Illustrated Presentation

Economic Sciences Poster from the Royal Swedish Academy of Sciences, web adapted by Nobel Web

Contents
Creating cooperation
False wisdom
A hard question
Further reading
Credits

The Royal Swedish Academy of Sciences has decided to award the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2009 with one half to Elinor Ostrom “for her analysis of economic governance, especially the commons” and with the other half to Oliver E. Williamson “for his analysis of economic governance, especially the boundaries of the firm“.

Handshake

Creating cooperation

Elinor Ostrom has demonstrated how common property can be successfully managed by user associations. Oliver Williamson has developed the theory that business firms serve as conflict resolution mechanisms. These are major contributions to economic governance research in general and to our understanding of non-market institutions in particular.

Puzzle

False wisdom

Conventional wisdom says that common ownership is a bad idea. “That which is owned by all is cared for by none.” Therefore, all scarce resources should either be owned privately by individuals or be regulated by central authorities. Or should they? Elinor Ostrom rejects that conventional wisdom. Based on numerous empirical studies of user-managed fish stocks, pastures, woods, lakes, and groundwater basins, she concludes that common property is often well tended.

The organization of cooperation

Elinor Ostrom identifies seven keys to successful cooperation:
• Rules clearly define entitlements.
• Conflict resolution mechanisms are in place.
• Duties stand in reasonable proportion to benefits.
• Monitoring and sanctioning is carried out either by the users themselves or by someone who is accountable
to the users.
• Sanctions are graduated, mild for a first violation and stricter as violations are repeated.
• Decision processes are democratic.
• The rights of users to self-organize are clearly recognized by outside authorities

Satellite images revealed that the traditionally managed land areas maintained a better condition, and also gave greater yields.

Understanding failures

All too often, resource degradation is due to flawed intervention by central government. Consider the satellite image of grasslands spanning two different jurisdictions. In the southern jurisdiction, grasslands are managed by groups of nomads according to traditional methods. In the northern jurisdiction, grasslands have been collectivized and animal husbandry has been modernized. Despite similar numbers of grazing animals per acre, only traditional group management has prevented the grasslands from degrading and also produced greatest yields.

Puzzle

A hard question

Why are there large firms? Couldn’t we all be selfemployed, trading our goods and services in the market? Ronald Coase, who received the 1991 Prize in Economic Sciences, proposed a general answer to this question more than seventy years ago. According to Coase, firms tend to emerge whenever transaction costs – i.e., the costs of exchanging goods, services, and money – are smaller inside the firm than in the corresponding market. What exactly are those transaction costs that may tip the balance between markets and hierarchies?

Williamson’s answer

Oliver Williamson argues that markets and hierarchies, such as firms, differ in how they resolve conflicts of interest. The drawback of markets is that there is more haggling and disagreement. Within a firm, disagreement can be avoided because the boss always has the last word. On the other hand, the authority of a boss can be abused. Therefore, it can be costly to conduct transactions inside the boundary of a firm too.

According to Williamson, markets with many buyers and sellers work well because it is easy to find other trading partners in case of disagreement. On the other hand, when there are no alternative suppliers or customers, disagreement is costly. In this case,
it is better to move the transaction inside the firm.

Predictions and policy implications

A central prediction of Williamson’s theory is that people are more prone to conduct their transactions inside the boundaries of a firm the more complex their transactions are and the more “special” their assets. This prediction is supported by a wealth of evidence.

In view of Williamson’s theory, it is not surprising that an aircraft producer that recently tried to outsource some of its production quickly retreated and brought the production back in-house. To avoid repeating such mistakes, business school students
carefully study Williamson’s work.

According to Williamson there can be substantial efficiency gains from mergers, and his theory has convinced competition authorities in many countries to take a lenient attitude towards vertical mergers.

Elinor Ostrom and Oliver E. Williamson

Elinor Ostrom

US citizen. Born in 1933 in Los Angeles, CA, 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.

Oliver E. Williamson

US citizen. Born in 1932 in Superior, WI, 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.