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?

The Price Is Wrong, Bob!

With significant contributions and analysis from Ben Resnick

The Price Is Right, one of America’s favorite game shows, can be used to illustrate numerous economic concepts, including optimal bidding strategies, risk preference, and search theory. Twice an episode, one of the most purely mathematical portions of the show occurs, when contestants take their turn to spin "the big wheel." In addition to being a crucial prelude to the Showcase Showdown, it is a convenient hands-on application of using probability theory to derive an optimal decision-making rule. The wheel contains 20 equally sized panels corresponding to values between $0.05 and $1.00. Three contestants reach the wheel during each half of the show. The winning contestant is the one whose total score comes closest to a dollar without going over; as a prize, they earn one of the two spots in the show’s final round, the Showcase Showdown. One at a time, each contestant spins the wheel to get an initial value. The player then has the option to keep his current value or spin one more time. If he spins again, his final score is the sum of his two spins. Any contestant that goes over $1.00 automatically loses. In the event that two or three contestants are tied with the same final value, they each spin the wheel once, highest score winning.

Consider three contestants: Mr. 1 will spin first, Ms. 2 will spin second, and Mrs. 3 will spin last. Assuming that all of the contestants aim to maximize their chances of winning a spot in the Showcase Showdown, we set out to derive the optimal strategy for Mr. 1. In order to determine his optimal strategy, we will make three simplifying assumptions. First, each result from spinning the wheel is an independently determined random outcome, where each panel is equally likely to be spun. Next, in the event of ties, each tied player has an equal chance of winning (either 50% for a two-person tie or 33% for a three-person tie). Finally, the show pays a $1,000 bonus prize (and a chance to earn even more money on a “bonus spin”) to any contestant scoring exactly $1.00 on one spin or a combination of two spins. However, we will not consider these cash prizes as an extra incentive to spin again since they have no bearing on which contestant goes to the Showcase Showdown. We focus only on the decision-making rule that gives Mr. 1 the best chance to make the final round.

The only decision a player makes during the game is whether to spin again or stop after the first. Clearly this decision will depend on the value of the first spin—the higher the first spin, the more reasonable it is to stop. To explain fully how a player maximizes his chance of reaching the Showcase Showdown, we solved for a cutoff value: the lowest initial spin value where Mr. 1 has a higher probability of winning by staying rather than spinning again. In order to find the optimal stopping value for Mr. 1, we first calculated the probability that Mr. 1 wins the game (either outright or through the tie-breaker) if he stays with any initial spin. This gives 20 different probabilities of winning the game if Mr. 1 stays, one for each possible spin value. For example, if Mr. 1 stops with $0.55, he stands a 7.4% chance of winning whereas if he stops with $1.00, he has an 86.2% of going to the Showcase Showdown. Next, we calculated the odds that Mr. 1 wins if he spins again. To do this, we looked at his likelihood of winning for each possible score after his second spin is added to his first. Mr. 1’s optimal cutoff in this game is $0.70, where stopping with a spin of $0.70 gives a 19.8% chance of winning, but spinning again gives only a 15.8% chance of winning. At any initial spin less than $0.70, Mr. 1 has a better chance of winning by spinning again. For example, after a first spin of $0.65, Mr. 1 has a 14.6% chance of winning if he stops and a 16.8% chance of winning by spinning again. By a similar method, we find that in the case where Mr. 1 goes over $1.00, the stopping rule that maximizes Ms. 2’s chances of winning is to stop with any initial spin of $0.55 or more.

Discussion Questions

1. How would you expect the stopping values to change if a fourth player were added to this game? What would the effect on the stopping values be if we factor in the bonus prize for a total score of exactly $1.00?

2. Given that the stopping values decrease as fewer players remain in the game, do you expect a player with a certain spot in the order to have an advantage? If so, which one?

3. Deal or No Deal is an example of another game show where a contestant’s optimal strategy could be described by a stopping rule. Can you think of other games where this type of strategy can be applied?

ARRGGHH... The Stakes Be High, Says I!

When you pay ransom to a hostage-taking pirate, traditional economic theory suggests that you increase the returns to piracy, encouraging more of it. If you kill a hostage-taking pirate, you increase the cost of piracy, which should discourage would-be pirates from taking to the seas.

The response by the Somali pirates to the U.S. Navy's recent killing of three pirates has been just the opposite though. These gangs say they are now devoted to revenge-taking over more ships and taking more hostages than ever. The cost of doing business has risen, and yet they want to do more of this business than ever. Why do you think this is?

Discussion Questions

1. In order to quickly obtain large ransoms, pirates must signal a credible threat to cargo ship owners. How might this credibility issue play into the pirates' response to the actions of the U.S. government?

2. The pirates killed by U.S. Navy snipers were holding an American captain of an American boat with an American crew. Might governments respond differently in situations involving multi-national crews?

3. The pirates who were killed were likely just henchmen with little power in the criminal organization. Did the "cost of doing business" really rise very much for the pirates running the organization?

4. In what ways does the government provision of naval security in international waters resemble a public good? Might the current allocation of security (both private and public) in international waters be inefficiently low?

5. From the standpoint of ransom maximization for a small individual gang of pirates, what is the optimal amount of piracy? What is the ransom maximizing strategy if the piracy off the Somali coast is coordinated by a cartel of gang lords?

Digital Distribution Meets the Video Game Market

GameStop and EB Games have always been the major players in the used video game market when it comes to retail sales. Given their level of success, it was only a matter of time before other major players, such as Amazon.com and Toys "R" Us, entered the market. But how does this affect the long-term profitability of retailers, game publishers, and game developers?

The short-term motivation of retailers such as GameStop buying and selling used games is that they share none of the profit with developers of the game. Game publishers and developers only receive a payment for the sale of brand new games and are thus negatively affected by the growing used video game market, especially during bad economic times when sales are already lower than desired. Although buying used games instead of new titles might only save consumers $5-$10, some GameStop stores also allow you to return used games within 7 days if they don’t work properly or you simply don’t like the game, an option unavailable if you pay for a new game.

Incentives play a crucial role in economic analysis. Properly aligned incentives can promote desired outcomes in the short run and long run. From the perspective of video game developers, the lost revenue from video games trading hands multiple times in the used market is evident. As an increasing number of retailers realize the gains from entering this market, video game developers will experience decreasing gains from the production of new games.

This provides publishers with the incentive to consider other mediums of distribution, in particular digital distribution. The video game market is not the first entertainment industry to delve into a more technical solution. In the music industry, CDs are being replaced by iPods and MP3s thanks to Apple's iTunes. In the movie rental industry, we have gone from renting at our local store to mailing in movies through services such as Netflix or Blockbuster to downloading movies directly to our TV through the internet or cable services.

Therefore, it is not surprising that the video game market is heading in this direction, especially with the growing popularity of the used video game market. Since its inception, the Nintendo Wii has offered games from older consoles for purchase through the Wii Marketplace. Because the Wii offers free Wi-Fi, Nintendo can bypass the middle man of in-person and online retailers. In addition, Microsoft has begun to experiment with this option by offering smaller-scale, arcade-like games for purchase using Microsoft points that can be purchased in the Xbox Live Marketplace. They also offer free demos of newly released games in hopes of attracting additional sales. The drawback with Microsoft is their Xbox Live internet service is not free, so only users with a paid account can access these services.

Discussion Questions:

1. From the consumer perspective, what would your indifference curves look like for these two goods? Do you believe a used game is equally as good as a new game? How would this affect the demand for used video games?

2. What kind of incentives, if any, could a video game developer provide to GameStop to encourage them to sell new games over used ones?

3. How will the growing popularity of releasing and purchasing video games through an individual console change the market structure of video game retailers? How does this compare to the success of the iPod and MP3s in general?

Principals and Agents

The theme of accountability is present in two important debates in Washington this week. On the international front, there are serious questions of how to deal with the lack of political progress in Iraq as Ambassador Crocker and General Petraeus testify before Congress. Likewise, in domestic policy, there's the equally serious question of how to deal with failing schools, as reauthorization of the No Child Left Behind Act (NCLB) of 2001 is debated in the Senate.

While these two issues are worlds apart in scope, the basic problem is the same. In economics, it's known as the principal-agent problem. Rather than looking at how individuals respond to the incentives of market prices, principal-agent theory looks at how "principals" (governments, employers, parents) can set up a system of incentives to encourage specific behavior from "agents" (citizens, workers, children).

Suppose you ran the U.S. government. You'd like to achieve academic success for students at home and real political progress for the Iraqi government. However, you cannot do these things alone: you can only provide incentives for students and teachers on the one hand, and for Iraqi leaders on the other.

So you set "benchmarks." For example, let's focus on the school scenario. The basic strategy of NCLB is that if a certain percentage of students at a school don't pass a standardized test, most of the teachers will be fired and replaced with new ones. This is meant to give teachers an additional incentive to make sure that all their pupils are learning.

The really difficult part comes when benchmarks are not met: when a school fails to meet the standards laid out by NCLB, or when the Iraqi government fails to reach the benchmarks set by the American government. What do you do then? Do you really follow through on your threat? What if you really believe that the teachers were working hard, or that the Iraqis just needed a little more time?

Discussion Questions

1. Think of a situation from your own life in which you wanted someone to do something and were in a position to provide them with incentives to do it. What incentives did you use? Did they work? Did the person do what you wanted?

2. Recent research by Derek Neal and Diane Whitmore Schanzenbach of the University of Chicago suggests that No Child Left Behind has an unintended consequence: "...the design of NCLB almost guarantees that the most academically disadvantaged children will not benefit from its implementation and may actually be harmed." Read the summary of their research. Do their results imply that NCLB should be rescinded? How might it be changed to provide better incentives?

3. Consider the problem of addiction. The main object of rehab and groups like Alcoholics Anonymous is to provide a system of incentives to break someone of addiction. But suppose someone returns to their addiction. What should be done then? Is there a strategic value to lenience when someone doesn't meet a benchmark?