Nobel prize - solutions to market failure

This year the Nobel Prize in Economics has been awarded to two people who have worked on solutions to allocations of resources when prices don't work.

Market failure is common. Scarce resources are then not allocated efficiently and this reduces overall welfare.

Sometimes prices can be adjusted to compensate, perhaps by taxing or subsidising the good or service. When that can't be done other solutions may not be obvious except for some sort of rationing system.

Lloyd Shapely, a mathematician, helped develop early game theory and also produced a paper on matching demand and supply when there are ethical or legal complications. Alvin Roth developed a method to allocate resources from this work, such as organs for transplant.

These two men are unusual winners of the prize, but perhaps appropriately they are applying economics to the real world and it is helping save lives. Given the bad press Economics got thanks to the banks this is good exposure for the discipline.

The prize in Economics is still worth  $1.2 million, and is shared by the two men. Shapely is 89 and could probably have done with the prize a little earlier!

The Guardian reports the prize here

An expected Nobel Prize

Professors Tom Sargent and Chris Sims are the 2011 winners of the Nobel Prize for Economics. I was expecting it for years.

The important work for which they have received the prize is their contribution to modelling expectations. Prior to their work economists used a method known as 'adaptive expectations' to predict how households and firms would react to policy changes. This meant the computer models of the time used an equation that implied expectations moved slowly after a change in policy or events. Without being too technical this meant that policy changes could have big effects on behavior even though the policy was very predictable and mechanistic.

Sargent and Sims showed that expectations changed faster than previously thought and that by manipulating the expectations of firms and households policy, say to reduce inflation, would be much more effective. Many of you will have already looked at the importance of inflation expectations in the inflation process.

Today their work is very important in deciding macroeconomic policy, particularly in designing monetary policy. Take for example the debate on the pace of deficit reduction. Confidence is crucial in consumption and investment and based on their work it could be argued that more public spending and higher budget deficits will actually cause a worsening of confidence due to the effect it has on the expectations of households and firms.

The Nobel website has a Popular Information section, look at the 'Information for the Public' link and that allows you to download an excellent, non-technical,  summary of their work. (Pretty important for anyone considering Oxbridge/LSE/Warwick/Southampton/UCL economics.)

Nobel site link here

The Guardian coverage here