Monday, November 09, 2009

The 2009 Nobel Prize in Economic Sciences

A few weeks ago, the committee that awards the Nobel Prize in Economic Sciences announced the winners of the 2009 award. The prize winners were Elinor Ostrom of Indiana University and Oliver Williamson of the University of California, Berkeley. The committee awarded this year’s prize to these economists for their work in economic governance. For Ostrom, the committee cited her research on the methods that actors use to avoid over utilization of common property resources. Williamson’s research provided theory on the conditions under which firms are better suited for economic organization than markets.

Ostrom found numerous examples in which actors had successfully avoided the “tragedy of the commons.” Standard theory had found that common property resources are too often exploited to the point of inefficiency and depletion. Ostrom examined numerous case studies in which actors avoided resource depletion through various governance structures. Much of her insight involved applying theories of repeated games in which actors may punish others who over extract common property resources.

Williamson provided theory to explain firm organization and conditions under which economic activity is better suited to take place within a firm than in a competitive market. An important basis for his theory involved the timing of work and bargaining. For instance, agreements made prior to work being performed can break down once the work is completed due to a change in the bargaining position of the actors. When the work is highly firm-specific then the actor who completed the work may find himself in a weak market position with only a single prospective buyer. In contrast, by arranging activity within a firm, the ex-ante and ex-post market issues are avoided. Similarly, the firm provides a clear hierarchy of authority which can help to clearly dictate the work that must be done. However, Williamson’s research also highlights an important disadvantage of firms: authority is prone to abuse.

The research of both Nobel Prize winners provided a richer framework for analyzing economic activity through its insight into governance. To learn about their research in greater detail, see the scientific background paper provided by the Nobel committee.

Discussion questions:

1. Describe some ways in which common property resources may be governed for the long term benefit of stakeholders. What are some of the difficulties involved in such governance?

2. What are some of the other advantages or disadvantages of firms, when compared to markets, which are not described above?

3. What other economic governance issues do you observe? Are these issues dealt with in a way that improves or worsens economic efficiency?

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Friday, November 06, 2009

Virtually Bankrupt

The space-themed video game EVE Online is described as a massively multiplayer online game (or MMO). In other words, the game is played over the internet in a virtual world where all (or nearly all) characters are controlled by users who are able to interact with each other. EVE Online separates itself from many other MMO games by offering an incredibly robust and fascinating economy, complete with its own currency of InterStellar Kredits (ISK), in-game supported contracts (that cover loans, trade agreements, and hiring other players to complete tasks for a fee), user-created and managed banks, and trade between players (in both money and goods). And if the game wasn’t realistic enough, the in-game universe even mirrored the troubles on Wall St. when the economy was hit by a bank scandal!

In July 2009, a manager of EBank, the largest in-game bank, embezzled 200 billion ISK then turned around and sold the in-game currency outside of the game for a real-world $5,000. Once news of the scandal became public, many depositors became concerned about the bank’s stability and decided to withdraw their money. These fears created a bank run that left EBank short 380 billion ISK. The chairman of the bank attributed this shortfall to both the embezzlement and further mismanagement that stemmed from ignoring safeguards and controls. Only a month later, the bank faced a total deficit of 1.2 trillion ISK and announced that it was freezing withdrawals on current funds and suspending all interest payments until it reached an equity status of 90%. As of this post, depositors are still awaiting the next announcement of EBank’s policies.

Many parts of the EVE online environment closely mimic economic events in the real world, but I do not think a bank run like this could be observed in America today because of the modern level of regulation. That said, the circumstances that led to the game’s financial crisis do mimic real-world occurrences from the early twentieth century. EBank’s problems stem, at least in part, from the fact that it was left to self-regulate and that its actions were largely unmonitored. Historically, similar conditions led to the banking crises of the 1930’s. These wide-spread bank failures led to increased legislation and controls on banking which established three main systems that prevent bank runs today: deposit insurance, capital requirements, and reserve requirements. If members of the game’s community wish to restore a reliable banking system, it seems likely policies that mimic one or more of these systems would be implemented.

However, if banking or using fiat money (currency with no underlying value) is viewed as unreliable, let me propose some other responses the game’s community could have. First, and most simply, a barter economy could develop as the main source of trade. In this scenario, any player seeking a good would need to find another player willing to give that good away in exchange for other goods. Obviously this sort of economy comes with drawbacks, as trade partners take time to find and each trade would need to be negotiated. This barter economy could expand to a commodity money trade system: where all goods are expressed in terms of multiple or fractional values of a single good with intrinsic value. (One of the best known examples of an economy like this occurs in prisons. Inmates are not allowed to hold money, but a system of trade develops around a single good, often cigarettes or energy bars.) Since this underlying good has a use, unlike fiat money, a bank often has no role since players can put money not spent to other uses.

The final system I’ll suggest is trade based on credit. For a system of trade that is built entirely on credit to support long-term trade, all traders in the market must know each other’s reputations prior to trading with any partner (even if they have never met). In the modern world, having a record of every person’s reputation instantly is simply not possible, so we do not observe this kind of trade. However, by definition, all trades occur in a game played over the Internet, so it seems perfectly practical for all players to always have access to websites at the same time. To support a credit trade system, a webpage could track the trading desires of each player (uniquely identified by their in-game name) as well as their reputation. Any player who does not fulfill his or her end of a deal could then be monitored and either punished or simply barred from future trade. All honest players would then be left to agree to turn over a good they don’t need to a player, and in exchange receive what they desire from someone else on credit. One further potential layer to make this more practical would be for all trades to go through a neutral third party (the same way people exchange valuable goods in escrow in the real world). This third party could charge a small fee to make a secure transaction and to maintain the outside website. The third party would also remove the potential for traders to attempt to blackmail each other by falsely reporting dishonest trades in order to sabotage reputations.

Discussion Questions:

1. How did rational expectations contribute to the bank run? Think about whether or not a bank run would have happened if each individual believed that everyone else had faith in the bank.

2. Who was hurt the most by the bank run: debtors, creditors, or people with no ties to the bank?

3. Based on the sale of embezzled money, find the U.S. Dollar-ISK exchange rate. How would the game’s economy change if purchasing in-game fiat with U.S. dollars was allowed?

4. Suppose one player proposes using an entire ship as the unit for commodity money, and another player suggests using one ton of steel as the unit. Assume that half a ship is useless, but that half a ton of steel is half as useful as a full ton. Which of these is a better proposal for commodity money? Is it important that money is divisible?