best suited for conducting different types of economic transactions. Why, for example, do some transactions take place within firms, while others are carried out in competitive markets?
Ronald Coase, a British economist who won the Nobel prize in 1991, argued that in some situations, and for some kinds of transactions, administrative decision-making within a single legal entity (ie, a company) is more efficient than a straightforward market transaction. Mr Coase’s arguments were influential and convinced economists that the internal workings of organisations were worth paying attention to explicitly. But it was left to Mr Williamson to refine Mr Coase’s theory and clarify what features of certain transactions made carrying them out more efficient within a firm rather than in the market.
Mr Williamson showed that complex transactions involving investment decisions that are much more valuable within a relationship than to a third party are best done within a firm. Part of the problem, he argued, was that some economic transactions are so complicated, and involve so many things which could go wrong, that writing a legally enforceable contract that takes all possibilities into account is impossible. Simpler transactions are completed easily in markets; more complicated ones may demand firms. But in later work he also showed that organising matters within companies had costs: in particular, it relied on internal authority to get things done, and this could be abused.
Ms Ostrom has concentrated on a different aspect of economic governance. She has spent her life studying how human societies manage common resources such as forests, rivers, pastures or wildlife. Just as with public goods, it is difficult to prevent people from using the commons. But unlike public goods, and like private ones, what one person takes leaves less for others. Economic theory then predicts that rational individuals will overuse these resources.
Economists (including Mr Coase) have tended to emphasise property rights as a solution to the problem of managing common resources. Typically that involves either privatisation or putting the resource in government hands. But Ms Ostrom, who is a political scientist by training, spent much of her early career studying how communities managed such common resources. She found that groups of people tended to have complex sets of rules, norms and penalties to ensure that such resources were used sustainably. Such self-governance often worked well.
Successful informal institutions, she found, have certain features in common, which sets them apart from institutions that fail. The principles of game theory, particularly the theory of repeated interactions, proved remarkably useful in formulating general principles of how common resources ought to be managed without necessarily resorting to private or state ownership.
Mr Williamson launched an entire branch of economic theorising which looks more deeply into firms than economists had tended to do previously. His theories have also helped with understanding the choice between equity and debt, and corporate finance more generally. Ms Ostrom’s research has spawned many experiments about how people interact strategically. Some of these have influenced game theory, which originally provided Ms Ostrom with her analytical tools.
The Nobel committee’s decision, like earlier awards to Amartya Sen and Daniel Kahneman, is a welcome shot in the arm for research that crosses disciplinary boundaries in the social sciences.
