Berkeley Economist Oliver Williamson and Indiana University Political Scientist Elinor Ostrom shared the Nobel Prize this week.

My long time favorite for the prize has been Benoit Mandelbrot. Mandelbrot’s work on the behavior of prices in markets should have helped us avoid the recent financial collapse, but until very recently his work has been give far less attention than it deserves.

The book The Black Swan by Nassim Taleb is built off of the theoretical work of Mandelbrot.

Mandelbrot makes the point that the rational actor approach to the markets ignores the “wild” nature of actual pricing in financial markets. So-called “efficient markets” advocates mistakenly apply concepts borrowed from physics to markets, ignoring the absence of phenomenon like inertia in those markets. He argues that there is a fractal structure to pricing of financial assets that could be far more powerful in explaining the apparently inexplicable nature of financial markets.

Perhaps next year as the drama of the recent collapse of our financial markets has sunk in, Dr. Mandelbrot will finally gain the recognition he deserves.

Nonetheless, I am particularly pleased to have heard of Dr. Williamson’s award. I was trained in law school in his tradition, what is known broadly as the “new institutionalism” or “new institutional economics.” Most of my research today looks broadly at the importance of institutions as opposed to simple images of arms length markets in understanding how the world works.

Economists have trouble grappling with many of Williamson’s views because they are deeply rooted in how the real world works – that is, they are largely inductive rather than deductive. Economics has been dominated for the last three decades by deductive and formulaic approaches increasingly divorced from reality. No wonder the field is in such a crisis.

That Ostrom won is also of note. Not only is she the first woman to win the prize but the first political scientist and that, of course, warms the heart of someone trained as a political scientist. Her work deals with non traditional issues as well, in particular, on issues related to commons such as water and other natural resources. She argues that a so-called “tragedy of the commons” is not necessarily inevitable. Ostrom, too, relies on non traditional qualitative research to make her case.

My work on the financial markets is influenced heavily by the work of Williamson and my co-author is one of his former Ph.D. students. I penned the following summary of his work for my university’s media relations department yesterday:

“Dr. Williamson is part of the ‘new institutional’ school within law and economics which argues that markets alone do not solve all economic problems and that markets themselves are far more complex institutions than is widely understood.

“A central insight of Dr. Williamson, based in part on the work of prior Nobel winner Ronald Coase of the University of Chicago, is that transactions in markets have costs associated with them.

“An entrepreneur who enters the market for goods and services must search out prices, negotiate a sales transaction and, if a long term contract or relationship is established with others in the market, monitor that relationship and possibly enter into dispute resolution in case of conflict in the relationship.

“All of those steps cost the entrepreneur something in either time or money. If those activities are brought inside a firm – and this applies whether or not the firm is private or government owned – then those costs might be reduced. Life inside a firm is not a world of freedom because management has the authority to carry out transactions, such as moving workers around the firm, by fiat. This helps explain why socialized institutions such as firms or corporations emerge even though we think of capitalism as a market based system.

“That key insight is a concept I bring into my classes on business organization and corporate governance for law students and business school students to help them make practical decisions about how to either build businesses or to represent business people.

“The current political debate about what kind of regulatory framework is necessary to resolve problems in the housing market and the financial markets will benefit, whether acknowledged or not, by the work of Dr. Williamson. His perspectives help us understand that the resolution of the current financial crisis is more complex than might be thought.”