What are economists good for? The question has been asked a lot in the past year, by everyone from the UK's Queen Elizabeth to small savers who have lost out – and by this column. If anyone has an answer, it should be the Swedish Academy, which awarded the Nobel prize in economic science yesterday. It did not disappoint.
The winners – Elinor Ostrom of Indiana University and Oliver Williamson of the University of California – are deserving in their own right. But their award also highlights – after a financial crisis and a crisis of confidence in economics – the great insights that good economic science can provide.
Both laureates address economic governance: how economic transactions are structured by institutions of authority and co-operation. Mr Williamson's work starts from the question of why there are firms. The answer is that in the presence of transaction costs, the formal authority of company decision-making may solve bargaining problems better inside the firm than market trading outside. This carries lessons for fields from competition policy to finance.
Ms Ostrom studies “common pool resources” such as fish stocks or groundwater. The well-known “tragedy of the commons” argument is that such resources are overexploited unless privatised or controlled by government. But Ms Ostrom's research finds cases of private users acting together to manage common resources efficiently. Using game theory, she establishes principles for how rules should be designed. For example, governance works better when punishment is the responsibility of the group itself, and when the users participate democratically in shaping the rules of use.
Both scholars think about what makes markets fail or succeed, and study non-market institutions that can also allocate resources. This prize acknowledges that economists have as much to say about the limits of markets as about their power. It is also a timely recognition of methodological pluralism. Ms Ostrom draws on a wealth of case studies. Mr Williamson's theory “remains relatively informal” as the Academy politely puts it. Echoing the joke that economists see something work in practice and wonder if it can work in theory, it adds that the question “is not whether [the Williamson theory] can be formalised, but when we will see fully fledged formalisations of it”.
The laureates' work shows economic theory can help us see reality with a deeper understanding of it. That is certainly worth a prize.
