12.10.09

INSTITUTIONS ARE CIVILIZATION. Camille Paglia said that in some interview, and I've used it as required in various classes. Today I returned examinations in a survey of public policy class. One question asks students to explain the economics of a passage in George Orwell's "Keep the Aspidistra Flying." "People lived by the money-code, but they contrived to keep their decency."

That gave me the opportunity to say a few words about this year's Nobel winners in economics. Oliver Williamson is all about contracts and opportunism, and Ellinor Ostrom (whose work I must confess to knowing nothing about previously) is inter alia about solving common property problems. Both winners were long shots in the Ladbrokes pool. Division of Labour is to the point summarizing their work.

Start with a Pigovian question: what to do about externality?Entertain a Coasean solution: bargain it away. Get stuck on transaction costs due to a Buchanan problem: collective action. Arrive at this year's Nobel: voluntary collective action can and often does work toward the emergence of good institutions. It's not private property rights per se, but well-defined and enforced rules of exclusion, which support beneficial social organization. As Alex Tabarrok aptly puts it, for Ostrom it's not the tragedy of the commons but the opportunity of the commons.

For Williamson, I suppose you could replace "get stuck on transaction costs" in the above with "managerial" or "monitoring" costs. In short, one solution that Coase poses to externality is merger, the problems with which are worked out in Williamson's contract theory of firms.

Both laureates underscore non-coercive governance. I applaud deeply.

For a good introduction, here is the scientific background provided by the Nobel committee.

There's a lot more at Marginal Revolution, keep scrolling. David Henderson cocks a snook at the math geeks, more than a few of whom went off at more favorable odds. Knowledge Problem expands on the policy implications, particularly the logic of decentralized coordination.

Michael Spence, a previous winner (and a solid math geek) has a readable overview of the economic problems this year's honorees tackled.
The common theme underlying the prize this year is that markets do not solve all problems of resource allocation and incentives well or even at all. That is not a new idea. What is important is that people and societies find ways through organizational structures and arrangements, political and other institutions, values, incentives and recognition, and the careful management of information, to solve these problems. Professors Ostrom and Williamson have led the development of this increasingly important part of economics. In reading their work, you are impressed that economics is not really fundamentally about markets, but about resource allocation and distribution problems. Markets appear because they operate effectively to handle a subset of these resource allocation challenges. Alternative creative institutional arrangements have been devised and refined over time to deal with those that markets handle imperfectly.
Institutions evolve to reduce transaction costs, anyone?

The deeper insight that these scholars have helped us to come to understand is that there are many circumstances in which non-cooperative outcomes (nash equilibria) are deficient or sub-optimal, and that a good part of economic and social progress lies in the creative design of institutions whose purpose is to cause these non-cooperative equilibria to come closer to socially and economically efficient and fair results.

Climate change is a commons problem on a global scale with the added complication that collective action is designed not directly to produce results (in the sense of temperature reduction), but rather to acquire tail insurance by shifting the probability distributions against outcomes that are highly destructive but not certain to occur. Though some are not convinced this is a problem worth acting on, a majority globally recognize that there are risks to be taken seriously. This may be the most complex commons problem we have yet faced. We are in the midst of shifting values with respect to energy efficiency and clean technology. The challenge is to design institutions, mechanisms and incentives that move us in the right direction.

What this year's honorees have explored is that design is not necessarily the province of Wise Experts Doing Good Government, which is why the more libertarian economics weblogs seem particularly pleased.

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