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?

2008 Nobel Prize in Economic Sciences

The Royal Swedish Academy of Sciences recently awarded the 2008 Nobel Prize in Economic Sciences (PDF) to Paul Krugman of Princeton University. Krugman showed how economies of scale can help to explain patterns of trade and the location of productive activity. His research into international trade developed a new trade theory that explained trade patterns that previous theories could not. The model that he developed for international trade also became useful for analyzing economic geography.

Before the publication of Krugman's seminal articles, international trade theory was dominated by the concepts of comparative advantage and factor-proportions. The former was due to the insights of David Ricardo, who emphasized opportunity costs as the basis for the gains from international specialization and exchange. Eli Heckscher and Bertil Ohlin further developed the theory by examining cross-country differences in factors of production as the basis for trade patterns. These traditional theories are good at explaining observed trade patterns between a developed nation and a low-income nation.

However, these traditional trade theories are not able to explain the vast majority of trade flows among developed nations. These trade flows, called intra-industry trade, involve trade within the same industries. Such trade does not conform to the traditional theories because opportunity costs and factor proportions are often similar in the nations that exchange products from the same industry. For example, automakers in the U.S. export cars to Japan, and Japanese automakers export cars to the United States. This can't be explained by the Ricardian concept of comparative advantage.



Krugman was awarded this year's Nobel Prize in economics in part because his models of international trade can explain such intra-industry trade as resulting from monopolistic competition, economies of scale, and consumer preference for product diversity. Krugman's model can be illustrated in a graph like the one above, which examines the relationship between the number of firms, the average cost of production, and product price in monopolistically competitive industry. Specifically, the CC curves represent the relationship between firms' average cost of production and the number of firms in an industry, and the PP curve represents the relationship between product price and the number of firms in an industry.

Recall that in a monopolistically competitive industry, firms produce products (like cars) that may differ in quality and style. As more firms enter a given market, each produces less, and average costs increase; therefore, the CC curves are upward sloping. At the same time, more firms mean more competition, which drives prices down; therefore the PP curve is downward sloping.

Where does trade come in? Well, suppose there are automobile producers in the U.S. and Japan. If there is no trade between the two countries, only a certain number of car types will be supported by the sizes of these two markets. But if the two countries can trade, then firms in both countries can sell to consumers in both countries, because some American consumers will prefer Japanese cars and vice versa. This increase in the size of the market means that the automakers are able to produce more cars at lower average cost by taking advantage of economies of scale. In Krugman's model, this causes the CC curve to shift from CC1 to CC2. Consequently, the market equilibrium moves from A to B, which results in a lower equilibrium product price, P, and a greater number of firms, n, producing for the industry. Consumers also benefit from a wider range of available product varieties .

Another important aspect of Krugman's work that was cited by the Nobel committee is the extension of his model to explain the location of economic activity, work that is credited with developing the field of economic geography. It helps to explain the core-periphery pattern of urbanization and migration seen in much of the world. Krugman also made noteworthy contributions to research on strategic trade policy and currency crises. Several pages summarizing his research are presented in the Nobel Prize committee's scientific background paper (PDF).

Discussion Questions

1. Paul Krugman is, for an academic economist, relatively well-known by the public due to his numerous television appearances, books, and articles in the popular press. Some academic economists have been critical of contributions that are easily accessible to the public. Do you believe that such less-scholarly work by Krugman detracts from or adds to the respect he has gained for the contributions which have earned him the Nobel Prize?

2. In what industries besides automobiles do we observe trade patterns which conform to Krugman's theory?

3. What are some of the drawbacks to globalization? Do you think that globalization has had a negative effect on your life, a positive effect on your life, or has had little impact on you? Explain.

Speculating about the Nobel

Next week, we can expect the winner to be announced for this year's Nobel Prize in Economics. (Last year, the Aplia Econ Blog posted an article about the previous winner, Edmund S. Phelps.) This weekend will see lots of speculation over who will take the prize. Proving there's a market for everything, Intrade posted its odds on this year's prospective Nobel laureates, and allows speculators to bet on who they think will win (thanks to Greg Mankiw for finding this site). The early favorite on Intrade (though trading has been extremely light) is the University of Chicago's Eugene Fama. Truth be told, Professor Fama is my favorite for this year's Nobel (at least, my favorite non-Aplian!).

It's a challenging matter determining how to judge academics relative to each other, especially when they may publish in significantly different fields. The number of citations an academic receives is probably the gold standard for measuring performance in academia. An author receives a citation when a later author recognizes the original author's work as contributing to the later author's own research. This site seeks to objectively measure economists' citations, but applies a weighting scheme to control for individually authored papers relative to co-authored papers and for the time elapsed since papers were cited. Eugene Fama also resides at the top of this list (though a lot of us at Aplia think number 21 on the list deserves a good look too).

Professor Fama has made major contributions to the finance field with his work on market efficiency and asset pricing. He is regarded by many as the father of the efficient market hypothesis. In the early 1990s, he published a series of papers with Kenneth French in which they challenged the Capital Asset Pricing Model's assertion that a stock's market beta is the primary determinant of variations in stock returns. They argued that the market and its participants are too complex to be encapsulated by a single factor. In an article entitled "The Cross-Section of Expected Stock Returns," they developed a three-factor model that tried to explain stock returns using two observed anomalies. They incorporated the fact that small companies tend to outperform big companies, while value stocks (with higher book/market ratios) tend to outperform growth stocks (with lower book/market ratios). Since the paper's publication, Fama-French's three-factor model has become a fundamental evaluation tool in the portfolio management industry.

Discussion Questions

1. Why is an economist's number of citations a relevant measure for his or her impact on the field?

2. The citation list weights recent citations more heavily than older ones. Why might this distinction be relevant when judging an academic?

3. Are markets efficient?

4. There have been a few times in stock-market history when crashes (huge stock-price declines) occurred, such as the stock-market crashes of 1929 and 1987 and the burst of the Internet bubble. What would an analyst who believes in market efficiency say to explain these events?

Nobel Prize in Economics

The Royal Swedish Academy of Sciences awarded the 2006 Nobel Prize in Economics to Edmund S. Phelps. His work on the expectations-augmented Phillips Curve revolutionized the way economists and policymakers view the relationship between inflation and unemployment.

Most economists in the 1960s believed that there was a permanent trade-off between inflation and unemployment, and they referred to this relationship as the Phillips Curve. The Phillips Curve made policymakers' jobs very easy. If unemployment was too high, then Congress could increase spending and the Federal Reserve could print more money. Higher spending and a larger money supply would raise the inflation rate and bring down the unemployment rate. Hence, the purpose of fiscal and monetary policy was to pick the optimal rate for inflation and unemployment.

Phelps's work suggested that the perceived trade-off between unemployment and inflation was only temporary. It also suggested that there would always be some unemployment--the natural rate of unemployment--due to frictions in the labor market. In the long run, Phelps argued, the trade-off between unemployment and inflation disappears--the unemployment rate returns to its natural rate, regardless of the inflation rate. Hence, the modern purpose of fiscal and monetary policy is to pick the optimal path for inflation and unemployment.

The following is a mathematical interpretation of the expectations-augmented Phillips Curve.

Actual Inflation Rate = Expected Inflation Rate + Constant x (Actual Unemployment Rate – Natural Rate of Unemployment)

The actual inflation rate is dependent on two factors: the expected inflation rate and the unemployment gap (the difference between the actual unemployment rate and the natural rate of unemployment).

During the 1960s, economists observed a nice, smooth downward-sloping relationship between the inflation rate and the unemployment rate because expected inflation was constant. However, soon after the 1960s, expected inflation began to converge with the actual inflation rate (the short-run Phillips Curve shifted to the right). We no longer observe a smooth downward-sloping relationship when the expected inflation rate changes.

Phelps argued that in the long run, expected inflation equals actual inflation. Now, let’s look back at the equation. If actual inflation equals expected inflation, then the unemployment rate must equal the natural rate of unemployment.

Therefore, in the long run, Congress and the Fed cannot affect unemployment through spending or printing more money.

1. Some economists have argued that the natural rate of unemployment increased in the 1970s, which led to misguided monetary policy. Use the short-run and long-run Phillips curves to show how a Fed that believes that there is a permanent trade-off between inflation and unemployment would inadvertently increase inflation without affecting the long-run unemployment rate.

2. Why is it important that the Fed targets an inflation rate rather than an unemployment rate?

A Second Nobel for Economics

The Norwegian Nobel Committee awarded the 2006 Nobel Peace Prize to the Grameen Bank, a for-profit business, and its founder, Bangladeshi economist Muhammad Yunus. The Committee's citation lauded Grameen Bank's innovative efforts to reduce poverty through micro-lending schemes that provide some of the world's poorest citizens with access to credit. So, what's microcredit and how do Yunus and Grameen use it to reduce poverty?

Citizens of developed countries like the United States take credit access for granted. With a stable source of income or a bit of collateral, like a house or a car, an American can take out a loan to start a business, remodel the bathroom, or buy an engagement ring.

Access to credit in less developed countries is far scarcer.

Poor peoples' incomes are inherently less stable and often too low to qualify for lending. The ill-defined property rights in many developing nations make it difficult for poor residents to prove that they own the housing or land that they occupy. Lacking income and legitimate titles to what little collateral they actually have, the credit prospects for most of the world's poor seem bleak. As a result, traditional credit schemes ignore low-income entrepreneurs whose business ideas can help their communities escape poverty.

Yunus had the vision to develop a lending model that could reach low-income entrepreneurs in Bangladesh. He realized that collateral requirements provided borrowers with a strong incentive to pay back their loans rather than defaulting and losing their property. To ensure that poor borrowers faced an equally strong incentive to repay their loans, Yunus replaced collateral with the borrowing circle.

The borrowing circle consists of 5 people--the initial borrower, and four friends who agree to help with loan payments if the going gets rough. (The friends may take out loans as well.) Should the borrower default, all four friends lose access to credit until the loan is repaid in full. Replacing collateral with social pressures worked remarkably well, helping people expand or launch small business ventures. Read this New York Times article to find out more about Yunus and the Grameen Bank.

1. Grameen Bank is a for-profit business, but is it profitable? According to the article, what's the U.S. dollar value of Grameen’s loans since 1983?

2. According to the article, how many borrowers has the Bank served? What percentage of Grameen’s loans is paid back? How do Grameen’s payback rates compare to those of traditional banks in Bangladesh?

3. Why might social pressures provide a greater incentive to repay loans than the threat of losing collateral? What's the downside of defaulting in the Grameen scheme versus a traditional, collateral based scheme?

4. How might credit access change the social standing of Bangladeshi women?

5. How does Yunus feel about relying on charity to battle poverty?

Coincidentally, the Aplia Econ Blog recently asked whether microcredit will reduce poverty.