American economists Elinor Ostrom and Oliver Williamson won The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Both of them contributed to the theory of how private enterprise provides governance. Elinor Ostrom, a professor of political science, was the first female economics Nobel laureate.
The Nobel prize committee described Ostrom’s findings as showing that privately organized communities often manage resources such as lakes and fish better than do governments. First of all, government bureaucrats have a knowledge problem; they lack sufficient information about what to regulate. Moreover, as economist Friedrich Hayek pointed out, the relevant knowledge is decentralized and ever changing, so even with computers the remote governmental authorities are unable to collect sufficient knowledge to efficiently micro-manage such resources. They may not even know what knowledge they should be gathering.
In her book Governing the Commons: The Evolution of Institutions for Collective Action, Elinor Ostrom identifies several "design principles" for contractual common pool management. There have to be clearly defined property boundaries, effective monitoring of the resources, and methods of conflict resolution. For large amounts of resources, the governance is best divided into various higher and lower levels. For private governance to be effective, the autonomy of the contractual community needs to be recognized by higher-level authorities.
Oliver Williamson, a professor of economics, contributed to the theory of the firm and industrial organization. Williamson examined the problem of "self-interest with guile," in which people are opportunistic, seeking to exploit monopolies. In the Williamson model, companies economize on transactions costs. Asset specificity, the specialized use of assets not easily transferable to other uses, determines the contracting process. If there is little asset specificity, competitive market contracting is effective. With high asset specificity, the effective solution to opportunism is governance within an organization and the integration of monopolies. The knowledge problem can also be more easily overcome by such company governance.
Three aspects that Williamson emphasizes are uncertainty, the frequency of recurrence, and the degree of transaction-specific investments. Recurring, nonredeployable and idiosyncratic investments, along with asset-specificity, require a unified governance with relational contracting, i.e. some type of internal organization with vertical integration.
Complex contracts with a long duration induce a transaction-specific on-going administrative type of contract. These are typical of landlord/tenant relationships in proprietary communities such as shopping centers and also of residential associations, which have complex governing documents of indefinite duration tied to real estate. These communities are characterized by unified governance. Another characteristic of such communities are the recurrent frequency of transactions. Residents or tenants use the same facilities day after day. Such recurrence, in addition to idiosyncratic investments, induce contractual governance.
Another aspect of governance concerns the optimal size of a firm with respect to the returns on investments. Williamson presents a model in which there are diminishing returns to increased size due to losses of control and information by top managers. Decentralization within a firm reduces this loss of coordination. Even with decentralization, the limits of knowledge and the ability to act on knowledge impose a limit to firm size, unless subsidized by government.
My book Public Goods and Private Communities (1994) showed both in theory and in practice how private communities succeed in providing public goods. In effect, communities such as land trusts, condominiums, and homeowners’ associations provide collective goods that generate land rent, and collect the rent as dues or assessments to pay for the goods. Private territorial communities also apply the concepts that Williamson and Ostrom wrote about.
The 2009 economics Nobel prize is a great boost to the concept of private governance. Those who seek tax reform should realize that land rent is being used effectively by private communities, so aside from the long and frustrating attempt to shift taxation to land value, a shift of governance to private communities would accomplish much the same result, and with much less political resistance.
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FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.
Foldvary is the author of The Soul of Liberty, Public Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.
Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.