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Economics for Everyone: Nuance of Nobel Prize

Economics Nobel Prize 2009 - from communities to corporations

December 16, 2009 5:56 IST | India Infoline News Service
U.S. professors Elinor Ostrom and Oliver Williamson are joint recipients of the Nobel Prize for economics.Ostrom becomes the first woman to win the prize in its 40-year history.

According to the Nobel award committee, the Economics Nobel Goes to Elinor Ostrom “for her analysis of economic governance especially the commons” and to Oliver E. Williamson, "for his analysis of economic governance, especially the boundaries of the firm". Their work sits at the boundary of economics, law and political science, and tackles different questions to the ones that economists have traditionally studied.At some fundamental level, they are really both addressing the  issue of how we create human cooperation through the design of appropriate institutions,"

Mr Williamson and Ms Ostrom work independently of each other but both have contributed plenty to economists’ understanding of which institutions—firms, markets, governments, or informal systems of social norms, for example—are best suited for conducting different types of economic transactions.

About Mr.Williamsons work

What did Mr.Williamsons do?
In lay man’s terms, he demonstrated when it is more efficient for a firm to produce a component in-house rather than outsourcing it to another firm. Ronald Coase, a British economist who won the Nobel Prize in 1991, argued that in some situations, and for some kinds of transactions, administrative decision-making within a single legal entity (ie, a company) is more efficient than a straightforward market transaction. Mr Coase’s arguments were influential and convinced economists that the internal workings of organisations were worth paying attention to explicitly. But it was left to Mr Williamson to refine Mr Coase’s theory and clarify what features of certain transactions made carrying them out more efficient within a firm rather than in the market.

Why was it path-breaking?
It was path-breaking because economic research at the time was largely fixated on market transactions and treated firms as black boxes of production. His work made economic scholars realize the need to analyze governance and incentives within and between firms in order to better understand how efficiency can be maintained in a capitalist society.

What are the policy implications?
His original insights and the research area he pioneered (now often referred to as Transaction Costs Economics) offered clear guidance for at least three important practical areas. One is the way in which business strategy can evaluate the costs and benefits of outsourcing. Another is the way in which local and federal governments should decide what to privatize. Yet another is to help regulators decide when and how to intervene with antitrust policy. Mr Williamson launched an entire branch of economic theorising which looks more deeply into firms than economists had tended to do previously. His theories have also helped with understanding the choice between equity and debt, and corporate finance more generally.

Ms Ostram’s work

What did Ms.Ostram do?
Ms Ostrom has concentrated on a different aspect of economic governance. She has spent her life studying how human societies manage common resources such as forests, rivers, pastures or wildlife. Just as with public goods, it is difficult to prevent people from using the commons. But unlike public goods, and like private ones, what one person takes leaves less for others. Economic theory then predicts that rational individuals will overuse these resources.

Why was it path-breaking?
Economists have tended to emphasise property rights as a solution to the problem of managing common resources. Typically that involves either privatisation or putting the resource in government hands. But Ms Ostrom, who is a political scientist by training, spent much of her early career studying how communities managed such common resources. She found that groups of people tended to have complex sets of rules, norms and penalties to ensure that such resources were used sustainably. Such self-governance often worked well.

The conventional wisdom of management of common property resources draws on a seminal 1968 article by Garrett Hardin, titled ‘The Tragedy of the Commons’.Ostrom and four colleagues noted in a 1999 article in Science that Hardin concluded, from a look at fisheries’ history, that “the users of a commons are caught in an inevitable process that leads to the destruction of the very resource on which they depend.”

Ms Ostrom has effectively used the concepts from subjects ranging from Science to sociology and from Economics to Game theory.

What are the policy implications?
Elinor Ostrom has demonstrated how common property can be successfully managed by user associations. 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. Ostrom demonstrates what happens when participants in a common property resource do not act as free riders (‘Free riders’ are those who consume more than their fair share of a public resource, or shoulder less than a fair share of the costs of its production) but instead trust one another and cooperate to achieve a better outcome for all.

Over the last three decades these seminal contributions have advanced economic governance research from the fringe to the forefront of scientific attention.The research of Elinor Ostrom and Oliver Williamson demonstrates that economic analysis can shed light on most forms of social organization.

THE NOBEL PRIZE:
The Nobel Memorial Prize in Economic Sciences, commonly referred to as the Nobel Prize in Economics, is an award for outstanding contributions to the science of economics and is generally considered one of the most prestigious awards for that science. The official name is the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (Swedish: Sveriges riksbanks pris i ekonomisk vetenskap till Alfred Nobels minne). It is not actually one of the Nobel Prizesestablished by the will of Alfred Nobel during 1895, but is commonly identified with them]The Prize in Economics, as it is referred to by the Nobel Foundation, was established and endowed by Sveriges Riksbank, Sweden's central bank, during 1968 on the Bank's 300th anniversary, in memory of Alfred Nobel's 1895 will. Like the Nobel Laureates in Chemistry and Physics, Laureates in Economics are selected by the Royal Swedish Academy of Sciences.It was first awarded during 1969 to the Dutch and Norwegian economistsJan Tinbergen and Ragnar Frisch, "for having developed and applied dynamic models for the analysis of economic processes.

CONCEPTS ASSOCIATED WITH OSTROMS WORK:

The Tragedy of the Commons:
The tragedy of the commons refers to a dilemma described in an influential article by that name written by Garrett Hardin and first published in the journal Science in 1968.The article describes a situation in which multiple individuals, acting independently, and solely and rationally consulting their own self-interest, will ultimately deplete a shared limited resource even when it is clear that it is not in anyone's long-term interest for this to happen

Central to Hardin's article is an example (first sketched in an 1833 pamphlet by William Forster Lloyd), of a hypothetical and simplified situation based on medieval land tenure in Europe, of herders sharing a common parcel of land, on which they are each entitled to let their cows graze. In Hardin's example, it is in each herder's interest to put the next (and succeeding) cows he acquires onto the land, even if the carrying capacity of the common is exceeded and it is temporarily or permanently damaged for all as a result. The herder receives all of the benefits from an additional cow, while the damage to the common is shared by the entire group. If all herders make this individually rational economic decision, the common will be depleted or even destroyed to the detriment of all.

The metaphor illustrates the argument that free access and unrestricted demand for a finite resource ultimately reduces the resource through over-exploitation, temporarily or permanently. This occurs because the benefits of exploitation accrue to individuals or groups, each of whom is motivated to maximize use of the resource to the point in which they become reliant on it, while the costs of the exploitation are borne by all those to whom the resource is available (which may be a wider class of individuals than those who are exploiting it). This, in turn, causes demand for the resource to increase, which causes the problem to snowball to the point that the resource is depleted (even if it retains a capacity to recover).

Free-rider problem:
Free riders’ are those who consume more than their fair share of a public resource, or shoulder less than a fair share of the costs of its production.Models of collective behaviour assume a free-rider problem where there is little trust, with everyone looking out for themselves.  Ostrom demonstrates what happens when participants in a common property resource do not act as free riders but instead trust one another and cooperate to achieve a better outcome for all.

Prisoner’s Dilemma:

The prisoners delemma is a fundamental problem in game theory that deomonstrates why two people might not cooperate even if it is in both their interests to do so.

Externalities:
In economics, an externality or spillover of an economic transaction is an impact on a party that is not directly involved in the transaction. In such a case, prices do not reflect the full costs or benefits in production or consumption of a product or service. An advantageous impact is called an external benefit or positive externality, while a detrimental impact is called an external cost or negative externality. Producers and consumers in a market may either not bear all of the costs or not reap all of the benefits of the economic activity. For example, manufacturing that causes air pollution imposes costs on the whole society, while fire-proofing a home improves the fire safety of neighbors.

CONCEPTS ASSOCIATED WITH WILLIAMSONS WORK:

Theory of firm:
During the last three decades, economic theories of the firm have become increasingly influential in a number of disciplines in business administration, notably in strategic management, organization theory, corporate governance, and marketing. 

In simplified terms, the theory of the firm aims to answer these questions:

Existence – why do firms emerge, why are not all transactions in the economy mediated over the market?

Boundaries – why is the boundary between firms and the market located exactly there? Which transactions are performed internally and which are negotiated on the market?

Organization – why are firms structured in such a specific way? What is the interplay of formal and informal relationships?

Heterogeneity of firm actions/performances – what drives different actions and performances of firms?

Outsourcing:
Outsourcing is subcontracting a service, such as product design or manufacturing, to a third-party company. The decision whether to outsource or to do inhouse is often based upon achieving a lower production cost, making better use of available resources, focusing energy on the core competencies of a particular business, or just making more efficient use of labor, capital, information technology or land resources. It is essentially a division of labour. Outsourcing became part of the business lexicon during the 1980s. Outsourcing involves the transfer of the management and/or day-to-day execution of an entire business function to an external service provider. Offshoring is outsourcing in which the buyer organization belongs to another country. Outsourcing and offshoring are used interchangeably in public discourse despite important technical differences. Outsourcing involves contracting with a supplier, which may or may not involve some degree of offshoring. Offshoring is the transfer of an organizational function to another country, regardless of whether the work is outsourced or stays within the same corporation/company.

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