Humboldtians in Focus

Beyond Market Wisdom

By Claudia Keser, Ralf Paquin and Christian Wey

This year, the Nobel Prize for Economics has been awarded to two Humboldtians: Elinor Ostrom and Oliver E. Williamson. Their work has yielded insights into why people and firms often behave rather differently from the way they are supposed to according to classic economic market theory.

Elinor Ostrom
Elinor Ostrom
Foto: Indiana University

At first glance, you may wonder why the Nobel Prize was awarded jointly to two academics who employ such different research methods for their very different research ambitions. Oliver Williamson of the University of California in Berkeleyargues purely theoretically and essentially deals with enterprises. In 1987, he was granted the Humboldt Research Award for his seminal achievements in developing institutional economics. Elinor Ostrom from Indiana University in Bloomington, by contrast, uses an empirical approach to analyse the self-management of common pool resources. In May of this year, she was granted the Reimar Lüst Award for International Scholarly and Cultural Exchange which is conferred jointly by the Humboldt Foundation and the Fritz Thyssen Foundation.

At second glance, you start to recognise the elements linking the work of the two laureates. They both examine situations in which free markets fail, but neither sees the solution in state intervention. Rather, they are interested in an issue that belongs in the field of microeconomics: how institutions – not least in terms of rules and steering mechanisms – arise naturally from the behaviour of individual economic subjects. To this end, they both use an interdisciplinary approach and do not – like most economists – use Homo economicus, the egoist who always seeks his own advantage, as a prototype.

Oliver E. Williamson
Oliver E. Williamson
Foto: Steve McConnell /
UC Berkeley

Elinor Ostrom has been awarded the prize for her investigations into common pool resources, also known as commons. These are both collectively-used natural resources, like mountain pasturesor fish stocks, which are not subject to individual property rights and are therefore in danger of excessive exploitation. And they are also all the institutions created by humankind for the benefit of the communality such as the police, the Internet, or even the kitchenette at the office.

Making sacrifices for the collective good

In 1968, the American ecologist Garrett J. Hardin complained that there was an increase in the excessive exploitation of environmental common goods worldwide and described it as the “tragedy of the commons”. Usually, the only solution seemed to be state regulation or the allocation of exclusive private property rights. However, Ostrom was able to show that this is certainly not necessary, indeed is sometimes even harmful. When it comes to increasing the collective benefit, users of common pool resources are actually willing to take on activities to create, monitor and implement regulations even if they incur costs – and this contradicts everything predicted by economic theory.

On her search for explanations Ostrom travelled around the world. She analysed high mountain pastures in Switzerland and Japan, irrigation systems in Spain, the Philippines and Sri Lanka, fishing communities in Canada, Turkey and, again, Sri Lanka. She was driven by the question why some of these collectively used resources flourish over very long periods whilst others are decimated. From a comparative analysis of her case studies – some of which are presented in her book “Governing the Commons: The Evolution of Institutions for Collective Action“ (1990) – Ostrom extrapolated a series of design principles for successful forms of common pool resource self-management (see right column).

“Under certain circumstances users of common pool resources are prepared to subordinate their own individual interests to those of the community.”

As, however, real situations are effectively too complex to be used to derive ideal general conditions for cooperation, the Nobel Prize winner continued her investigations in an experimental economics laboratory. With her colleagues Roy Gardner and James Walker she translated the commons problem into a mathematical interaction model that can be solved both theoretically and in the form of a game. She tried it out with students at Indiana University in Bloomington. Participation was voluntary and anonymous and the reward was a success-related bonus.

The subjects played several rounds of the game. Initially, they confirmed the prediction made by the mathematical model that it would lead to excessive exploitation of the resource. Ostrom and her colleagues subsequently modified the rules by allowing the users to communicate with and punish each other. This increased the willingness to cooperate. Indeed, the users proved to be at their most cooperative when they were able to determine the system of punishment themselves.

Keeping it in the firm

Oliver Williamson has been honoured for his work on determining when and why transactions should take place within the boundaries of a firm and not on the free market. His point of departure is an approach developed by Ronald Coase which assumes that economic transactions incur costs: you have to research the offers including their respective advantages and disadvantages; you may have to negotiate a contract; you will have to check the goods received and so on.

While Coase only pointed to the existence and importance of these so-called transaction costs in a general way, Williamson was able to demonstrate the “unreasonable” behaviour on which they were based and the factors that influenced them. To do so, he drew on the assumption of bounded rationality formulated by Herbert A. Simon in 1957: that due to our limited intellectual capacity, we humans are not able to collate all the relevant information and process it accurately. Apart from this, we humans tend to behave in an opportunist fashion and, if given the chance, take unfair advantage of a partner which may lead to additional transaction costs once the business has been completed.

Against the backdrop of these considerations Williamson focused on the issue of which circumstances are ideal for which form of organising individual transactions. What he discovered was that it can often be more advantageous not to conduct transactions on the market but within a company hierarchy. This is especially true of transactions that recur frequently, are especially complex or involve large dedicated investments which would be lost if the trading partner changed. In a case like this it is sensible not to start searching for the cheapest supplier from scratch every time, but to incorporate the firm you have chosen into the company and then to source the goods internally.

Hierarchical transactions within the firm are particularly efficient because frictional losses are kept to a minimum. As Williamson’s analyses showed, however, this is countered by the management costs that ensue from conflicts of interest between owner and manager. The incentives and opportunities for management to abuse their position for their own benefit grow in proportion with the size of the enterprise.

“Bounded human rationality influences decision-making and therefore the costs of economic transactions.”

In the end, when selecting the ideal form of organisation – market, company or hybrid form – you have to consider whether the reduction in transaction costs is greater than the losses incurred by inefficient management. In his work, Williamson has particularly undermined the traditional animosity of competition policy towards mergers by emphasising their potential for achieving growth in efficiency. Today, this argument is well-established and can perhaps be seen as Williamson’s most influential contribution to economic policy, although he has also had a sustained influence on business administration. Examples include his contribution to corporate management and finance.

Solving economic problems still an important research topic

In conclusion, it can be claimed that the work of Elinor Ostrom and Oliver Williamson has significantly driven forward research on the microeconomic foundations of institutions. Both assume that in economic terms humans only act with bounded rationality. Williamson essentially attributes the causes to the cognitive field, as a result of which complex contract situations cannot be comprehended in their entirety. Ostrom, on the other hand, also considers the motivation barriers postulated by Reinhard Selten. People usually do indeed recognise that egoistical behaviour can have socially unwelcome results and are then prepared, under certain circumstances, to subordinate their own individual interests to those of the community.

Both laureates have demonstrated that the borders of rationality play an important role in the organisational solution of concrete economic problems. Now the time has come to investigate the causes and effects of these barriers more carefully: there are still plenty of open questions to keep economists occupied for some time to come.

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Claudia Keser Claudia Keser
Foto: Pressestelle Universität Göttingen

Professor Dr. Claudia Keser teaches Microeconomics at Göttingen University and heads the Göttingen Laboratory of Behavioral Economics. In 1999 – 2000, she was a Feodor Lynen Research Fellow at the Université de Montréal, Canada. Dr. Ralf Paquin teaches International Economics, also at Göttingen. Professor Dr. Christian Wey teaches Political Economic Theory at the Technische Universität Berlin and heads the Information Society and Competition Department at the German Institute for Economic Research in Berlin.

This piece is a slightly modified version of the one that appeared in the December edition of “Spektrum der Wissenschaft”.

Principles for stable local common pool resource self-management

  1. Clearly defined boundaries, i.e. definite rules governing who is eligible to use the resource; the boundaries of the resource itself must be clearly defined.
  2. Rules are adapted to local conditions.
  3. Collective-choice arrangements allow most resource users to participate in making the rules.
  4. Resources are monitored.
  5. Graduated sanctions are taken in case of violation of community rules.
  6. Mechanisms of conflict resolution are cheap and easily accessible.
  7. The self-determination of the community is recognised by external (governmental) authorities.
  8. Organisation of larger common pool resources into multiple enterprises with a manageable number of members.

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