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?

Resource Management, Post-Apocalypse Style

So suppose—and I’m not trying to get you down here—that an asteroid were to hit the earth, wiping out 90% of known species. (Or, if you prefer, that a combination of deforestation and our fascination with only growing a few key crops achieves the same outcome.) How could we regain our current biodiversity?

In case these kinds of things keep you up at night, you can rest easier thanks to the Svalbard Global Seed Vault that opened yesterday in Arctic Norway. There’s a great blog post about it on the New York Times website. The vault is a step up from existing seed banks, which are threatened by political instability or a lack of funding.

The post points out, though, that a group called grain.org has criticized the seed vault. Read their criticism here.

Discussion Questions

1. The post asks, “How much of this intergovernmental work help[s] sustain farming diversity, as opposed to museum-style genetic diversity?” Another way of asking this is as follows: producing food requires land, labor, and capital. The seeds themselves are just part of the equation. What happens if farmers, after hundreds of years of not farming these crops, lose the skills associated with their use? What can be done to preserve knowledge of how to maintain a species that is no longer actively farmed?

2. The seed vault acts as a centralized mechanism, much like a kidney donor list, that describes who is entitled to the seeds in the vault and under what circumstances. How does that mechanism compare to a market mechanism? Is it true, as grain.org argues, that the wrong stakeholders are given priority in this system? What rights do (and should) farmers have, as opposed to governments?

The Ethanol Bubble?

The New York Times reports that in less than one year, ethanol prices have plummeted over 30%. As a result, there is even talk of a government bailout for ethanol producers in case the price of ethanol falls too low!

So, why did price spikes in last year's ethanol market give way to falling prices this year? To understand the price fluctuations, we need to know how the short-run behavior of firms in competitive industries (such as ethanol) differs from their long-run behavior. In the textbook model of perfectly competitive industries, an increase in demand causes the equilibrium price of ethanol to increase in the short run—from P1 to P2 in the diagram below. In the short run, higher ethanol prices lead to higher profits for ethanol producers.

In the long run, the lure of profits attracts new ethanol producers. The long-run entry of additional ethanol producers expands the supply of ethanol, causing the price to fall back to its initial level:

Notice that economic profits converge to zero in the long run. As explained by most textbooks, zero economic profit does not mean that ethanol producers barely have enough to eat. Zero economic profit means that ethanol producers are earning incomes that compensate them for the next best salary they had to give up to go into producing ethanol.

Ultimately, in competitive environments, a surge in demand causes an initial spike in prices, but the equilibrium price gradually falls back toward initial levels. In the end, the long-run price of ethanol may not even change, but more ethanol will be produced than before.

Discussion Questions

1. Referring to the diagram on the left above, why does it take only a short period for prices to spike, but a long period for prices to fall again?

2. Referring to the diagram on the right above, why is the quantity of ethanol fixed for a period in the very short run?

3. Corn is a key ingredient to the production of ethanol. The New York Times article points out that corn prices have remained high over the past year even as the price of ethanol has declined. How might developments in the ethanol market have contributed to the rising price of corn?

The 2007 Nobel Prize: Mechanism What?

The 2007 Nobel Prize in Economics went to Leonid Hurwicz, Roger Myerson, and Eric Maskin for “having laid the foundations of mechanism design theory.”

Mechanism design isn’t covered in the typical introductory economics class. The narrative of your first econ class usually goes something like this: “The ‘invisible hand’ of the free market is the most efficient way of answering the fundamental economic questions: what to produce, how to produce it, and who consumes it. Sometimes the market doesn’t work—for example, in the case of externalities or public goods.”

In short, a single mechanism—the “market”—is usually the topic of discussion for intro courses. But there are lots of other mechanisms for answering these fundamental questions. And unlike the market, which is a decentralized mechanism (meaning it is not run by a central authority), there are plenty of man-made institutions that are centralized mechanisms. One example of such a mechanism is an auction, which allocates goods according to bids. Another is a political election, which allocates political power according to the preferences of the electorate. Both auctions and elections have rules, and these rules determine the optimal behavior of bidders and politicians.

One of the biggest challenges of designing an economic mechanism is that people have private information about their own preferences. One of the most famous examples of a mechanism design problem is the provision of public goods. Suppose a small town is considering the establishment of a public park in the town square. Should it ask the citizens how much each of them would value the park, and ask them to contribute that amount? Clearly, each of the citizens would have an incentive to “free ride” on their neighbors by understating their own value of the public good—so as a mechanism, just asking for voluntary contributions leaves a lot to be desired.

We will be creating a news analysis assignment about mechanism design for professors who use Aplia in their classrooms. In the meantime, here are some discussion questions to get the ball rolling.

Discussion Questions

1. “Market failure” often occurs when dealing with things other than purely private goods—for example, public goods, common resources, or goods with externalities. One solution to market failure can be broadly categorized as “market solutions.” An example of such a market solution is the levying of a Pigovian tax, which keeps the basic mechanism of the market but alters the incentives of participants. Another solution to market failure would be to replace the market with another institution entirely. For example, the right to use a specific frequency of the wireless spectrum is allocated by the Federal Communications Commission using an auction mechanism. Can you think of other examples of market failure that we address by using centralized mechanisms? What are the advantages and disadvantages to centralized mechanisms as opposed to market solutions?

2. The term “asymmetric information” refers to cases in which parties hold private (or hidden) information about their preferences or costs. One of the core challenges of mechanism design is to encourage people to reveal their private information in a truthful and credible way. For example, it is easy to show that the optimal strategy for a bidder in a Vickrey auction like eBay is to bid one’s true value. Think of a situation in which asymmetric information causes problems. What kind of mechanism could you design to elicit truthful information from the participants in that situation?

3. A recent Washington Post article has provoked a fair amount of discussion about the effectiveness of torture in acquiring information from prisoners. The most heavily quoted passage of the article reads:

“We got more information out of a German general with a game of chess or Ping-Pong than they do today, with their torture,” said Henry Kolm, 90, an MIT physicist who had been assigned to play chess in Germany with Hitler’s deputy, Rudolf Hess.

What do you think the economic study of mechanism design would have to say about torture? Is it an effective method for eliciting private information? How would an economist interrogate a suspected terrorist?

Harvey's Milk

On June 9, new rules governing organic dairy farming will take effect. The Harvey rule—so named for the Maine blueberry farmer whose lawsuit prompted the change—will increase the cost of converting a conventional dairy operation to an organic one. Under the old rules, obtaining the organic designation required nine months of feeding cows a blend of 80% organic and 20% conventional feed, followed by three months of 100% organic feed. The Harvey rule requires farmers to feed cows 100% organic feed for the entire conversion year. In essence, the new rule makes the conversion process "more" organic.

The expectation of a more expensive transition, combined with relatively high organic-milk prices, caused many farmers to "go organic" under the old rules last spring in order to avoid the Harvey rules. As a result, the supply of organic milk should increase this spring as more organic farms enter the market. Read Andrew Martin's article in the New York Times to learn more about the Harvey rule's impact on the market for organic dairy.

Discussion Questions

1. Even with surging organic-milk supply, the article argues that

…consumers probably will not see lower prices. Several manufacturers and retailers said they did not plan to reduce prices, in part because the oversupply would be quickly absorbed by increasing demand.

The graph above illustrates the scenario where rising demand for organic milk neutralizes the price effect of an increase in supply. Do you think this is a likely scenario? In the absence of sufficiently strong demand, do you think organic dairy manufacturers and retailers have the market power to keep prices from falling?

2. How will the increase in the supply of organic milk affect the market for products like organic yogurt and cheese, for which organic milk is an input? As more and more dairy farmers go organic, how will the reduction in the number of conventional dairy farmers affect the price of conventional milk?

3. According to the article:

The challenge of making a dairy farm organic is that the farmer’s costs rise during the conversion year, but they are not yet offset by the higher income from selling organic milk. The high cost of feed corn is a big factor; corn farmers see few incentives to go organic because they can make so much money selling their crops to make ethanol.

How will the rising number of organic dairy farmers and the imposition of the Harvey rule affect the incentives faced by corn farmers when deciding whether to go organic? Conversely, how might further growth in the ethanol industry affect incentives for dairy farmers to go organic?

4. Governments often announce new legislation well before it takes effect—sometimes with unintended consequences. For example, the federal government might announce that it intends to impose land-development restrictions in areas inhabited by endangered species. Developers will face an incentive to initiate development before the costly rules take effect—potentially ruining the habitats the legislation was intended to save. Did the sizable lag between the Harvey rule's announcement and its imposition in any way compromise its intent?

Click here for another Aplia perspective on organic foods and resource allocation.

Fueling Protests and Cars

Tortillas—a central component of the Mexican diet—have been a source of recent uproar in Mexico. Rising tortilla prices fueled protests in Mexico City two weeks ago. Many people in Mexico earn only $5 per day, and with the price of tortillas approaching $0.45 per pound, protests were inevitable.

Tortilla prices may be fueling the protests, but it's the growing demand for corn among American ethanol producers that's fueling the rise in tortilla prices. As more and more ethanol plants come online in the U.S., the number of buyers in the corn market increases, putting upward pressure on corn prices. Rising corn prices mean rising input prices for tortilla makers and rising tortilla prices for consumers. So does fueling your Honda Accord with ethanol-laced gasoline take tortillas off the plates of Mexicans? The answer depends on the time horizon: the short run or the long run.

Three characteristics in the market for corn make it highly competitive. First, there are many corn producers in the United States, Mexico, and the rest of the world. Second, corn tastes about the same no matter which farmer sells you the corn. Third, there are few barriers to new corn producers entering the market in the long run.

In the short run, however, firms cannot exit or enter the market. Rising ethanol production in the U.S. creates a higher demand for corn. The market demand for corn shifts to the right from D1 to D2, increasing the price of corn from P1 to P2. Corn producers react to the higher price by producing more corn (moving from q1 to q2). The higher demand for corn also causes corn producers to earn an economic profit.

How does this affect the tortilla market in Mexico? Corn is a major input for tortillas—as corn prices rise, the cost of tortilla production rises. The supply of tortillas shifts to the left from S* to S**. The price of tortillas increases and the quantity of tortillas consumed decreases. The reduction in tortilla supply causes the price of tortillas to rise sharply in Mexico because tortillas are essential to the Mexican diet (the demand for tortillas is fairly inelastic). As a result, the financial burden of higher corn prices falls on tortilla consumers more so than the producers.

Fortunately, as the Los Angeles Times reports, help is on the way for the people of Mexico. In the long run, firms may exit or enter the market. Unusually high short-run profits in the corn market will undoubtedly cause more farmers to plant corn in the long run. As they do, the supply of corn will shift to the right from S1 to S2. As more farmers plant corn in the long run, profits return to normal and the price of corn falls. In the long run, as the diagrams suggest, it's possible that the higher demand for ethanol will have no effect on corn and tortilla prices.


Click here for another Aplia perspective on food prices and ethanol.

Discussion Questions

1. How would a price ceiling at P* affect the Mexican tortilla market?

2. Should the Mexican government subsidize tortilla producers until corn prices fall back to previous levels? How would a subsidy—or voucher—for tortilla consumers affect the tortilla market in the short-run?

3. Are Mexicans worse off or better off due to the increase in U.S. ethanol production?

Organic, Fair-Trade, and Local Foods

According to the Associated Food and Petroleum Dealers, a traditional Thanksgiving dinner for 10 can cost as little as $36.70, or $3.67 per person. For some UC Berkeley students, celebrating Thanksgiving means paying a lot more--but buying food that is sustainable, organic, local, and ethical (SOLE).

The Berkeley food revolution seems to be catching on in the commercial world as well. Like the SOLE students, a large group of consumers prefer to buy organic, believing that in doing so they are protecting the environment, helping poor farmers, combating global warming, and leading healthier lifestyles. Especially to high-income consumers, these benefits make it worth paying an extra dollar or two for lunch or dinner. The stellar growth of Whole Foods and Trader Joe's, two high-end supermarkets that sell eco-friendly produce, has forced grocery mammoths like Safeway to introduce their own lines of organic foods. However, as The Economist reports, buying organic, fair-trade, and local foods might not accomplish the intended goals.

At first glance, organic foods seem to be net beneficial to the consumer diet and the environment. After all, humans have been eating organic food for most of history, since before the industrialization of food. However, The Economist argues that the health benefits of organic foods as opposed to genetically modified foods are unsubstantiated; that the production of organic foods is massively inefficient; that paying "fair" prices to poor farmers effectively subsidizes their bad agricultural choices; and that exclusively buying locally grown food sacrifices the gains from trade. In general, the article argues, the benefits of eating organic are exaggerated, and the costs are understated.

Discussion Questions

1. What actions does the article recommend to consumers who want to reduce the effects of global warming?

2. Economists generally agree that "real" free trade is a tide that raises all boats. Explain how the United States and the European Union have promoted protectionism in their agricultural sectors. If the U.S. and the EU were to stop subsidizing their own farming industries, how would world agriculture change?

3. Suppose you wanted to compare the costs and benefits of organic versus conventional agriculture. How would you go about doing that?

Do Renewable Fuels Mean World Hunger?

Sky-high oil prices and concerns over global warming have sparked a debate about renewable energy sources. One such alternative is to use biological fuels (rather than fossil fuels like oil) to power automobile cars. Willie Nelson has started selling BioWillie, a form of diesel made in part from vegetable oil. And ethanol, a form of gasoline made from corn, has begun to take off as a viable alternative to traditional gasoline in cars.

The possibility of using corn to produce fuel is one that is obviously attractive to the nation's corn growers. But if the United States were to start using corn as a significant source of energy, would that mean that the rest of the world would have less to eat? Would poor children go starving just so yuppies could drive their SUVs? This article in the New York Times examines that possibility, but some simple economic analysis shows that these fears are unfounded.

Consider the market for corn in Iowa. Usually, demand in the market comes from animal feed producers and food processors, who make the corn into corn syrup for use in things like Danish pastries. However, this year, demand for corn increased because there are more buyers in the corn market: namely, ethanol producers.

In the short run--that is, after the corn has been harvested in a given year--the supply of corn is fixed. This is sometimes called a momentary supply curve. (You can see the fixed supply of corn in the picture in the article--it's that giant 35-foot pile in the main photo!) Therefore higher demand translates into higher prices, as is shown in Figure 1.

In the long run, though, higher prices for corn will mean that more corn will be produced. (In fact, as the article mentions, the U.S. government actually pays corn farmers NOT to farm 35 million acres of corn.) Because of these agricultural subsidies, in fact, third-world farmers are priced out of the market--so they don't plant corn. Higher demand for corn, in the long run, would mean that both U.S. producers and world producers would have more incentive to plant corn. Therefore, the long-run supply curve of corn is much more elastic (i.e., much flatter) than the momentary supply curve--so the same shift in the demand causes a smaller increase in prices, and enough corn to be planted to satisfy the need for food and fuel, as shown in Figure 2. In the long run, an increase in the demand for corn increases the amount of corn produced and consumed in the world.

1. The article quotes Lester R. Brown, an agriculture expert in Washington, D.C., and president of the Earth Policy Institute, as saying, "We're putting the supermarket in competition with the corner filling station for the output of the farm." Draw a PPF showing how much food and fuel an economy can produce with a given amount of corn. What aspect of your drawing represents the tradeoff that Mr. Brown describes? Now draw another PPF showing how much food and fuel an economy can produce if twice as much corn is planted. In what sense are short-run tradeoffs different from those in the long run?

2. Draw a supply and demand graph of the market for corn. What would happen in this diagram if the United States stopped paying corn farmers NOT to farm that 35 million acres of corn?

3. Much of the corn grown in the United States is used for animal feed. What effect would an increase in the price of Iowa corn have on the market for hamburgers?

4. What other short-run tradeoffs might be rendered irrelevant by long-term market adjustments