Chater 3
Institutions, Neoclassical and Institutional
Economics
3.1 Neoclassical economics
Neoclassical basic assumptions:
• Zero transaction cost
• Profit and utility maximization
• Perfect information/knowledge
• Rational choice
• Institutions are given and do not matter in the
economic analysis (instrumental rationality
3.2 What is institutions?
no single definition
• Institutions are "settled habits of thought common to the
generality of men." (Veblen 1919)
• Institutions are understood as essentially “collective action
in control of individual action” (Commons 1934, 69).
• Institutions refers to the rules, norms, and strategies used
by humans in repetitive interactions (Ostrom,1990)
• Institutions are ‘rules, enforcement mechanisms and
organizations’ (World Bank, 2002)
3.2 What is institutions?
• “Institutions are the rules of the game in a society; more
formally, they are the humanly devised constraints that shape
human interaction. In consequence they structure incentives
in exchange, whether political, social, or economic.”
A set of formal and informal rules of conduct that facilitate
coordination or govern relationships between individuals.
D.C. North (1990)
• Institutions have been devised by human beings to create
order and reduce uncertainty in exchange“ (North 1991, p.
97)
Formal vs. Informal Institutions
Formal Institutions
• Formal institutions are the constitutional framework,
which sets out the rules for economic, social and political
‘players’
• Players are economic (firms), political (parliament) and
social (Mosques and churches) organizations
• Institutions are path-dependent and country-specific
Informal Institutions
• Informal institutions are the norms of a society, which
also set out the rules for economic, social and political
‘players’
e.g ‘Edir’ and ‘Equb’
How Do Informal Institutions Work?
• Informal institutions allow players to enforce
economic exchange, typically through
reputation mechanisms, which provide
information about the behavior of players;
identify poor behavior; and exclude and
punish players that ‘cheat’ according to the
rules of the game
Formal vs Informal rules
Formal rules
Formal rules are consciously designed by humans and
often codified in written form
E.g constitutions, laws and regulations.
They are also often enforced by some external authority.
e.g Police and the courts enforce the rule of law.
The rules, the enforcement mechanisms, the
organizations and the way these influence behavioral
patterns together are considered as formal institutions.
Formal vs Informal rules
Informal rules
Informal rules evolve spontaneously and unintentionally over
time through human interaction, and take the form of unwritten
conventions, routines, customs, codes of conduct and behavioral
norms (Menger 1963).
e.g
• The norms to honor promises,
• The norms for not cutting trees
• To protect private property,
• To speak Somali in Somalia
The ways these informal rules are adhered to and their effect on
behavioral patterns can be considered as informal institution.
Non-compliance with informal rules is sanctioned through
decentralized and spontaneous social feedback.
3.3 Common features of institutions
Institutions are sustained by shared conceptions and
expectations( i.e. to achieve a certain gaols).
Stable over time: institutions have relatively durable,
self-reinforcing, and persistent qualities.
Institutions reinforce their own moral legitimation: that
which endures is often-rightly or wrongly-seen as
morally just.
They must pose constraints and affect individual
behavior of its members.
3.4 Institutions vs Organizations
These two terms are often used interchangeably in everyday
language.
Institutions are complexes of rules, norms and behavioral
patterns.
Organizations are made up of groups of individuals bound
together by some common purpose to achieve certain objectives.
e.g
• Economic bodies (firms, trade unions, family farms etc),
• Social bodies (Mosques, churches, clubs, athletic associations),
and Educational bodies (schools, universities).
The complex of formal rules, regulations, code of conducts,
norms, conventions, etc. that determine the behavioral pattern of
actors in these organizations could be thought as institution.
If institutions are the rules of the game, organizations and their
entrepreneurs can be thought as the players of the game.
3.5 What is Institutional Economics?
Institutional economics can be regarded as a family of theories that
share the thesis that ‘institutions matter’ in the study of economics,
that they even constitute an essential subject of reflection
(Chevance, 2009)
One of the contribution of Institutional economics is explicit
consideration of institutions as they play a central role in explaining
real world economic problems.
Institutional economics focuses on understanding the role
of institutions such as organisations, laws and contracts in
influencing economic decisions
3.5 What is Institutional Economics?
In Institutional economics, some of the unrealistic assumptions
of neo-classical economics (such as perfect information, zero
transaction costs, full rationality) are relaxed, but the
assumption of self-seeking individuals attempting to maximize
an objective function subject to constraints still holds
Institutional economics assumes instead that individuals have
incomplete information and limited mental capacity and
because of this they face uncertainty about unforeseen events
and outcomes and incur transaction costs to acquire
information.
To reduce risk and transaction costs humans create
institutions, writing and enforcing constitutions, laws,
contracts an regulations—so-called formal institutions—and
structuring and inculcating norms of conduct, beliefs and
habits of thought and behavior—or informal institutions
3.6 Old and new institutional economics
Why Old Institutional economics and what is it?
• The first institutionalist school
• Emerged as the protest against methodological
individualism of the mainstream Neo-classical
Economics.
• Emphasized importance of institutions(explaining
and influencing economic behaviour) but lacked
rigorous and systematic theoretical foundations, as
well as empirical support.
• Concerned more with description of institutions.
3.6 Old and new institutional economics
• Why is it called “New”?
• To distinguish it from the “old” institutionalist school (Veblen,
Commons)
• Oliver Williamson is the inventor of the term ‘new institutional
economics’, which from the 1990s on came to refer to various
active theoretical currents, united by the idea that ‘institutions
matter’ and that these can be analysed with the instruments
of standard economic theory – with certain adjustments.
• NIE operates within the framework of neo-classical economics,
but it relaxes some of its assumptions and incorporates
institutions as an additional constraint.
Foundations of NIE
• Ronald Coase (Law and Economics)
– 1937 – The Nature of the Firm
– 1960 – The Problem of Social Costs
– 1974 – The Lighthouse in Economics
• Douglass North (Economic History)
– 1973 – The Rise of the Western World
– 1981 – Structure and Change in Economic History
– 1992 – Institutional Change and Economic Performance
• Oliver E. Williamson (Economics and Organization)
– 1975 – Markets and Hierarchies
– 1985 – Economic Institutions of Capitalism
– 1996 – Mechanism of Governance
Branches of NIE
• Transaction Cost Economics (Coase, Williamson,
North)
• Property Rights Theory (Alchian, Demsetz, Furubotn,
Bromley, Barzel)
• Contract Theory
– Principal Agent Theory (Stiglitz, Tirole)
– Incomplete Contract Theory (Hart, Moore)
• New Economic History
• New Political Economy
New Institutional Economics (NIE)
The purpose of NIE is two-fold:
1. Explain (opposed to describe) the determinants of
institutions and analyze the institutional change
2. Evaluate impact of Institutions on economic
efficiency and distribution.
Questions addressed by NIE
• Effects of institutions, e.g. property rights, on
– Resource allocation
– Income distribution
– Incentives (efforts, investments, innovation)
– Transaction costs
What does NIE address in developing country?
NIE is a useful tool to address policy issues in
developing countries because:
– Frequent occurrence of market failure &
incomplete or imperfect markets
– Many of the formal rules of behavior that are
taken for granted in developed economies do not
exist in developing countries