Markets and Institutions

Here are my recent Mint columns on markets, institutions and management

Markets, morals and motives

The fall of Communism two decades ago also seemed to be the triumph of markets. Since then, we’ve seen that was not the case. If anything, the world is confronting two global market failures: The rampant greed in the financial sector that almost collapsed the entire economic system, and the largest of all tragedies of the commons—the warming of earth’s atmosphere and oceans. There are many specific causes and solutions for these massive problems, but they also highlight more fundamental issues of human behavior.

My colleague, Daniel Friedman, has written an erudite and brilliant book, Morals and Markets, which gets to the heart of the dilemmas we face.

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Managers and markets

Markets are quite good at allocating products and services to those who want them the most (and can pay to fulfil those desires). The insight of Ronald Coase, and after him, Oliver Williamson, was to view business firms as solutions to the problem of resource allocation when markets do not work well in some ways. The boundary between firms and markets changes with the times, as technologies and capabilities evolve. Some firms may swallow their suppliers, others may outsource. Firms use hierarchies to organize decision making, and hierarchies need managers. In my last column (19 October), I noted that markets are also not abstractions, and may require rules, monitors and enforcers to function well. EBay manages its vast electronic marketplace, and various managers in eBay oversee the different components of that market management. In a more traditional manufacturing firm, workers make physical products, and managers organize and oversee those production activities.

The idea of management as a science has been around for over a century, and found expression in time-and-motion studies, process certifications and more broadly in the MBA degree and management consulting profession. Recently, academics such as Nick Bloom have been quantifying management quality through indices of adherence to good practices, and measuring management quality in many firms in several countries. Management quality turns out to vary a lot within and across countries, and is positively correlated with productivity and profits (“Does management matter?” Mint, 11 August 2008). Can one do better than measuring a correlation, though?

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The Economics Nobel

This year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel went to two distinguished scholars with long careers. Elinor Ostrom became the first woman to win the prize, “for her analysis of economic governance, especially the commons”. Oliver Williamson was also recognized for his analysis of governance, but especially with respect to the “boundaries of the firm”. Both scholars have examined how non-market alternatives can work where markets run into problems.

Ostrom has contributed to our practical and conceptual knowledge of how user associations can successfully manage common property resources. Markets may fail in such cases because individual actions can have impacts on others that the market cannot properly price. Collective decision making can work through rules and enforcement that shape incentives. User associations might be characterized as primarily horizontal organizations. Williamson has looked at more vertical organizations, namely business firms. Firms exist to produce goods and services to sell in the marketplace, but many of their internal resource allocation decisions could conceivably be made through arm’s-length market-mediated transactions. Williamson explores the many reasons why this is so. An important example is of situations where relationship-specific investments would limit or distort ex post market competition.

The prize announcement spoke of economic governance and the organization of cooperation. It highlighted the fundamental contributions of Ostrom and Williamson. Subsequent comments tried to draw some lessons for our current world.

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