Nobel: Ostrom and Williamson

Hearty, heartfelt congratulations to Elinor Ostrom and Oliver Williamson for winning this year’s Economics Nobel! From the press release:

"Economic transactions take place not only in markets, but also within firms, associations, households, and agencies. Whereas economic theory has comprehensively illuminated the virtues and limitations of markets, it has traditionally paid less attention to other institutional arrangements. The research of Elinor Ostrom and Oliver Williamson demonstrates that economic analysis can shed light on most forms of social organization.

Elinor Ostrom has challenged the conventional wisdom that common property is poorly managed and should be either regulated by central authorities or privatized. Based on numerous studies of user-managed fish stocks, pastures, woods, lakes, and groundwater basins, Ostrom concludes that the outcomes are, more often than not, better than predicted by standard theories. She observes that resource users frequently develop sophisticated mechanisms for decision-making and rule enforcement to handle conflicts of interest, and she characterizes the rules that promote successful outcomes.

Oliver Williamson has argued that markets and hierarchical organizations, such as firms, represent alternative governance structures which differ in their approaches to resolving conflicts of interest. The drawback of markets is that they often entail haggling and disagreement. The drawback of firms is that authority, which mitigates contention, can be abused. Competitive markets work relatively well because buyers and sellers can turn to other trading partners in case of dissent. But when market competition is limited, firms are better suited for conflict resolution than markets. A key prediction of Williamson’s theory, which has also been supported empirically, is therefore that the propensity of economic agents to conduct their transactions inside the boundaries of a firm increases along with the relationship-specific features of their assets."

Few other economists have influenced my thinking as much as Ostrom and Williamson. Congratulations! Lynne Kiesling

Elinor Ostrom may arguable be considered the mother of field work in development economics. She has worked closely investigating water associations in Los Angeles, police departments in Indiana, and irrigation systems in Nepal. In each of these cases her work has explored how between the atomized individual and the heavy-hand of government there is a range of voluntary, collective associations that over time can evolve efficient and equitable rules for the use of common resources.

With her husband, political scientist Vincent Ostrom, she established the Workshop in Political Theory and Policy Analysis in 1973 at Indiana University, an extraordinarily productive and evolving association of students and professors which has produced a wealth of theory, empirical studies and experiments in political science and especially collective action. The Ostrom's work bridges political science and economics. Both are well known at GMU since both have been past presidents of the Public Choice society and both have been influenced by the Buchanan-Tullock program. You can also see elements of Hayekian thought about the importance of local knowledge in the work of both Ostroms (here is a good interview). My colleague, Peter Boettke has just published a book on the Ostrom's and the Bloomington School.

Elinor Ostrom's work culminated in Governing the Commons: The Evolution of Institutions for Collective Action which uses case studies to argue that around the world private associations have often, but not always, managed to avoid the tragedy of the commons and develop efficient uses of resources. (Ostrom summarizes some of her findings from this research here). Using game theory she provided theoretical underpinnings for these findings and using experimental methods she put these theories to the test in the lab.

For Ostrom it's not the tragedy of the commons but the opportunity of the commons. Not only can a commons be well-governed but the rules which help to provide efficiency in resource use are also those that foster community and engagement. A formally government protected forest, for example, will fail to protect if the local users do not regard the rules as legitimate. In Hayekian terms legislation is not the same as law. Ostrom's work is about understanding how the laws of common resource governance evolve and how we may better conserve resources by making legislation that does not conflict with law. Alex Tabarrok

In Adam Smith there is the pin factory and the market and from that beginning we trace the long literature in economics focused on the twin questions, What price to set? How much to produce? Following Coase, Williamson asks different questions, Why a pin factory? Why are the 18 steps to make a pin performed by a single firm rather than two or more? Why are there many firms instead of one large firm? Why does the pin factory not vertically integrate upwards to buy the steel factory and downwards to buy the retail hardware shop?

Williamson's answer rest on the notions of bounded rationality, contract incompleteness, asset specificity and opportunism. Start at the end, asset specificity and opportunism. When a deal has been sealed the parties typically move from having many potential partners to being locked in. That's bad because it raises the possibility of opportunism--one party can exploit the other. But it's also good because when the lock-in is credible each party may be more willing to invest in assets which are extra-productive but specific to the relationship.

Marriage, for example, takes away some possibilities but it adds others. With marriage, for example, come the possibility of a child (n.b. asset specificity, the child is of extra value but only to the specific parties involved in the marriage) but that very benefit also means that one of the parties has the leverage to be opportunistic. Knowing all of this when they enter the contract the parties bargain ex-ante, they exchange promises and make investments (the ring), they establish rules for ex-post bargaining or decide on the background rules to apply in that eventually (pre-nup, no fault divorce, covenant marriage). The rules are never perfect and the contacts are always incomplete.

Transaction cost economics is all about applying these ideas in different settings to figure out the best governance structures (marriage, vertical integration etc.) in different circumstances. How does one deal with expensive investments (such as highly individual dies or plant construction) that are specific to a given trade and put the investor at risk yet which increase productivity? Williamson analyzes how firms come to rely on long term contracts or vertical integration or other seemingly non-competitive solutions to enhance market productivity. Early generations of antitrust enforcers often saw these as monopolistic dealings, but scholars such as Williamson helped us understand how these are essential to the workings of the invisible hand.

Williamson's paper, The Economics of Governance (working version) published in the May 2005 AER is an excellent recent summary of his views in the area. Williamson's work is notable for inspiring a large body of empirical and theoretical work in modern industrial organization and having influence in law, political science, and management. His work has been widely cited, and by some counts he was the most widely cited economist in the world. I especially thank John Nye who contributed to this post. Alex Tabarrok

When I was in Bloomington, Indiana last week, Justin Ross and I talked about the "Bloomington school of public choice," meaning Elinor Ostrom. (see Aligica and Boettke.) Little did I know that she was about to be awarded a Nobel Prize, along with Oliver Williamson. She is known for looking at ways that private individuals cooperate to manage what we think of as "pubilc goods," or "common pool resources."

For example, to prevent overfishing, mainstream economics says that government must regulate. Nobel Laureate Ronald Coase says that an alternative is to define property rights carefully. Ostrom studied cases in which private individuals established rules that worked. Meanwhile, government regulations (including assignment of property rights) often failed, particularly when individuals did not buy in to the purpose of the regulation.

With the advent of the Internet, the issue of private provision of public goods has emerged once again. Think of Wikipedia, or perhaps Twitter, or the various task forces that monitor security issues and define software standards.

Williamson is known for looking at the issue of the boundaries of the firm. This is another issue that interested Coase. I think of Williamson as looking at the issue in terms of central planning vs. markets.

For example, in health care delivery, I think we need more central planning. Not by government, but by corporations competing to offer better quality and efficiency. The problem is that the corporate model threatens the status of doctors. However, as Michael Cannon and I argued here, when a patient has a complex set of problems, the model of doctor autonomy can work very poorly. In Williamson's terms, the corporate model can resolve the conflicts that arise between different doctors more effectively than our existing model. For example, when my father was moved to eight different hospital units in fourteen days, a new doctor was in charge of him at each unit. The priorities and treatment plan changed each time. In my opinion, these autonomous hospital units should have been replaced by a hierarchy, in which care is directed by a project manager accountable to the patient.

I prefer a more Hayekian take on industrial organization. That is, I think that industrial organization ought to be aligned with knowledge. Decentralization of power makes sense when information is decentralized. When information can be usefully concentrated, then concentration of power can be efficient. In my forthcoming Unchecked and Unbalanced, I argue that knowledge is becoming more specialized and decentralized, and that this conflicts with the trend for political power to become more concentrated. Arnold Kling

Apart from issuing my now-annual October lament that Armen Alchian and Gordon Tullock still do not have Nobel Prizes, I applaud this year’s selection of Elinor Ostrom and Oliver Williamson. Williamson’s 1985 book The Economic Institutions of Capitalism remains a classic that repays careful study, even in 2009. And Ostrom’s work on how people often solve public-goods problems voluntarily is too often overlooked — until today, that is! Don Boudreaux