Nobel economic prize for Elinor Ostrom and Oliver Williamson — Intro To Economic Governance — No Easy Answer to ‘Too Big to Fail,’ Nobelist Williamson Says — Nobel prize for economics awarded to US academics
“Unlike a certain other Nobel Prize, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel actually requires evidence of substantial achievement. Mere aspirations and lofty rhetoric count for nothing. This year’s Nobel Prize in Economics has been given to two economists, Elinor Ostrom and Oliver Williamson, who have deepened our understanding of economic governance. More specifically, Ostrom and Williamson have shown how it is possible for firms and other communities to facilitate economic efficiency from “within.” In this sense, they follow in the footsteps of another Nobel laureate, Ronald Coase, whose groundbreaking 1937 article, “The Nature of the Firm,” did so much to establish the idea that businesses reduce transaction costs.
We live in an age when many are (rightly) questioning the obsession of mainstream economics with mathematics and econometrics, and also blaming mainstream economists for aspects of the 2008 meltdown. The Nobel committee awarded two scholars whose research doesn’t fit entirely within that mainstream mold — two scholars whose focus has been on the development of rules within groups and communities (including large corporations) that allow for conflict resolution and efficiency gains in ways that are often far more sophisticated than externally imposed state regulation.”
(NRO) — Samuel Gregg is director of research at the Acton Institute.
Steven D. Levitt
The reaction of the economics community to Elinor Ostrom’s prize will likely be quite different. The reason? If you had done a poll of academic economists yesterday and asked who Elinor Ostrom was, or what she worked on, I doubt that more than one in five economists could have given you an answer. I personally would have failed the test. I had to look her up on Wikipedia, and even after reading the entry, I have no recollection of ever seeing or hearing her name mentioned by an economist. She is a political scientist, both by training and her career — one of the most decorated political scientists around. So the fact I have never heard of her reflects badly on me, and it also highlights just how substantial the boundaries between social science disciplines remain.
So the short answer is that the economics profession is going to hate the prize going to Ostrom even more than Republicans hated the Peace prize going to Obama. Economists want this to be an economists’ prize (after all, economists are self-interested). This award demonstrates, in a way that no previous prize has, that the prize is moving toward a Nobel in Social Science, not a Nobel in economics. I don’t mean to imply this is necessarily a bad thing — economists certainly do not have a monopoly on talent within the social sciences — just that it will be unpopular among my peers.
Adam Smith Institute – Written by Dr Eamonn Butler, 15 October 2009
Nobel economists’ work on common ownership shows that markets, not distant governments, manage things better. For the first time, the Nobel economics prize has gone to a woman, Elinor Ostrom of Indiana University. She shares it with colleague Oliver Williamson.
Much more significant, however, is what the pair have to say about the management of resources, particularly resources that are owned in common, like forests, parks and fisheries. The bottom line is that they show these things are much better managed by the people who use them, than by some distant owner – particularly distant government owners.
One of the things the pair studied, for example, was the case of the Maine lobster fishing families, who brought in their own system of tradeable quotas. It meant that market principles were brought to bear on the exploitation – and protection – of this natural resource. Iceland’s trawler industry also derived great benefit from the system of individual transferable quotas designed by my free-market friend Hannes Gissuarson.
Of course, the BBC and friends will stress that the new laureates also say that commons resources don’t need to be privatized to be well managed. That is true. But at the moment, many commons resources are squarely in the hands of governments – meaning bureaucrats – who are very far removed from the actual concerns of the users and local residents, and wouldn’t know a market principle if it bit them. If privatization merely hands the resource to some new absentee landlord, it will do not good at all.
But privatization can be a good way to get the resources out of these bureaucratic hands, and into the hands of those who care about them and – if the right incentives are put in place – will protect and manage them. I have no doubt that we should sell the Forestry Commission’s plantations in Scotland and Wales, for example, to local people.
There may be implications in this for all sorts of other areas – such as whether we can simply let people who own historic houses get on and care for them in their own way, or whether every new window pane has to be approved by English Heritage or some other quango. As with so many things, perhaps it’s time to clear out the quangos and trust the people again.
Institutions are sets of rules that govern human interaction. The main purpose of many institutions is to facilitate production and exchange. Examples of institutions that affect human prosperity by enabling production and exchange include laws, business organizations and political government. Economic governance research seeks to understand the nature of such institutions in light of the underlying economic problems they handle.
One important class of institutions is the legal rules and enforcement mechanisms that protect property rights and enable the trade of property, that is, the rules of the market. Another class of institutions supports production and exchange outside markets. For example, many transactions take place inside business firms.
Likewise, governments frequently play a major role in funding pure public goods, such as national defense and maintenance of public spaces. Key questions are therefore: which mode of governance is best suited for what type of transaction, and to what extent can the modes of governance that we observe be explained by their relative efficiency?
This year’s prize is awarded to two scholars who have made major contributions to our understanding of economic governance, Elinor Ostrom and Oliver Williamson.
In a series of papers and books from 1971 onwards, Oliver Williamson (1971, 1975, 1985) has argued that markets and firms should be seen as alternative governance structures, which differ in how they resolve conflicts of interest. The drawback of markets is that negotiations invite haggling and disagreement; in firms, these problems are smaller because conflicts can be resolved through the use of authority. The drawback of firms is that authority can be abused.
In markets with many similar sellers and buyers, conflicts are usually tolerable since both sellers and buyers can find other trading partners in case of disagreement. One prediction of Williamson’s theory is therefore that the greater their mutual dependence, the more likely people are to conduct their transactions inside the boundary of a firm.
The degree of mutual dependence in turn is largely determined by the extent to which assets can be redeployed outside the relationship. For example, a coal mine and a nearby electric generating plant are more likely to be jointly incorporated the greater the distance to other mines and plants.
Elinor Ostrom (1990) has challenged the conventional wisdom that common property is poorly managed and should be completely privatized or regulated by central authorities. Based on numerous studies of user-managed fish stocks, pastures, woods, lakes, and groundwater basins, Ostrom concluded that the outcomes are often better than predicted by standard theories.
The perspective of these theories was too static to capture the sophisticated institutions for decision-making and rule enforcement that have emerged to handle conflicts of interest in user-managed common pools around the world. By turning to more recent theories that take dynamics into account, Ostrom found that some of the observed institutions could be well understood as equilibrium outcomes of repeated games.
However, other rules and types of behavior are difficult to reconcile with this theory, at least under the common assumption that players are selfish materialists who only punish others when it is their own interest. In field studies and laboratory experiments individuals’ willingness to punish defectors appears greater than predicted by such a model. These observations are important not only to the study of natural resource management, but also to the study of human cooperation more generally.
The two contributions are complementary. Williamson focuses on the problem of regulating transactions that are not covered by detailed contracts or legal rules; Ostrom focuses on the separate problem of rule enforcement.
Both Ostrom’s and Williamson’s contributions address head-on the challenges posed by the 1991 Laureate in Economic Sciences, Ronald Coase (1937, 1960). Coase argued that no satisfactory theory of the firm could rely entirely on properties of production technologies, because economies of scale and scope might be utilized either within or across legal boundaries. Instead, the natural hypothesis is that firms tend to form when administrative decision-making yields better outcomes than the alternative market transaction.
While Coase’s argument eventually convinced economists about the need to look inside the boundaries of firms, it offered only the preliminaries of an actual theory of the firm. Without specifying the determinants of the costs associated with individual bargains or the costs of administrative decision-making, Coase’s statement has little empirical content.
The challenge remained to find ways of sharpening the theory enough to yield refutable predictions. What exactly do organizations such as firms and associations accomplish that cannot be better accomplished in markets?
Over the last few decades, economic governance research has emerged as an important area of inquiry. The works of Elinor Ostrom and Oliver Williamson have greatly contributed to its advancement.
Oliver Williamson has formulated a theory of the firm as a conflict resolution mechanism and Elinor Ostrom has subsequently demonstrated how self-governance is possible in common pools. At first glance, these contributions may seem somewhat disparate. However, in stark contrast to areas of economic analysis which presume that contracts are complete and automatically enforced by a smoothly functioning legal system, both Ostrom and Williamson address head on the problems of drawing up and enforcing contracts.
Let us also note that Ostrom’s and Williamson’s endeavors are vital parts of a broader attempt to understand the problems of conflict resolution and contract enforcement (Dixit, 2004, 2009). Some of this work relies on verbal theorizing and historical examples (e.g., that of the Laureate in Economic Sciences Douglass North, 1990, 2005).
Other contributions have used repeated game models to study associations such as merchant guilds (Greif, Milgrom, and Weingast, 1994), as well as the emergence of third parties, such as law merchants and private judges (Milgrom, North, and Weingast, 1990), and even the Mafia (Dixit, 2003). For a broad perspective on the emergence of institutions that support market exchange, see Greif (2006a,b).
Elinor Ostrom delivering a lecture at Indiana University, Bloomington, July 2008
Photo: Courtesy of Indiana University
Elinor Ostrom, US citizen. Born in 1933 in Los Angeles, CA, USA. Ph.D. in Political Science in 1965 from the University of California, Los Angeles, USA. Arthur F. Bentley Professor of Political Science and Professor at the School of Public and Environmental Affairs, both at Indiana University, Bloomington, USA. Founding Director of the Center for the Study of Institutional Diversity, Arizona State University, Tempe, USA.
Ostrom bases her conclusions primarily on case studies. Over the years, Ostrom’s own field work gave rise to some of the cases, starting with her doctoral dissertation in 1965. Here, she studied the institutional entrepreneurship involved in an effort to halt the intrusion of saltwater into a groundwater basin under parts of the Los Angeles metropolitan area.
However, a few case studies rarely permit broad generalizations. The key to Ostrom’s breakthrough insights was instead the realization, about twenty years later, that there exist thousands of detailed case studies of the management of CPRs, and that most of them were written by authors interested in only one or a small set of cases.9 By collecting and comparing these iso¬lated studies, it should be possible to make substantially stronger inferences.
In most of the cases, local communities had successfully managed CPRs, sometimes for centuries, but Ostrom also pays close attention to unsuccessful cases. Ostrom empirically studies both the rules that emerge when local communities organize to deal with common pool problems and the processes associated with the evolution and enforcement of these rules.
She documents that local organization can be remarkably efficient, but also identifies cases in which resources collapse. Such case studies help to clarify the conditions under which local governance is feasible. They also highlight circumstances under which neither privatization nor state ownership work quite as well as standard economic analysis suggests.
In order to interpret her material, Ostrom makes extensive use of concepts from non-cooperative game theory, especially the theory of repeated games, associated with Robert Aumann, a recipient of the 2005 Prize in Economic Sciences. As early as 1959, Aumann proved remarkably powerful results concerning the extent to which patient people are in principle able to cooperate.
ut it took a long time before anyone made the connection between these abstract mathematical results and the feasibility of CPR management. Moreover, even as theorists developed such relationships (e.g., Benhabib and Radner, 1992), their results were frequently ignored.
Over the years, game theorists have provided increasingly exact conditions under which full cooperation is feasible, in highly structured settings, among individuals with both unbounded cognitive capacity (e.g., Mailath and Samuelson, 2006) as well as small cognitive capacity (e.g., Nowak, 2006).
Around 1990, and to some extent even today, theory had much less to say about the level of cooperation that would be most likely among individuals with plausible cognitive capacities in settings structured to some extent by the participants themselves. Thus, Ostrom’s data could not be used to test any particular game-theoretic model. However, as we shall see, the data provide valuable inspiration for the development of such models.
At the workshop in Political Theory and Policy Analysis, political scientists Elinor Ostrom (center), Roger Parks (left) and a student analyze data on American law enforcement agencies. The photo was taken in November, 1977. Photo: Courtesy of Indiana University
Under plausible assumptions about the actions available to resource users, repeated game reasoning indicates that cooperation becomes more difficult as the size of the group of users increases, or as the users’ time horizon decreases due, for example, to migration. These predictions are largely borne out by Ostrom’s empirical studies. However, a more interesting question is whether – when these factors are held constant – some groups of users are better able to cooperate than others. That is, are there any design principles that can be elucidated from the case material?
Ostrom proposes several principles for successful CPR management. Some of them are quite obvious, at least with the benefit of hindsight. For example, (i) rules should clearly define who has what entitlement, (ii) adequate conflict resolution mechanisms should be in place, and (iii) an individual’s duty to maintain the resource should stand in reasonable proportion to the benefits.
Other principles are more surprising. For instance, Ostrom proposes that (iv) monitoring and sanctioning should be carried out either by the users themselves or by someone who is accountable to the users. This principle not only challenges conventional notions whereby enforcement should be left to impartial outsiders, but also raises a host of questions as to exactly why individuals are willing to undertake costly monitoring and sanctioning.
The costs are usually private, but the benefits are distributed across the entire group, so a selfish materialist might hesitate to engage in monitoring and sanctioning unless the costs are low or there are direct benefits from sanctioning. Ostrom (1990, pp. 94–98) documents instances of low costs as well as extrinsic rewards for punishing. However, from Ostrom, Walker and Gardner (1992) onwards, she came to reject the idea that punishment is always carried out for extrinsic benefit; intrinsic reciprocity motives also play an important role.
Another nontrivial design principle is that (v) sanctions should be graduated, mild for a first violation and stricter as violations are repeated.
Ostrom also finds that (vi) governance is more successful when decision processes are democratic, in the sense that a majority of users are allowed to participate in the modification of the rules and when (vii) the right of users to self-organize is clearly recognized by outside authorities.
In Governing the Commons, as well as in later publications, Ostrom documents and discusses such principles and why they contribute to desirable outcomes. Even though these design principles do not provide an easy solution to the often complex policy problems involved, in cases where they are all heeded, “collective action and monitoring problems tend to be solved in a reinforcing manner” (Ostrom, 2005, p. 267).
Ostrom furthermore identifies some design principles that are applicable even under privatiza¬tion or state governance. For example, positive outcomes always seem easier to reach when monitoring is straightforward, and Ostrom carefully sets forth how monitoring can be simplified in common pools. For example, calendar restrictions (hunting seasons, etc.) are often much easier to monitor than quantity restrictions.
A final lesson from the many case studies is that large-scale cooperation can be amassed gradu¬ally from below. Appropriation, provision, monitoring, enforcement, conflict resolution and governance activities can all be organized in multiple layers of nested enterprises. Once a group has a well-functioning set of rules, it is in a position to collaborate with other groups, eventually fostering cooperation between a large number of people. Formation of a large group at the out¬set, without forming smaller groups first, is more difficult.
Needless to say, Ostrom’s research also prompts a number of new questions. It is important to investigate whether cooperation must be built from below, or whether other approaches are feasible when dealing with large-scale problems. In recent years, Ostrom has accordingly taken on the extensive question of whether the lessons from small local commons can be exploited to solve the problems of larger and even global commons (e.g., Dietz, Ostrom, and Stern, 2003).
A related question, which echoes Williamson’s attempt to link governance to asset characteristics, is to explore in more detail the relationship between the underlying technology and/or tastes and the mode of governance (e.g., Copeland and Taylor, 2009).
Elinor Ostrom (front) with members of the Irrigation Management Systems Study Group during field work in Nepal.
Photo taken in March, 1993. Copyright © Arizona State University
Since Ostrom’s initial research was based on field studies, her theorizing was inductive. While the ensuing propositions were put to the test as new field studies emerged, the multidimensionality of relevant factors precludes a rejection of the theory. In order to test individual propositions more directly, Ostrom and colleagues have therefore conducted a series of laboratory experiments on behavior in social dilemmas; see Ostrom, Gardner, Walker (1994). Building on the seminal experimental work of Dawes, McTavish, and Shaklee (1977) and Marwell and Ames (1979, 1980) – as well as ensuing work by economists and psychologists in the 1980s – Ostrom examined whether findings from the field could be recreated in the more artificial, but controlled, laboratory environment.
In a typical experiment, a number of subjects interact during several periods, without knowing exactly which period is the last. In each period, each subject can contribute towards a public good. Across the interesting decision range, an individual’s marginal cost of contribution is larger than his marginal benefit, but smaller than the total benefit. Thus, a rational and selfish individual would contribute nothing if the game were played in a single period only.
An important feature of the experiments was the introduction of sanctioning possibilities. In one experimental treatment, subjects would be informed about the contributions of all the other subjects in the previous round and be allowed to selectively punish each of the opponents. A punishment would be costly to both the punished opponent and the punisher. Thus, a rational and selfish individual would not punish if the game were played for one period only.
With the notable exception of Yamagishi (1986), previous experimental work did not allow subjects to punish each other selectively. Since punishment appears to be crucial in the field, it is of considerable interest to see whether it matters in the laboratory and, if so, why. Ostrom, Walker and Gardner (1992) find that many subjects engage in directed punishment in the laboratory, but that such punishment works much better if subjects are allowed to communicate than when they are not (Yamagishi, 1986, had confined attention to the no-communication condition).
These laboratory findings have triggered a large volume of subsequent experimental work. For example, Fehr and Gächter (2000) show that punishment occurs and disciplines behavior in social dilemmas even if the experimental game has a known horizon and subjects are unable to gain individual reputations for punishing, thereby suggesting that people get intrinsic pleasure from punishing defectors.
Masclet et al. (2003) demonstrate that purely symbolic sanctions can be almost as effective as monetary sanctions, suggesting that induviduals’ fear of explicit disapproval is a major reason why sanctions matter. Kosfeld, Okada, and Riedl (2009) show that subjects voluntarily establish large groups that impose internal sanctions on cheating members, but that small groups tend to dissemble even if dissembling harms members as well as outsiders (indeed, the threat that small groups will collapse is presumably what keeps the group large).
These experiments in turn reinforce Ostrom’s argument that a proper understanding of human cooperation requires a more nuanced analysis of individuals’ motives than has been usual in economic science, especially regarding the nature and origin of reciprocity (Ostrom, 1998, 2000). Such models have been developed at a daunting pace during the last two decades, partly inspired by Ostrom’s call. An introduction to the relevant social preference (proximate cause) literature is given by, e.g., Fehr and Schmidt (2006); for introductions to the evolutionary (ultimate cause) literature, see, e.g., Sethi and Somanathan (2003) and Nowak (2006).
Ostrom’s evidence from the field and from the laboratory also affects what set of games theorists should study in order to grasp the logic of the collective action observed in the field. The conventional parable of a repeated n-person prisoners’ dilemma has produced a wealth of conceptual insights, but this parable is too sparse to adequately capture the directed punishments
and rewards that are used in the observed common pools. Sethi and Somanathan (1996) is the seminal study of cooperation in a CPR game (which has the essential characteristics of an n-person Prisoners’ Dilemma) that allows each player to punish any other player after each round of CPR interaction.
Oliver Williamson answers a congratulatory call from a colleague after being awarded the 2009 Prize in Economic Sciences
Photo: Courtesy of Steve McConnell/UC Berkeley
Oliver E. Williamson, US citizen. Born in 1932 in Superior, WI, USA. Ph.D. in Economics in 1963 from Carnegie Mellon University, Pittsburgh, PA, USA. Edgar F. Kaiser Professor Emeritus of Business, Economics and Law and Professor of the Graduate School, both at the University of California, Berkeley, USA.
In a seminal paper in 1971, and an ensuing book, Markets and Hierarchies, four years later, Oliver Williamson developed a detailed theory of the firm in the Coasean spirit. For reasons to be explained below, Williamson claimed that organizing transactions within firms is more desirable when transactions are complex and when physical and human assets are strongly relationship-specific. Since both complexity and specificity can be usefully measured, Williamson’s theory had the required empirical content.
Williamson’s theoretical argument is fourfold. First, the market is likely to work well unless there are obstacles to writing or enforcing detailed contracts.1
For example, at the beginning of a buyer-seller relationship, there is usually competition on at least one side of the market. With competition, there is little room for agents on the long side of the market to behave strategically, so nothing prevents agreement on an efficient contract.
Second, once an agent on the long side of the market has undertaken relationship-specific investments in physical or human capital, what started out as a transaction in a “thick” market, is transformed into a “thin” market re¬lationship in which the parties are mutually dependent. Absent a complete long-term contract, there are then substantial surpluses (quasi-rents) to bargain over ex post. Third, the losses associated with ex-post bargaining are positively related to the quasi-rents. Fourth, by integrating transactions within the boundaries of a firm, losses can be reduced.
The first two points are relatively uncontroversial, but the third may require an explanation. Why do bargaining costs tend to be higher when it is harder to switch trading partners? Williamson offers two inter-related arguments. First, parties have stronger incentives to haggle, i.e., to spend resources in order to improve their bargaining position and thereby increase their share of the available quasi-rents (gross surplus from trade). Second, when it is difficult to switch trading partners, a larger surplus is lost whenever negotiations fail or only partially succeed due to intense haggling.
The final point says that these costs of haggling and maladaptation can be reduced by incorporating all complementary assets within the same firm. Due to the firm’s legal status, including right-to-manage laws, many conflicts can be avoided through the decision-making authority of the chief executive.2
Williamson’s initial contributions emphasized the benefits of vertical integration, but a complete theory of the boundaries of firms also has to specify the costs. Such an argument, based on the notion that authority can be abused, is set forth in a second major monograph from 1985, The Economic Institutions of Capitalism (especially Chapter 6). The very incompleteness of contracting, that invites vertical integration in the first place, is also the reason why vertical integration is not a uniformly satisfactory solution. Executives may pursue redistribution even when it is inefficient.3
To summarize Williamson’s main argument, suppose that the same set of people can attempt to conduct the same set of transactions either in the market or within the boundaries of a firm. Organizing the transaction within a firm centralizes decision rights, thereby saving on bargaining costs and reducing the risk of bargaining impasse, but at the same time allows executives more scope to extract rents in inefficient ways.
The net effect of this trade-off depends on both the difficulty of writing useful contracts ex ante and the extent to which assets are relationship-specific ex post. Williamson’s hypothesis is that governance will be aligned to the underlying technology and tastes depending on this trade-off. Transactions will be conducted inside firms if they involve assets which are only valuable to particular sellers or buyers, especially if uncertainty or complexity raise the cost of writing complete and enforceable contracts. Otherwise, they will take place in the market.
By now, there is a wealth of evidence showing that vertical integration is affected by both com¬plexity and asset specificity. Shelanski and Klein (1995) provide a survey of empirical work specifically directed toward testing Williamson’s hypotheses, and Masten (1996) presents a compilation of some of the best articles in this genre. More recent studies include Novak and Eppinger (2001) and Simester and Knez (2002). Lafontaine and Slade (2007) provide a broad overview of the evidence concerning the determinants of vertical integration. They summarize their survey of the empirical literature as follows:
The weight of the evidence is overwhelming. Indeed, virtually all predictions from transaction cost analysis appear to be borne out by the data. In particular, when the relationship that is assessed involves backward integration between a manufacturer and her suppliers, there are almost no statistically significant results that contradict TC [transaction cost] predictions. (p. 658)
Consider, for example, Joskow’s (1985, 1987) studies of transactions between coal mines and electric generators. 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.
The natural variation in asset specificity that arises due to the difference in distance between adjacent coal repositories implies that Joskow could credibly identify a causal relationship between asset specificity and contractual relations. As Williamson’s theory predicts, the contracts are relatively rudimentary and have shorter duration when asset specificity is low, and become more detailed and long-lasting as asset specificity increases. In cases of extreme specificity, contracts either last very long (up to fifty years), or the mine and the generator are both owned by the same firm. 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 major contribution is to provide an explanation for the location of firms’ boundaries. However, the theory also has normative implications for firms as well as for competition legislation. Let us briefly address these normative implications.
The evidence cited above suggests that vertical integration of production is affected by the trade-off that Williamson identified. This does not imply that the owners of these firms have understood the underlying economic logic. More plausibly, the empirical regularity instead emerges because firms that have inappropriate boundaries tend to be less profitable and are hence less likely to survive. If so, Williamson’s theory has normative content that is of value to managers.
In fact, Williamson’s books have frequently been compulsory reading in courses on corporate strategy at business schools throughout the world, with the explicit aim of training managers to improve their decision-making. To the extent that this teaching is successful, Williamson’s research not only helps to explain observed regularities but also entails better utilization of the world’s scarce resources.
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 scho¬lars in the 1960s that vertical integration is best understood as a means of acquiring market power.
Williamson’s analysis provides a coherent rationale for, and has probably contributed to, the reduction of antitrust concerns associated with vertical mergers in the 1970s and 80s. By 1984, merger guidelines in the United States explicitly accepted that most mergers occur for reasons of improved efficiency, and that such efficiencies are particularly likely in the context of vertical mergers.4
Subsequent work: Broadening the arguments
By now there is a huge literature on the boundaries of the firm, and we shall not attempt to de¬scribe it all here; see Gibbons (2005) for an overview of both closely and more distantly related work. We offer only a brief look, starting with some of the complementary research that emerged soon after 1975.
Whereas Williamson focused on the problem of efficient conflict resolution, much subsequent work instead emphasized that incomplete contracts in combination with asset specificity can create inefficiency even if conflicts are resolved efficiently ex post. When parties are obliged to make large relationship-specific investments, they do not care primarily about the efficiency of the division of future surplus, but about their own private return. For example, if a supplier must invest in highly specific machinery in order to serve a particular customer, and the state-contingent terms of trade cannot be easily detailed in advance, the supplier might worry that the customer could extract a significant portion of the surplus when the price is finally negotiated. This problem is known as the hold-up problem.5
An important early statement of the hold-up problem is due to Klein, Crawford, and Alchian (1978), and the first formal studies of hold-up problems with explicitly non-contractible invest¬ments are Grossman and Hart (1986) and Hart and Moore (1990) (henceforth GHM). GHM focus on ex-ante investment distortions instead of ex-post conflict costs. Their key argument is that asset ownership entails a negotiation advantage. Thus, instead of asking which assets should have the same owner, GHM asks who should own which assets. Put simply, while neg¬lecting several important caveats, GHM conclude that ownership should be given to the party who makes the most important non-contractible relationship-specific investment. In relation to Williamson’s theory, GHM’s theory is complementary. For reasons explained by Whinston (2003), the additional predictions have proven harder to test, but the limited evidence that exists is supportive (Lafontaine and Slade, 2007).
Standing in the kitchen of his Berkeley home, Oliver Williamson explains his economic theories just hours after the announcement of the 2009 Prize in Economic Sciences. Photo: Courtesy of Steve McConnell/UC Berkeley
Subsequent work: Deepening the analysis
In comparison with other modern research in economics, Williamson’s theory of the firm remains relatively informal. A likely reason is that the economics profession has not yet perfected the formal apparatus required to do justice to the theory (Williamson, 2000). Two major challenges have been to model contractual incompleteness and inefficient bargaining.
Contractual incompleteness is presumably related to bounded rationality, and useful models of bounded rationality have taken a long time to emerge – despite the pioneering efforts of the 1978 Laureate in Economic Sciences Herbert Simon (1951, 1955). Nowadays, however, there are several detailed formal models of the relationship between bounded rationality and contractual incompleteness, including for example Anderlini and Felli (1994), Segal (1999), and Tirole (2009).
As regards inefficient bargaining, the most common approach is to ascribe disagreement to asymmetric information.6 Consistently with this view, Williamson (1975, p. 26) argued that conflict may arise due to opportunistic bargaining strategies such as “selective or distorted information disclosure” and “self-disbelieved threats and promises”. Abreu and Gul (2000) and Compte and Jehiel (2002) develop state-of-the-art bargaining models in which there can be substantial losses due to the latter form of strategic posturing. Thus, the relevant question is not whether Williamson’s theory can be formalized, but when we will see fully fledged formalizations of it.
Williamson’s work has also inspired a wealth of research that seeks to articulate how conflicts are resolved within firms. One line of research, initiated by Kreps (1990), studies the crucial problem of how conflicts are resolved in the absence of a contract that will be enforced exter¬nally. Kreps uses the theory of repeated games to explain how reputational mechanisms can substitute for contracts, and sets forth a game theoretic model of the firm – or its owner/ manager – as a bearer of reputations. (Repeated game logic is also an important aspect of Ostrom’s contributions; see above.) Baker, Gibbons, and Murphy (2002) study this issue in a model that is more explicitly geared to analyze internal governance; see also the related work by Garvey (1995) and Halonen (2002).
Although Williamson’s main contribution was to formulate a theory of vertical integration, the broader message is that different kinds of transactions call for different governance structures. More specifically, the optimal choice of governance mechanism is affected by asset specificity. Among the many other applications of this general idea, ranging from theories of marriage (Pollak, 1985) to theories of regulation (Goldberg, 1976), one has turned out to be particularly important, namely corporate finance.
Williamson (1988) notes that the choice between equity and debt contracts closely resembles the choice between vertical integration and separation. Shareholders and creditors not only receive different cash flows, but have completely different bundles of rights. For example, consider the relationship between an entrepreneur and different outside investors. One class of investors, creditors, usually do not acquire control rights unless the entrepreneur defaults, whereas another class of investors, stockholders, typically have considerable control rights when the entrepreneur is not in default. Williamson suggests that non-specific assets, which can be redeployed at low cost, are well suited for debt finance. After a default, creditors can simply seize these assets from the entrepreneur. Specific assets on the other hand are less well suited for debt finance, because control rights lose their value if they are redeployed outside the relationship.
Subsequent formal modeling, by Aghion and Bolton (1992), Hart and Moore (1989), Hart (1995) and many others, confirms the usefulness of the incomplete contracts approach for analyzing corporate finance decisions. More generally, this line of work has been instrumental in promoting the merger between the fields of corporate finance and corporate governance – a merger process that was initiated by Jensen and Meckling (1976).
Another far-reaching lesson from Williamson’s governance research is that core questions concerning actual and desirable social organization span several disciplines. Both through his writings and his founding editorship of the Journal of Law, Economics and Organization, Oliver Williamson has contributed to eliminating many of the barriers to intellectual exchange among different disciplines of the social sciences.
Bloombert – By Vivien Lou Chen
There’s no easy way to deal with the question of institutions whose failure might pose a threat to the financial system, said Oliver Williamson, co-winner of this year’s Nobel Economics Prize.
“There is no silver bullet,” Williamson, 77, said at a news conference yesterday at the University of California at Berkeley, where he is professor emeritus. “There is no instant answer that I or any of my students or any of my colleagues would be prepared to advance on that.”
Williamson is a founder of organizational economics — the study of how institutions are created and developed and how they affect growth. In research that may have applications to the financial crisis, he suggested that it is better to regulate large companies than to try to break them up or limit their size.
The administration of President Barack Obama has proposed giving the Federal Reserve responsibility for overseeing financial institutions deemed “too big to fail.”
Williamson shared this year’s Nobel prize with Elinor Ostrom, a political scientist at Indiana University in Bloomington and the first woman to receive the economics award.
“There’s a possibility we could foresee some of the hazards,” such as those in the current crisis, and “take advance action,” Williamson said. The Fed and Treasury Department face “important organizational issues” similar to those raised by his work. Still, he said, he doesn’t think the crisis influenced the Nobel committee’s decision to award him the prize.
Williamson called himself “a lucky guy.”
In his academic work, Williamson found that large corporations exist primarily because they are efficient and benefit owners, workers, suppliers and customers, the Royal Swedish Academy of Sciences said today in Stockholm.
The Guardian is disappointed: They wanted Obama and only supporters of global warming…At least one of the two had a degree in Economics…
• Nobel winners studied co-operation and common property
• Economists’ work could help in countering global warming
… Ostrom, who is the first female winner of the economics prize, was recognised for her work on how “common property can be successfully managed by user associations”.
Ostrom’s research has examined how politics, economics and the legal system affect how natural resources are used – and has shown that community-driven projects can be more efficent than privatisation or socialism.
“Elinor Ostrom has challenged the conventional wisdom that common property is poorly managed and should be either regulated by central authorities or privatised. 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,” explained the academy.
Ostrom said it was “an immense surprise” to learn of her success today. “To be chosen for this prize is a great honour, and I’m still a little bit in shock,” she said.
Ostrom said that her research into the way in which citizens will organise themselves to protect an important asset was particularly relevant to the issue of climate change.
“A lot of people are waiting for more international co-operation to solve it [global warming]. There is this assumption that there are public officials who are geniuses, and that the rest of us are not.
“It is important that there is international agreement, but we can be taking steps at family level, community level, civic and national level … There are many steps that can be taken that will not solve it on their own but cumulatively will make a big difference.”
Williamson’s work has centred on the way in which conflicts of interest are handled in different ways by hierarchical organisations, such as firms, compared with stock markets. It explains why it is sometimes better for a company to develop a product or service inhouse, rather than buying it from outside.
“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,” explained the academy.
Williamson was not available to comment on his award. The academy said they had “woken him at 3am to tell him the news, and he is a happy laureate”.
This is the 40th time that the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded. Ostrom and Williamson will each receive five million Swedish crowns, the equivalent of £453,000.
Favourites miss out
By choosing Williamson and Ostrom, the Swedish academy looked beyond the area of economics devoted to stockmarket behaviour. The financial crisis has done little for the reputation of economics in general, with some pundits even suggesting that the prize should not even be awarded at all this year.
The bookmaker’s favourite for the prize was Eugene Fama, the University of Chicago professor who is known as the father of the “efficient market hypothesis”. This theory, which essentially states that the price of a traded asset, such as a share, fully reflects its true value, has been discredited by the market turmoil of the last two years.
Along with fellow academic Kenneth French, another favourite for the Nobel prize, Fama went on to develop the “Fama-French three-factor model”. It included the size of a company, and whether it was a “value stock” (the kind pursued by Warren Buffett) to describe market behaviour. The Fama-French model explains why small, value companies typically outperform the rest of the stock market.
Last year the prize was awarded to Paul Krugman for his work on international trade, which explains why it is more efficient for countries to specialise in the production of certain goods or products. Through his popular blog, The Conscience of a Liberal, Krugman has argued for larger government stimulus packages to drag the world economy away from a depression, and criticised the Obama administration for the way that it rescued the US banks.
Krugman congratulated today’s winners, saying that Williamson’s work “underlies a tremendous amount of modern economic thinking”. He admitted that he was not familiar with Ostrom’s work before today, but now understood why she had won.
“If the goal is to understand the creation of economic institutions, it’s crucial to be aware that there is more variety in institutions, a wider range of strategies that work, than simply the binary divide between individuals and firms.”
The economics prize is not one of the original five awards set up by Alfred Noble, but was added in 1969.
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Telephone interview with Elinor Ostrom recorded immediately following the announcement of The 2009 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, 12 October 2009. The interviewer is Adam Smith, Editor-in-Chief of Nobelprize.org.Listen to the Interview 11 min. Play
Telephone interview with Oliver E. Williamson recorded immediately following the announcement of The 2009 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, 12 October 2009. The interviewer is Adam Smith, Editor-in-Chief of Nobelprize.org. Listen to the Interview 7 min. Play