The Economics Nobel

The 2009 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has gone to Elinor Ostrom and Oliver E. Williamson. Those of us who thought it should go to Armen Alchian and Harold Demsetz are, thus, once again disappointed. (But at least the Committee didn't repeat a bone-headed choice like Paul Krugman.)

Anyway, here's how MarketWatch reported the news:

In a decision as shocking as Friday's surprise peace prize win, President Obama failed to win the Nobel Memorial Prize in Economic Sciences Monday.

While few observers think Obama has done anything for world peace in the nearly nine months he's been in office, the same clearly can't be said for economics.

The president has worked tirelessly since even before his inauguration to wrest control of the U.S. economy from failed free markets, and the evil CEOs who profit from them, and to turn it over to wise, fair and benevolent bureaucrats.

In a decision as shocking as Friday's surprise peace prize win, President Obama failed to win the Nobel Memorial Prize in Economic Sciences Monday.

While few observers think Obama has done anything for world peace in the nearly nine months he's been in office, the same clearly can't be said for economics.

The president has worked tirelessly since even before his inauguration to wrest control of the U.S. economy from failed free markets, and the evil CEOs who profit from them, and to turn it over to wise, fair and benevolent bureaucrats.

We are amused.

I've written reviews of two of Williamson's books. Let's pull them out of the archives:

Oliver Williamson is one of the seminal figures of New Institutional Economics. The Mechanisms of Governance is the third book in which Williamson has collected his principal writings, while working them into a coherent whole. The earlier volumes, Markets and Hierarchies and The Economic Institutions of Capitalism, are justly regarded as the foundational texts of the transaction costs economics school of institutional economics. The Mechanisms of Governance seems certain to join them as essentials for any legally literate economist or economically literate lawyer.

Transaction cost economics focuses on institutions, in contrast to neoclassical economics' focus on individuals, providing simple models that help us understand how institutions function and how they will respond to regulation. We can analogize transaction costs to friction: they are dead weight losses that reduce efficiency. They make transactions more costly and less likely to occur. Among the most important sources of transaction costs is the limited cognitive power of human decisionmakers. Unlike the Chicago School of law and economics, which posits the traditional concept of rational choice, Williamson asserts that rationality is bounded. Put another way, he assumes that economic actors seek to maximize their expected utility, but also that the limitations of human cognition often result in decisions that fail to maximize utility. Decisionmakers inherently have limited memories, computational skills, and other mental tools, which in turn limit their ability to gather and process information. As he demonstrates, this phenomenon, known as bounded rationality, has pervasive implications for understanding how institutions work.

Accordingly, Williamson's approach provides an analytical framework that is useful not only to economists, but also to lawyers and policymakers. Among other subjects, Williamson tackles such subjects as vertical integration, corporate governance, and industrial organization.

In sum, highly recommended. My only hesitation is Williamson's unfortunate writing style. Although The Mechanisms of Governance is largely free of the recreational mathematics that plagues much modern economic writing, which is useful for those of us who flunked Differential Equations, it is very jargon-intensive. Worse yet, much of the jargon is self-created. All of which makes reading Williamson an effort-intensive project. Usually the cost-benefit analysis nevertheless comes out in his favor, but sometimes one puzzles out the jargon to find a rather obvious point that could have been conveyed far more simply.

*****
Economic Institutions of Capitalism is a classic work of new institutional economics. In it, Williamson works out his theories of transaction cost economics across an array of interesting economic questions. Most of the covered topics will be of interest not only to economists, but also to lawyers and policymakers. Among other examples, Williamson tackles such subjects as vertical integration, corporate governance, and industrial organizations. Why review a book that was published over a decade ago? Because it's a classic that still rewards reading.

Williamson's core idea is the theory of transaction cost economics. We can analogize transaction costs to friction: they are dead weight losses that reduce efficiency. They make transactions more costly and less likely to occur. Among the most important sources of transaction costs is the limited cognitive power of human decisionmakers. Unlike the Chicago School of law and economics, which posits the traditional concept of rational choice, Williamson asserts that rationality is bounded. Put another way, he assumes that economic actors seek to maximize their expected utility, but also that the limitations of human cognition often result in decisions that fail to maximize utility. Decisionmakers inherently have limited memories, computational skills, and other mental tools, which in turn limit their ability to gather and process information. As he demonstrates, this phenomenon, known as bounded rationality, has pervasive implications for understanding how institutions work.

At the policy level, transaction cost analysis is highly relevant to setting legal rules. Suppose a steam locomotive drives by a field of wheat. Sparks from the engine set crops on fire. Should the railroad company be liable? In a world of zero transaction costs, the initial assignment of rights is irrelevant. If the legal rule we choose is inefficient, the parties can bargain around it. In a world of transaction costs, however, the parties may not be able to bargain. This is likely to be true in our example. The railroad travels past the property of many landowners, who put their property to differing uses and put differing values on those uses. Negotiating an optimal solution will all of those owners would be, at best, time consuming and onerous. Hence, choosing the right rule-which is typically the rule the parties would have chosen if they were able to bargain (the so-called hypothetical bargain)-becomes quite important.

In sum, highly recommended. Be warned, however, that you'll have to put up with Williamson's unfortunate writing style. Although EIoC is largely free of the recreational mathematics that plagues modern economic writing, which is useful for those of us who flunked Differential Equations, it is very jargon-intensive. Worse yet, much of the jargon is self-created. All of which makes reading Williamson an effort-intensive project. Usually the cost-benefit analysis nevertheless comes out in his favor, but sometimes one puzzles out the jargon to find a rather obvious point that could have been conveyed far more simply. (The business about contracting nodes, pp. 32ff, is a classic example.)

Comments

[Michael Hunter]

Thanks for posting this, Professor. Not being an economist or law and economics scholar, I've never read Williamson's work, and this provides a helpful place for a novice such as me to start. Thanks, too, for the exhortation to drive on through the jargon. Posting both reviews does reveal a certain penchant for repeating yourself, however. (To be fair, it also reveals a certain honesty; you didn't try to obscure your self-borrowing after the fact.) More importantly, the shared language and analysis in the two reviews leaves me unsure of any differences between the two books. Do they cover different subjects? Does the second book address criticisms of the first? Which of the two should a casual reader start (and perhaps end) with?

[Steve Bainbridge]

Michael: Sorry about the splat. It's a bad habit, but one of which I am frequently guilty. There's a lot of differences between the two books. The earlier book is perhaps more geared towards macro problems of organization, while the latter is more geared towards internal firm governance. But both reward reading.

[William Sjostrom]

I agree with you fully on Alchian, Demsetz,and Williamson, and Ostrom's contributions are first rate. But why are you trashing Krugman's award? His NY Times column is awful, he has injected himself into debates about empirical macroeconomics about which he has little knowledge based on misuse of a reputation in a different area, and he has a history of nasty behavior well before he became famous with his raving Bush mania (his '98 attack on Brian Arthur in Slate drew an outraged response from Ken Arrow). Nonetheless, Krugman's contributions to trade theory are widely regarded as extremely important in the field. You might note that the awards to Williamson and Ostrom did not include statements like "and for being a really nice person". There is no logical contradiction between being a first rate economist and being a louse. It speaks badly of the Nobel prize that Joan Robinson was passed over 13 times before she died, because The Economics of Imperfect Competition was hugely path breaking. That she was a nasty person and worshiped Mao strikes me as irrelevant to her contributions to economics. Samuelson's contributions to modern economic theory are simply huge, but do you remember his Newsweek columns? They were pompous and devoid of analysis, merely reporting Truth from Mount Olympus. His obituary of the distinguished Cambridge monetary theorist Denis Robertson in the Quarterly Journal of Economics is littered with sneers. And there is the very nasty story about how he used his status to try to shut down the Journal of Economic Theory in a pique over a rejected paper. Not a nice person, but a superb economist. Was Chicago wrong to hire Brian Leiter because he seems to be something of a shit?

[Michael Hunter]

Thanks!