Building economic models usually involves stripping the world down to its most essential features. But simple theories often struggle to explain the way things really work. Both the winners of this year’s Nobel Prize for Economics have been honored for recognizing this complexity. Their researches provide insights into economic institutions that play crucial roles in the real world, to which economists have not paid enough attention.
The central theme of Willamson’s work is that “markets and hierarchical organizations, such as firms, represent alternative governance structures which differ in their approaches to resolving conflicts of interest”. It implies that firms confront different interests that often contradict each other. Willamson argues that there is a drawback of markets under which firms often entail bargaining and disagreement. The drawback of firms is that authority, which mitigates controversy, 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.
A key prediction of Williamson’s theory, which has also been supported empirically, is that the propensity of economic agents to conduct their transactions inside the boundaries of a firm increases along with the relationship-specific features of their assets. These conflicting interests of the firms within a given system have different approaches to resolve. In this perspective, his work represents the alternative governance structures that differ in their approaches to resolving conflicts of interest.
In the same manner, the central theme of Ostrom’s work, the first woman to receive the Nobel Prize in Economics, is the governance of “common resource pools” such as pastures, fisheries or forests. Unlike pure public goods such as the atmosphere, where one person’s use does not reduce the amount available to others, people deplete these resources when they use them. Standard economic models predict that in the absence of clearly defined property rights, such common resources will be overexploited, with individuals acting without regard for the effects of their actions on the overall pool. Excessive fishing or grazing (the “tragedy of the commons”) will result. Over time, stocks of the common resource will dwindle.
Ostrom’s work is based on the case studies from fisheries in Maine to the irrigation system in Nepal. Her study is concentrated on how common resources are actually managed by communities. She found that people often devise rather sophisticated systems of governance to ensure that these resources are not overused. These systems involve explicit rules about what people can use, what their responsibilities are, and how they will be punished if they break the rules. In particular, she found that self-governance often worked much better than an ill-informed government taking over and imposing sometimes clumsy, and often ineffective, rules. Her work centers on how communities manage their common lands and natural resources such as pastures, lakes and forests. Though the approach in recent decades has been to regulate or limit the use of such resources or to privatize them, Ostrom’s research finds that common property is often very well managed by the people who use it.
Citing the example of irrigation, a case from Nepal, she has stated the problem clearly. For example, farmers share the use of a creek for irrigation. They face a collective problem of organizing to clear out the fallen trees and brush from the previous winter. Each farmer would like to have the others do it. There are incentives to free-ride on the “public spiritedness” of others – however, everyone may think this way and nothing will get done. On the basis of this hypothesis, she finds that factors such as face-to-face contact (likely when there are small numbers), the equality of each farmer’s stake in the benefits of irrigation and the ease of monitoring the farmer’s contribution to brush removal all make the likelihood of cooperation greater.
These findings have contributed a lot in the practical world. If we take the case of forest resources of Nepal, under the public management system, the forest cover was cleared rapidly. The country has lost its heavy forest cover to solve political interests. But in recent years, community forestry system is in effect. This system empowers immediate users to manage, control and use forest resources. In fact, in its effect, the forest cover in the country is increasing. Users themselves have managed it. In a similar fashion, other commons such as local roads, bridges, irrigation, environmental goods, lakes, pastures, etc can be better governed by the users rather than the public institutions.
Writer is Associate Professor, Central Department of Economics, TU
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