2009 Nobel Economists Challenge Contemporary Views of Markets

The winners of this year’s Nobel Prize in Economics has gone to two American academics whose work has challenged traditional views of the market as the most effective driver of economic activity by describing empirical examples that contradict long established notions in the dismal science.

According to the Wall Street Journal, the two winners, Elinor Ostrom (who is the prize’s first female recipient) and Oliver E. Williamson, were not viewed as likely candidates to receive the award, making the committee’s decision somewhat of an upset. Ostrom largely considers herself a political economist while Williamson’s influence has mostly been in fields outside of economics. This is not the first time, however, that the award has gone to non-economists. The winner of the 1994 prize, John F. Nash, for example, is a mathematician while Daniel Kahneman, the 2002 prize winner, is a psychologist.

Ostrom’s work investigated different ways in which scarce water resources were managed in arid Southern California (and, later, Nepal), with her conclusions challenging the economic applications of what has been called the Tragedy of the Commons.

The theory, first articulated by ecologist Garrett Hardin in 1968, states that shared limited resources used by multiple rational actors will inevitably be exhausted or destroyed, as all actors will attempt to maximize their use of that shared resource at the expense of everyone else doing the exact same thing. Hardin used the example of cows in a common pasture, though one could also envision using fish stocks, forests or even the Internet. Some economists have used this as a justification for further privatization of natural resources, as giving something an owner incentivizes that owner to take care of it.

With this theory in mind, the best way to manage the scarce water of Southern California would be to auction off every last drop to the private sector and charge for its use so as to discourage overuse by those in the commons. Ostrom, however, found that this was not the case at all. Communities and water producers, instead of exhausting their water in a public domain free for all, ended up negotiating detailed agreements that allocated water more efficiently than the free market. In short, she found that networks of individual actors negotiating over the use of a shared resource were often more efficient in allocating scarce resources than a single private entity with sole decision making power, thus refuting arguments that privatization was the best solution to quandaries such as this.

Williamson’s work, meanwhile, examined the efficiency of a firm’s internal governance for making financial decisions versus that of the open market. Over the body of his work, Williamson has revealed that many “standard economic decisions that standard theory said would be more efficiently left to the marketplace were actually better left within a firm.” A colleague of Williamson, economist Steve Tadelis, used a plane developed by Boeing, the 787 Dreamliner, as a concrete example of this theory in action.

“Boeing, which previously designed and built planes in-house, outsourced much of the Dreamliner's manufacturing. But because it had less control over its supply line, Boeing couldn't adapt as quickly and flexibly to the changes and problems that invariably arose within a project as complex as the Dreamliner. Boeing has since taken much of the Dreamliner's production back in-house.”

The Nobel Prize Committee, on their analysis of the theory, use coal mines and coal burning plants as another example. “The mining of coal and the burning of coal to generate electricity are two quite unrelated processes. However, it is quite costly to transport coal, so if there is only one mine nearby that produces coal of adequate quality, there is a high degree of mutual dependence between the owner of the mine and the owner of the electric plant. Roughly speaking, Williamson’s theory says that the further away a mine/generator pair is located from other mines and generators, the greater is the likelihood that the pair is jointly owned,” said the committee’s paper. “Thus, as asset specificity goes from low to high, the relationship between mine operators and electric generators is gradually transformed from a pure market relationship to a pure non-market relationship.”

“Williamson’s theory of vertical integration clarifies why firms are essentially different from markets. As a consequence, it challenges the position held by many economists and legal scholars in the 1960s that vertical integration is best understood as a means of acquiring market power,” it adds later.

Paul Krugman, fellow Nobel Prize winner and New York Times columnist, says that the recognition of both Williamson and Ostrom represent increased attention on what he calls institutional economics, which studies how human created institutions affect economic behavior. In Williamson’s case, it’s the firm while, in Ostrom’s case, it’s the network. David Henderson, the editor of "The Concise Encyclopedia of Economics," wrote in a Wall Street Journal column that the awards this year are striking for their focus on empirical, observed phenomena, noting that economics has grown increasing abstract and mathematical. The latest winners are a marked break from this trend.