Reconciling Williamson and Ostrom in our world: 20th October 2009: Financial Express

It is quite appropriate that the Nobel Prize in Economics this year has been awarded to persons who have worked broadly in the field of governance, which is the talking point today. The winners have spoken on how to enforce rules where detailed contracts or legal frameworks do not exist. The recent financial crisis was a failure of governance where unbridled greed exposed the fallacies of Smith’s invisible hand. The two awardees do compel us to reflect over how their theories should be viewed in the context of what has transpired.
Elinor Ostrom’s work is significant because it talks of how community resources are best managed by users of the resource. At the most rudimentary level, when a housing society owns the premises, it best uses the resources that go along with it. There is no wastage of water or electricity as the society ensures that there is optimisation Forests, water, pastures etc, would ideally be best managed by users, provided property rights are transferred to them. This is the problem in India, where there is a difference between owners, managers and users, with all of them having their own motivations. The owners are typically the government or the private sector. Governments are inefficient as they have no interest in maximising benefits and often conduct business where there is no expertise. They manage an irrigation system because they have to, and are not concerned with leakages or wastage. Private sector is profit- motivated and would squeeze the maximum from the resource that does not optimise the welfare of society. Users do not value a service when the government provides it at a low cost. Farmers tend to waste water or over-graze cattle or over-exploit land for sowing when it is cheap. If the resource is provided by the private sector, then it is not affordable for them. This is the conundrum.
Therefore, ideally, resources should be owned by users. The formation of cooperatives was a step in this direction, where the cooperative works for enhancing value for the members. However, rarely has the natural resource been owned by the cooperative. This means that unless we have a combination of joint ownership by users, which means transfer of property rights to them at a cost, such resources will continue to be sub-optimally used as they are owned by the government or private enterprise.
Now, this ideal situation would confront the Oliver Williamson theory,which states that administrative decisions within a legal entity are more efficient than a market transaction. Williamson showed that complex transactions, involving investment decisions that are much more valuable within a relationship than to a third party, are best made within a firm. But he also showed that organising matters within companies had costs as it relied on internal authority—which could be abused—to get things done.
In light of the recent financial crisis, is it possible to put these two theories together? Firms should be classified as those that are owner-driven or professionally managed, where owners are several and dispersed. Owner-driven firms tend to be more efficient in taking decisions and tend to be more efficient than the markets, but they will not have public interest. Here, there is less likelihood of abuse of internal authority. But the financial crisis showed that it was organisations where the appointed chiefs were not the owners that delivered sub-optimal results, by over-leveraging and stretching their luck in the securitisation markets.
If we go back to the Ostrom case of user ownership, the possibility of abuse of internal authority is possible. Absence of professionals to run the organisation will have an inherent bias toward less efficient governance. While farmers may run their resource say an irrigation project well, the moment the scale changes, there would be need to bring in professionals who can improve functioning. As we move from micro-level resource to a larger setup, the downside risk of decision-taking internally could be a stumbling block.
Both theories are good at the micro-level in the ideal state, which rarely occurs. Ownership necessarily leads to the creation of structures, and managing the same cannot be divorced from the market. The price mechanism-based capitalist setup should ideally provide the best solutions, with government restricting itself to fiscal duties like taxation. Ostrom is an extreme case while Williamson’s will never always get it right. The Schumpeterian story of creative destruction would be a necessary corollary, just as natural calamites and wars are necessary to prove Malthus right.