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December 15, 2009 Previous day Next day
SBC Team

Prize-Winning Thinking

Posted by SBC Team Dec 15, 2009
What the research of this year's Nobel-winning economists says about entrepreneurship

By Reed Richardson


In the midst of a struggling economy, a disturbing flu pandemic, and an ongoing national debate over health insurance reform, most small business owners can be forgiven if they didn't pay much attention to this year's Nobel Prize winner in economic science. Besides, all those macroeconomic theories seem to have little in common with the day-to-day activities of a small company just trying to keep sales aloft, manage cash flow, and make payroll during tough times, right? Well, not exactly. In fact, the research of the two 2009 Nobel economic winners, Elinor Ostrom and Oliver Williamson, offers some interesting and reassuring thoughts about the value of entrepreneurship and even some real-world advice that might just come in handy to small business owners.


More Entrepreneurship = Better Business AND Better Society

Ostrom, who is actually a political science professor at Indiana University, was something of a surprise pick for the Nobel, in part because of her background but also because she has spent much of her academic career doing fieldwork, studying real-world political and economic situations. Her scholarly approach, which saw her examine everything from irrigation systems in Nepal to mountaintop pastures in Switzerland to police departments in Indiana, focused on discovering the best practices for local and regional public resource management. Not, on its face, a topic that would seem to lend itself to insights about small business. But when Ostrom drilled down into these situations, over and over she discovered that smaller, more local organizations, which were more directly connected to the public resources in question, did a better job managing and preserving them than coldly calculating capital markets or disconnected governmental regulation. In short, the more these groups approached their resource issues creatively, as an entrepreneur would, the more successful they tended to be.


"Entrepreneurship is a particular form of leadership focused primarily on problem solving and putting heterogeneous processes together in complementary and effective ways," Ostrom noted in a recent U.N. white paper discussing some of her findings. But because the benefits of public resources are spread across a community, she noted that many scholars had previously ignored the possibility that entrepreneurial thinking at a local level could effectively protect and produce these essential goods and services. Ostrom's breakthrough was to recognize this oversight and then delve deeper into the details of why that was.


One interesting example highlighting this phenomenon was described by the Nobel Committee's citation and involves grasslands management in the interior of Asia. Over the past few decades, satellite images of interior Asia had shown a growing disparity between the healthy pastures of Mongolia, where local, nomadic herders collectively managed the land, and the degraded grasslands of neighboring Russia and China, where far-off central governments dictated land-use policy. Even after the Chinese government changed course in the early 1980s to correct this, privatizing much of that country's grasslands by selling it off to individual landowners, the disparity continued. The conclusion, the Nobel committee noted, was unmistakable-these traditional Mongolian herders had succeeded where both rigid central planning and unfettered market forces had failed. And though they probably wouldn't be readily recognized as behaving like small business owners in the traditional American sense, these Mongolian nomads, by satisfying their individual commercial needs while at the same time looking out for the greater economic welfare of their neighbors, bear more than a passing resemblance to the regional family farm co-operatives and local business development groups found in small towns and big cities town across the United States.


"Opening the private sphere to entrepreneurship," Ostrom has written, "is well understood as a key to increasing the level and quality of private goods available to customers." And to solve the many collective public resource problems facing our society today, Ostrom argues that we should increasingly adopt this same small business-like approach and look beyond just the market or the government for long-term solutions. "To unlock human potential, we must unlock the way we think," she writes. "Opening the public sphere to entrepreneurship and innovation at local, regional, and international levels is also a key to increasing the level and quality of public goods-e.g., peace, safety, and health-available to citizens."


Independent Contractor, Small Business, Large Corporation-Right-sizing your business

The other 2009 Nobel economics winner, UC-Berkeley economics professor Oliver Williamson, has spent his academic career studying an age-old business management question: What's the most efficient size for a particular business and why? For the most part, Williamson's research, much of which is embodied in his two-now classic-texts, Markets and Hierarchies and The Economic Institutions of Capitalism, studied large, multinational corporations, finding that they arose because they could execute more efficiently as one giant entity rather than as smaller, separate companies. But even though large firms were his focus, many of the same seminal arguments that he studied, like how much or how little of a company's supply chain or sales force should be directly owned versus sub-contracted, apply to small businesses as well.


Williamson's research into this inside vs. outsource question, explains Harvard economist Edward Glaeser in the New York Times, found that "the operation of the market costs something and by forming an organization and allowing some authority (‘an entrepreneur') to direct the resources, certain marketing costs can be saved." This notion of "transaction costs" is now a common consideration for nearly every business owner, but Williamson was an early champion of the concept.


This approach is particularly helpful for entrepreneurs trying to answer the real-world question of which method of financing-debt vs. equity-they should choose to finance a project. According to Williamson's transaction-cost economics (TCE) model, business owners should lean heavily toward debt financing when the project or expansion in question is relatively straightforward and involves easily redeployable assets, like an office space or a fleet of delivery trucks. Or, as Williamson puts it in one of his seminal research papers, "Some projects are easy to finance by debt and ought to be financed by debt." However, when the project to be funded is something like an advertising campaign or a research and development program, he argues that equity financing is a better choice, even if an entrepreneur must surrender some autonomy to, say, a venture capital investor or shareholder to get it. "The upshot is equity finance, which affords more intrusive the preferred financial instrument for projects where asset specificity is great."


In addition, Williamson's TCE model found that large, highly vertical companies weren't always the most efficient. "He argued that a simple hierarchy with workers, ground level managers and an entrepreneur was a remarkably efficient way of handling production when information was imperfect," Glaeser also noted in his Times article. Indeed, as once small and rather horizontally structured companies mature and grow up, Williamson's research found that the efficiencies of scale gained often come at a cost elsewhere. "Longer hierarchies," Glaeser explains of Williamson's findings, "invariably involved a loss of information and a failure of subordinates to adhere to the entrepreneur's original intent." Of course, for many entrepreneurs, that feeling of directly controlling one's own destiny is likely why they started their business in the first place and the prospect of losing that in order to make their company more efficient may be one transaction cost with too steep of a price.

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