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?

Should Resale Price Maintenance Be Legal?

If economists generally agree about anything, it is that competitively set prices maximize efficiency and welfare. On the other hand, another central tenet of economics is that efficiency may be achieved by allowing individuals and firms to enter into contracts with one another: for example, Ronald Coase famously showed that problems involving externalities could be solved if all affected parties could negotiate with one another.

However, not all contracts are legal. Most prominently, laws like the Sherman Antitrust Act place strict prohibitions on the kinds of contracts firms can write with one another. For example, airlines cannot agree with one another to keep prices high; that would be illegal collusion. Furthermore, manufacturers cannot require retailers to sell their products at a minimum price—a practice called "resale price maintenance."

The logic behind the banning of resale price maintenance is that the practice raises prices, and therefore decreases consumer welfare. This week, the ban came under attack as a leather-goods manufacturer argued before the Supreme Court that it should be allowed to dictate prices to retail outlets. Justice Antonin Scalia agreed, saying:

...the mere fact that [resale price maintenance] would increase prices doesn't prove anything. If in fact it's giving the consumer a choice of more service at a somewhat higher price, that would enhance consumer welfare, so long as there are competitive products at a lower price.

Recall that consumer surplus is defined by economists as the difference between what a consumer is willing to pay and the price they actually pay. One way of summarizing Justice Scalia's argument is that there are two variables in determining consumer surplus: the price, and the value of the service. If resale price maintenance encourages retail outlets to compete on service, the value to consumers may increase, and may increase more than the increase in price.

The key to this argument is the phrase "so long as there are competitive products at a lower price." In the case of the leather-goods market, it's true that there are lots of producers of leather goods. Therefore, high prices can only be sustained if there is an accompanying increase in quality of service.

Discussion Questions

1. Resale price maintenance agreements would seem to be good for retailers, as they allow them to sell at a price above marginal cost. Yet the plaintiff in this lawsuit was in fact the retailer, Kay's Kloset, who wanted to sell the leather goods made by Leegin Creative Leather Products at a discount. Who do you think benefits more from resale price maintenance agreements, manufacturers or retailers? Why?

2. On his blog, Greg Mankiw reprints the excellent summary from his textbook of the arguments for and against resale price maintenance. One argument for resale price maintenance is that it solves a free-rider problem that would otherwise prevent stores from offering good service:

[A manufacturer] may want its retailers to provide customers a pleasant showroom and a knowledgeable sales force. Yet, without resale price maintenance, some customers would take advantage of one store's service to learn about [a product's] features and then buy the item at a discount retailer that does not provide this service.

Do you think that resale price maintenance solves an important free-rider problem, as Mankiw suggests? Why or why not?

3. Resale price maintenance contracts are just one example of a kind of economic contract that is illegal. Philosophically, one might argue that it is illegal precisely because it limits the kind of contracts that one of the parties entering the contract can sign. For example, a resale price maintenance agreement that fixes the price of a leather jacket at $200 essentially stipulates that the retailer cannot enter into a contract with a buyer at which the jacket is sold for less than $200. Can you think of other contracts that people enter into that inhibit their ability to act freely in the future? Are they useful? Are they illegal? Should they be?

4. Some things are "per se" illegal under the Sherman Act, while for others, the "rule of reason" applies—that is, courts judge how anticompetitive they are on a case-by-case basis. If the leather-goods manufacturer is successful in this petition, resale price maintenance contracts would shift from the former category to the latter. Is that appropriate? How would you apply the "rule of reason" to a resale price maintenance case?

Should the Music Industry Abandon DRM?

Regulators around the world, most notably in Norway and other European countries, have recently expressed concern that the Digital Rights Management (DRM) on the iTunes Music Store inhibits competition, both in the online-music retail industry and in the market for music players. DRM is the software system that ensures that purchased songs cannot be freely copied. The theory is that Apple’s Fairplay system of DRM means that users who make purchases from the iTunes Store can only play those songs on Apple’s iPod. This locks them in to purchasing iPods today and in the future. If this happens to enough people, entry by others into either music selling or music-player manufacturing may be difficult.

Apple’s CEO and co-founder, Steve Jobs, recently posted an essay on the subject. It is very well written and its economics are very clear. Jobs first points out that in order to prevent unauthorized copying of songs, music publishers require iTunes to use a DRM system that is uncompromised (i.e., one that isn’t hacked so that DRM features are removed). Apple considers that the only way they can achieve the level of security required of them by the music publishers is not to license Fairplay to others. With both of these conditions present, Jobs argues, it is out of Apple’s hands, and so competition authorities should look elsewhere.

But Jobs goes on:

• Are iPod owners really locked in? No, he shows that on the average iPod, only 3% of music is purchased from the iTunes Store. What this means is that very few users are locked in to the iPod, and when it comes down to it, they have chosen to do so because they could always have got their music like most other people (from buying CDs, which he mentions, and illegal downloads, which he doesn’t).
• Why not let music play without DRM? Jobs says, “Fine with me.” Indeed, 90% of music sales are DRM-free now.

Indeed, he says, blame music companies. Apple wants a freer world:

So if the music companies are selling over 90 percent of their music DRM-free, what benefits do they get from selling the remaining small percentage of their music encumbered with a DRM system? There appear to be none. If anything, the technical expertise and overhead required to create, operate and update a DRM system has limited the number of participants selling DRM protected music. If such requirements were removed, the music industry might experience an influx of new companies willing to invest in innovative new stores and players. This can only be seen as a positive by the music companies.

Much of the concern over DRM systems has arisen in European countries. Perhaps those unhappy with the current situation should redirect their energies towards persuading the music companies to sell their music DRM-free. For Europeans, two and a half of the big four music companies are located right in their backyard. The largest, Universal, is 100% owned by Vivendi, a French company. EMI is a British company, and Sony BMG is 50% owned by Bertelsmann, a German company. Convincing them to license their music to Apple and others DRM-free will create a truly interoperable music marketplace. Apple will embrace this wholeheartedly.

An excellent point. That should smooth relations with them nicely.

Discussion Questions

1. A strong argument is made in most introductory economics classes that a strong system of property rights is important for economies to function smoothly. While it is easy to assign property rights to private goods like land or cattle, it is more difficult in the case of public goods—goods that are nonrival and nonexcludable. If you post a downloadable MP3 on a public webpage, it essentially becomes a public good. DRM attempts to make a good excludable that would otherwise be nonexcludable. However, as Jobs points out, DRM also makes it more difficult for consumers to enjoy music any way they like. If you were designing the legal framework in which music could be bought and sold, what kinds of property rights would you assign, and how would you protect and enforce them?

2. Several web commentators have noted that security isn't the reason the DRM software used by iTunes hasn't been hacked—it's the fact that there is a loophole so wide you could drive a proverbial truckload of CDs through it. Specifically, there's nothing preventing you from buying something on iTunes, burning it to a CD, and then importing the files as MP3s that can be played on any player. How does the existence of this well-known workaround affect the arguments of European governments?

3. Jobs suggests that the two options available to Apple are to use Fairplay or not to have encrypted music. However, suppose Apple chose to offer multiple DRM formats on the iTunes Store and let customers choose which DRM format they wanted to use. That would (a) allow iPod users to choose what they want to get locked in to; and (b) allow owners of other music players to purchase from the iTunes Store. What would the costs and benefits of this be for Apple?

Joshua Gans is a professor of economics at the University of Melbourne. He has previously blogged on this issue here and here.

John, Paul, George, Ringo, Steve, and Ronald

For the past two decades, there has been a legal fight over whether consumers have had a difficult time comparing Apples to Apples. More specifically, Britain's Apple Corps Ltd.—the company started by the Beatles and currently owned by Paul McCartney, Ringo Starr, John Lennon's widow Yoko Ono, and the estate of George Harrison—was at odds with America's Apple Inc., maker of Macintosh computers and iPods, over who had the rights to the Apple name.

It may seem odd to trademark a fruit's name, although no odder, perhaps, than trademarking Sun, Amazon, Staples, or any other noun. But especially in the information age, the value of a brand name can be crucially important. Suppose I wrote a program, called it "Windows Vista," and sold it online for $30. If it looked just the same as Microsoft's Windows Vista, customers might very well be confused as to which one was the genuine article. This confusion would harm Microsoft. Similarly, argued Apple Corps, the existence of Apple Inc. using the Apple name and logo had an adverse impact on Apple Corps' business.

According to Nobel Prize–winning economist Ronald Coase, the appropriate solution in the case of externalities like this is to have a strong system of property rights. As long as the two parties can bargain with one another, an efficient solution will be reached. Today, an efficient solution was reached—although it was hardly cost-free. According to the terms of the deal announced today, Apple Inc. will own the entire Apple trademark, and will "license certain trademarks back to Apple for continued use," according to Reuters.

In many ways, this is a textbook application of the Coase Theorem. The usual example used to illustrate the Coase Theorem is that of a factory and a fishery that operate along the same river. The factory pollutes the river, which has an adverse effect on the fishery. If the two firms act separately, the factory doesn't take the costs of its pollution into account when figuring out the optimal amount to produce. If the fishery buys the factory, or vice versa, then the combined company is hurting itself when it pollutes, and so is more likely to cut back pollution to the efficient amount: that is, the amount where the marginal benefit of additional pollution to the factory is equal to the marginal cost to the fishery. Similarly, now that Apple Inc. owns the rights to both trademarks, it will presumably be careful not to diminish the Beatles' Apple image—if, indeed, being associated directly with iPods would be considered a negative in today's world.

Discussion Questions

1. Apple's Steve Jobs released a statement saying, "We love the Beatles, and it has been painful being at odds with them over these trademarks." If this dispute was essentially friendly, why did it take 20 years, and huge sums in legal fees, to resolve?

2. Many analysts are now predicting a deal that would make Beatles music—which has so far not been available on any online music service—available via Apple's iTunes. According to the Reuters article, "A source familiar with the situation told Reuters at the time that it was 'safe to assume that something sooner rather than later will happen.'" What effect, if any, do you think the prospect of selling Beatles music on iTunes had on resolving the dispute between the two Apples?

3. The two Apples had reached an agreement in 1991 stating that Apple Inc. could use the Apple logo as long as it didn't enter the music business. When Apple Inc. launched iTunes, Apple Corps sued, saying that Apple Inc. had violated that agreement. Apple Inc. countered that iTunes was just a "data transmission service." Do you think iTunes constitutes a move into the music business? Why or why not?