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Nobel Prize for Economics explained

Two University of Copenhagen professors explain why this year's Nobel Prize in Economics was given to Williamson and Ostrom: They gave us a deeper understanding of the reach of markets and the pros and cons of alternative economic organizations

Oliver Williamson and Elinor Ostrom have won this year’s Nobel Prize in Economics for their lifelong research in economic governance and new institutional economics.

Economists have traditionally focused on the market and its functions. Williamson and Ostrom, partly in response to the work of Coase who received the award in 1991, have look at the parts of the economy that do not function within the market.

They have contributed fundamentally to our understanding of why financial transactions are conducted both outside the market, for example, inside companies without state interference, or in smaller social groups.

To own or not

Williamson’s research is based on a fundamental question: Why does the corporation have the size that it does? Why do some companies own their suppliers, while others do not? Williamson’s insight is that both have their advantages and disadvantages.

If there are many potential suppliers and it is easy to write relevant contracts, there is every reason to believe that the market is functioning well, and a company will not need to own its own supplier. On the contrary, in highly specialized production, where it is harder to write relevant contracts, conflicts may arise that are difficult to resolve.

In these cases, ownership of the supplier company will give the company the authority to decide what it wants-ownership is an advantage. But ownership is also a drawback, in that this authority can be abused, which argues for a market solution. These advantages and disadvantages must be balanced: In the first case, market transactions are the optimal solution. In the second, it is optimal that transactions are conducted within the company.

Valid theories in the real world

Williamson’s work formed the basis of modern economic theories about the relationship between organizational design and the degree of specialization, and many empirical studies have shown the validity of his ideas in the real world.

His insights have also had substantial political implications: Competitive authorities should be more sceptical of mergers of companies that have the same value chain than mergers between suppliers and customers, the so-called vertical mergers.

Logic of the small community

Over 40 years, Ostrom has systematically studied the problems of collective action both in the field and in experiments. Her research has been used found the concept of ‘governance’ as a separate research field and as something that you should focus on in practice. Her main research has been to study how small communities around the world solve collective action problems, the so-called common-pool resource problems.

If everyone in a small community is sharing the same fishing ground, you run the risk of overfishing, since individual fisherman do not take the negative effect his catch has on other people’s fishing, and the sustainability of fish stocks as a whole, into account.

Some communities manage to solve problems like this without selling fishing rights or getting the state involved. Ostrom’s research shows which factors are present across cultures and continents which help to solve these collective problems. She also shows how the emergence of formal and informal rules and norms reflect specific local challenges. Her work has helped to focus on governance as a key concept for the World Bank and as a recurring theme in large projects. She also shows that solutions to community problems in general must be rooted locally and that bottom-up projects therefore have a greater chance of success than those dictated from above that are not adapted to local realities.