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The New Institutional Economics: Its Start, Its Meaning, Its Prospects
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This article deals with the early stages, meaning, and prospects of a field known under the
name of “New Institutional Economics” - a generic term introduced by Oliver Williamson
(1975, 1). It soon became a standard (or banner) under which a diverse group of economists
assembled, who shared one common intellectual ground: institutions matter, the relationship
between institutional structure and economic behavior requires attention, the determinants of
institutions can be analyzed with the aid of economic theory.
1
Revised version of a paper written at the Hoover Institution, Stanford University, Fall 2003 and first presented
at the Center of New Institutional Social Science, Washington University St. Louis, MO, USA, 4 December
2003 and later at the School of Management of the Saint-Petersburg State University, St. Petersburg, Russia 19
October 2005. Financial support of the Fritz Thyssen Foundation is gratefully acknowledged. I thank John
Drobak (Washington University), Jan Kmenta (University of Michigan) and Eirik G. Furubotn (Texas A&M),
Valery Katkalo and Natalia Drozdova (Saint-Petersburg State University) for valuable comments. I also thank
Rainer Kulms (Editor-in-Chief of EBOR) for his thoughtful suggestions. Any remaining mistakes are the sole
responsibility of the author.
*
Professor of Economics (em.), Universität des Saarlandes, Rechts- und Wirtschaftswissenschaftliche Fakultät,
P.O. Box 151150, D-66041 Saarbrücken, Germany, e-mail: r.richter@mx.uni-saarland.de
PaperNIEH24.doc 11/15/05 2
1.2. The NIE, its First Understanding: Oliver Williamson, creator of the term “New
Institutional Economics”, understands the term rather broadly. He subsumes under the NIE
Aspects of mainline microtheory, economic history, the economics of property rights, comparative systems,
labor economics, and industrial organization….
(1) that received microtheory …operates at too high a level of abstraction to permit many
important microeconomic phenomena to be addressed in an uncontrived way; and
(2) that the study of “transaction” ………. is a core matter and deserves renewed attention.2
2
Among the studies that deal, directly or indirectly, with the NIE Williamson mentions (1975, 1, n.1): Alchian
and Demsetz (1972, 1973), Arrow (1969, 1974), Davis and North (1971), Doeringer and Piore(1971), Kornai
(1971), Nelson and Winter (1973), Ward (1971) and his own contributions Williamson (1971, 1973).
PaperNIEH24.doc 11/15/05 3
A few pages later Williamson (1975, 7) describes the principal differences between the earlier literature and
his approach as follows:
(1) I am much more concerned than are prior treatments with tracing out the ramifications of
bounded rationality;
(2) I expressly introduce the notion of opportunism and am interested in the ways that
opportunistic behavior is influenced by economic organization; and (3) I emphasize that it is not
uncertainty or small numbers, individually and together, that occasion market failure but it is rather the
joining of these factors with bounded rationality on the one hand and opportunism on the other that gives
rise to exchange difficulties.
Williamson concentrates in his work on what he later calls transaction cost economics (TCE),
which he says is “part of new institutional economics” (Williamson 1985b, 16).
The term NIE seems to have remained largely dormant during the following five or so years.
However, Leonard Silk mentioned the word in the New York Times of September 24, 1980 as
a possible “new direction that will gradually draw economists away from their tired repetition
of stale and sterile arguments.”3 I myself “discovered” it around the same time on page one of
Williamson’s 1975 book. Shortly before I had become editor of the time-honored Zeitschrift
für gesamte Staatswissenschaft (founded in 1844), at that time still a German language journal
on general economics.4 I wanted to “internationalize” the Zeitschrift and looked for a suitable
specialty, a niche, coming close to its original field, the “entire science of the state.”5 Public
Choice and Law and Economics were already well covered by journals, thus the New
Institutional Economics in the sense of Oliver Williamson appeared to be a promising choice.
Eirik G. Furubotn was prepared to help me, and, without thinking twice, we started together a
series of international seminars on the NIE with the aim to help the old Zeitschrift on its feet.
That was in 1983. The series became known as “Wallerfangen Conference” and is held
annually – with different organizers and at changing places, up till now. Papers and
discussions are published in the Journal of Institutional and Theoretical Economics (JITE)
since 1984.6
1.3 A Brief Interlude: Two Strands of Thought
Among the various approaches to institutional economics, two strands of thought are of
interest for an assessment of the NIE. They are (by use of gentle force):
1. A line of thought from, say, David Hume (1739/40) to Carl Menger (1883), F.A. Hayek
(1948, 1967), R. R. Nelson and S. G. Winter (1982), M. Kirzner (1973), D. Lewis (1969), A.
Schotter (1981), R. Axelrod (1984), K. Binmore (1994, 1998), A. Greif (1998), M. Aoki
(2001). This line is characterized by self-adjusting processes. Transaction costs play no
explanatory role. We call it the "invisible-hand approach to institutional economics".
3
See Langlois (1986, 1).
4
Among them, after all, the 1965 paper by Reinhard Selten for which he later (in 1994) received the Nobel
Prize.
5
On the German science of the state see Lindenfeld (1997).
6
An overview of the names of the organizers, topics, contents and participants of the so far held 21 NIE
seminars can be found in the internet under http://www.mpp-rdg.mpg.de/oekinst.html
PaperNIEH24.doc 11/15/05 4
2. Another line of thought leads roughly from Frank Knight (1922) and John R. Commons
(1934) to Chester Barnard (1938), F. A. Hayek (1945), Ronald Coase (1937, 1960), J.M.
Buchanan and G. Tullock (1962), M. Olson (1965), A. Chandler (1962, 1977), Herbert Simon
(1957, 1987), A.A. Alchian (1961), K. J. Arrow (1969), O. E. Williamson (1975, 1985), L.
Davis and D.C. North (1971), and D.C. North (1981, 1990), J. Knight (1992). In this
approach, transaction costs (or information costs) are essential as an explanatory element. For
want of a better term, we dub this line the "visible-hand approach to institutional economics".
Note: By any means, the two lines of thought are not to be taken as an indication of the
historical roots of the NIE. That is a rather complicated issue which cannot be dealt with here.
As for the history of the NIE itself we limit ourselves to one single question, viz., how the
term „new institutional economics” evolved to an unifying standard.
1.4 The Development of the Term “NIE” to a Unifying Standard
As mentioned above, the term “new institutional economics” became a more widely known
term around 1980, i.e., five years after it had been coined by Oliver Williamson (1975, 1). It
took another three or four years until economists used it in topics or titles of their
publications. In EconLit, the term NIE does not appears before 1984, but then increasingly in
titles of journal articles, books, papers in collective volumes or conference issues.7 One
simple way to feel the pulse of our profession is to read editorial prefaces. Editors are
supposedly the brokers (or switchmen) of our profession. So, why not apply their judgments
as a measuring instrument for the development of the use of the term NIE. Following this
strategy, I am going to offer a brief report and evaluation of the editors’ comments to six
successively published collective volumes, starting with above mentioned first publication in
which the term NIE appeared, edited by Furubotn and Richter (1984), and continuing with
the collective volumes edited by Langlois (1986), Nabli and Nugent (1989), Harris, Hunter
and Lewis (1995), Drobak and Nye (1997), and Clague (1997).
1.4.1 Which Institutional Economic Fields do Belong to the NIE?
A first, somewhat simple question to ask is: Which special fields do editors of the listed
collective volumes consider to be part of the NIE? The answer is:
7
I found 395 records until end of 2002, starting 1984 with four papers which appeared in the conference issue of
the first International Seminar on the New Institutional Economics of 1983 (Furubotn and Richter 1984).
PaperNIEH24.doc 11/15/05 5
Certainly, our six collective volumes and their editors are no representative sample. Still, it
may not be all wrong to guess that table 1 reflects the prevailing view of our profession,
which fields, and with what weight, should be considered part of the NIE. Property rights and
transaction cost economics are quite certainly among them. In fact, they were “voted” for by
the editors of all six volumes. A distinct minority of editors’ comments (2 out of 6) name
contract theory, collective action, public choice, evolutionary economics, and the new
institutional economics approach to history as part of the NIE. The fields of modern Austrian
economics and constitutional choice fall far behind with only one vote for each. The great
weight given to the property rights and transaction cost economics speaks for our earlier
presumption that the end piece of the visible-hand approach to institutional economics is
regarded as belonging to the methods of the “new institutional economics”.
8
See: http://www.uni-saarland.de/fak1/fr12/albert/mitarbeiter/richter/institut/waller.htm
PaperNIEH24.doc 11/15/05 6
Furubotn and Richter (1984) argue that the foundation stones of the NIE would consist of the
traditional ones of neoclassical theory, viz., methodological individualism and self interest
principle. But while in neoclassical economics the influence of the institutional framework
was disregarded completely or specified only in perfunctory a way, the NIE would seek to
demonstrate that institutions matter. Beyond this, institutions themselves would be regarded
as legitimate objects of economic analysis. In other words, the unifying elements of the NIE
would be its basic methodology and its analytical objects. It would not matter that a number
of different approaches are employed in attempting to integrate institutional considerations
into economic theory. The authors stress that the study of “transactions” themselves and of
transaction costs is crucial and that another important shift in thinking relates to the way in
which property rights structures are perceived. The participation of Armen Alchian, Ronald
Coase, Douglass North and Oliver Williamson underline these judgments.
Langlois (1986) argues that the NIE consists of a number of identifiable strands. Principal
among these are, in the first place, evolutionary theory and the modern Austrian school9 as
influenced by F. A. Hayek. Historically, Carl Menger would have
... perhaps more claim to be the patron saint of the new institutional economics than any of the original
institutionalists [like John R. Commons who is quoted by Williamson]. (loc. cit. 5)
Finally, Oliver Williamson, Ronald Coase and Herbert Simon are mentioned (in this order).
The Austrian and evolutionary prioritization by Langlois is underlined by conference
participants such as Brian J. Loasby, Andrew Schotter, Richard R. Nelson, Gerald P.
O’Driscoll, Jr.
Nabli and Nugent (1989) edited a collective volume on the application of the NIE to
Development Economics. While there is as yet no consensus on what is included in the NIE,
Nabli and Nugent find that two broad and general approaches would be salient, "…namely
transaction and information costs, on the one hand, and the theory of collective action on the
other" (loc.cit. 10).
The transaction cost approach is targeted, in the first place, at private goods. It contains the
property rights economics, transaction cost economics proper, and the more mathematical
oriented agency (or contract) theory. 10
The theory of collective action, is targeted at public goods of both, physical character such as
pollution or highways, and of an abstract character such as a "… higher wage rate, a higher
price, …, a regulation, a lower tax rate or a policy rule." (loc. cit. 14).
The two general approaches would be complementary. As long as transaction costs are not be
prohibitively high, external effects of individual actions could be compensated by contractual
arrangements between individual parties. Otherwise, collective action would obtain (loc. cit.
9
In fact, a considerable part of this introductory essay is devoted to the defense of the Austrian view of
“competition as a process”(loc. cit., pp. 7 – 15).
10
As for the latter the authors speak of themes “concerned with incomplete information and asymmetric
information in particular.” (p. 12)
PaperNIEH24.doc 11/15/05 7
18). Contributors to this volume include the editors themselves and Samar K. Dutta, Timur
Kuran, Bruce H. Herrick.
Harriss, Hunter and Lewis (1995) edited another conference issue on development
economics11. Proof of the importance of the NIE would be the award of the Nobel Prize for
Economics first to Ronald Coase in 1991 and to Douglass North in 1993. The NIE would be
able to explain non-market forms of organization as rational consequences of market failures.
It would, thus, challenge the dominant role ascribed to the market by the orthodoxies of the
last ten years or so (loc. cit., 1). North, who participated at the conference, emphasized that
the NIE retains the neoclassical assumptions of individual choice subject to constraints. The
constraints, however, would include also institutions. Transaction costs would play an
important role as well as ideas and ideologies. The latter would be “… a critical factor in the
performance of economies, as the source of the diverse performance of economies, and the
explanation for ‘inefficient’ markets.” (North 1995, 19). Keynote speakers at this conference
were Douglass C. North, Robert H. Bates and John Toye.
Drobak and Nye (1997) edited a collection of papers that were presented at a celebration of
the award of the 1993 Nobel Prize in Economics to Douglass North. The editors say, the NIE
would be less a distinct school “…..than a particular set of shared concerns grounded in
existing economic theories and doctrines” (loc. cit xv). New institutional economic historians,
like North, would begin with an appreciation of neoclassical price theory as a powerful tool
for predicting many economic outcomes in the real world. But the neoclassical assumption of
perfect individual rationality would have to be watered down or even replaced by other
assumptions about human behavior.12 Central fields belonging to the NIE would be
transaction cost and property rights economics, political economy and public choice,
quantitative economic history, cognition, ideology, and the role of path dependency. Speakers
at this conference were, i.a., Douglass C. North, Robert William Fogel, Avner Greif, Gary
Libecap, Barry R. Weingast, Paul A. David.
Clague (1997) edited also a collection of papers on the application of the NIE to development
issues. He describes the NIE as an expanded economics. It would relax some of the strong
assumptions of traditional economics with respect to the motivation of, and the information
available to, individual decision makers, and it would widen the scope of economics to
include political phenomena and the evolution of institutions. The NIE would have called
attention to the vital role of government administrative capacity in shaping the institutional
environment of business. It might help to explain why bureaucracies perform well or badly
and how the inefficient and corrupt ones could be reformed. Among the conference
contributors were, i.a., Mancur Olson, Philip Keefer, Elinor Ostrom, and Margaret Levi.
11
Held at the London School of Economics and Political Science in September 1993.
12
North suggests to use what is known from other disciplines such as cognitive science or learning theory (loc.
cit. xix).
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Summing up: All editors of our sample seem to agree that the NIE is not characterized or
defined by a selection of fields but by the intellectual bond of its basic methodology. A clear
majority favors contributions that belong to the "visible-hand approach to institutional
economics". Only a small minority (one out of 6 in our sample) prefers components of its
counterpart, the “invisible hand approach” (Langlois).
Those favoring the visible hand approach agree that the foundation stones of the NIE are the
same as the ones of neoclassical economics: methodological individualism and individual
rational choice given a set of constraints. However, due to transaction or information costs,
information is limited and, thus, institutions matter.
Like the old institutionalists,13 the new institutionalists start from a criticism of current
economic theory for its “too high level of abstraction” (Williamson 1975, 1). But while the
old institutionalists clearly refuse the abstract assumptions of classical or neoclassical
economics, the new institutionalists tend to accept them, though, in a watered down form
because of transaction costs, Knightian uncertainty, bounded rationality etc., and from the
perspective that institutional arrangements tend to substitute, to some extent, for these
qualifications. In any case, all editors of our sample keep their distance from old institutional
economics - most of them expressis verbis,14 There are clearly major differences between the
old and new institutional economics, nevertheless, as Rutherford (2001, 187) rightly points
out, some aspects of the new institutionalism “… do connect back to the old – including a
tendency to spread beyond the standard neoclassical boundaries.”
Finally, all editors of the six collective volumes under consideration seem to agree that the
composition of the fields of the NIE depends mainly on the particular object of research. In
this respect, our sample is somewhat one-sided. Most of the six volumes are concerned with
macro issues: Three deal with issues of development economics, one with new institutional
economic approach to history, another one with issues of evolutionary economics. Only one
issue includes also micro economic problems. Certainly, that is no representative mix of
applications, in particular since a great deal of new institutional economic studies are on
micro economic issues such as firms15, industrial organization16, antitrust17, contractual
relations18, market organization19 etc.. Still, our sample gives some insight into how the
generic term “new institutional economics” became a standard (or banner) under which a
diverse group of economists assembled.
13
As represented by the German Historical School and American Institutionalism.
14
Furubotn and Richter (1984, 1), Langlois (1986, 2 - 5), Nabli and Nugent (1989, 10), Drobak and Nye (1997,
xv).
15
JITE (1986).
16
JITE (1985).
17
JITE (1990).
18
JITE (1987).
19
JITE (1994).
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1.5 The Foundation of the International Society for New Institutional Economics
(ISNIE)
With the foundation of the International Society for New Institutional Economics (ISNIE) - its
first conference was held at Washington University, St. Louis, MO20 in September 19 – 21,
1997 - the NIE came “of age.” The organizers advertised in the internet the conference to
scholars “…..working on transaction costs, contracting, political rules of the game, the rules
of law, norms and culture, and who pursue these interests using standard scientific methods.”
(Furubotn and Richter 1997, 780).
At the inaugural conference, North, Williamson and Coase – in this order – described the NIE
basically as above. Although the immediate objective of the NIE is to replace the abstract,
static models of neoclassical economics, Coase cautioned that a frontal attack on neoclassicis
m would be neither needed nor desirable. For appropriable theoretical development to be
achieved, it is sufficient to focus on factual matters. Somewhat later Coase (1999, 1 ff.) said,
ISNIE would have a mission, viz “…to replace the current analysis with something better, the
New Institutional Economics…..The Influence of the New Institutional Economics will be
exerted in the various sub-disciplines [of economics]. Guerilla actions will take place, which
will result in the New Institutional Economics dominating first one and than other of these
sub-disciplines, as indeed is beginning to happen.” But he adds “We will not replace price
theory (supply and demand and all that) but will make it vastly more fruitful.”
A selection of the papers presented at the second annual conference of ISNIE at Paris in
September 1998 has been published by Claude Ménard (2000), among them again
contributions by the old guard: Ronald Coase, Douglass North, Oliver Williamson, Harold
Demsetz, Yoram Barzel but also by Masahiko Aoki who supported the concept of the
institution-as-equilibrium-of-a-game concept. Coase and North stress again that the
representatives of the NIE don’t want to replace neoclassical theory but are trying to use these
analytical tools “to study the working of the economic system” (Coase 2000, 4, or Coase
1999, 5 as quoted above). But that appears to contradict North’s concept of the “cognitive
science/institutional approach to history” or Williamson’s casuistic technique to broach
bounded rationality. Why not admit that a change in paradigm is already under way?
20
See the brief report by Furubotn and Richter (1998).
PaperNIEH24.doc 11/15/05 10
21
As North (1986, 236) rightly remarks: “Pareto efficiency … simply don’t make sense a great deal” (in the
economics of institutions). For details see Furubotn and Richter (2005, 108 – 110).
PaperNIEH24.doc 11/15/05 11
However, both approaches hardly square with the constantly referred to neoclassical
economics and seem unwilling to make the break to a fundamentally new paradigm.22 While
this is not achieved, one should at least be ready to apply different, problem related analytical
methods for different objects of economic research and define the science of economics by its
objects, instead of its method - as is done in other applied sciences. Economics is more
appropriate to compare to engineering or medicine instead of physics or biology (Varian
1993, 2 f.).
The Williamsonian approach to the NIE is mainly applied in microeconomic fields like the
theory of firm, of industrial organization, antitrust, the economics of organization. The
Northian approach is used to tackle macroeconomic issues as those of the history of national
economies, of development economics or transformation economics.
22
Selten (2001) and Gigerenzer (2001, in this sense, are the boldest and call for heuristics rather than
optimizations.
23
For lack of knowledge of what the future will bring, i.e., of all the stochastic variables.
PaperNIEH24.doc 11/15/05 12
2.2 The Analytical Core of North’s New Institutional Economics of History (NIEH)
Douglass North aims at an economic explanation of the structure and performance of
economies through time.25 He starts from the simple observation that human cooperation
requires rules of behavior, viz. institutional constraints, which, in the final analysis, define the
opportunity set of individuals.26 In the world of costless transactions and perfect foresight the
nature of institutional constraints (as, e.g., full ownership or rent of land) does not matter. It is
without influence on the economic performance of the polity. That is no longer true for a
world with positive transaction costs and imperfect foresight. Here, the nature of the
institutional framework plays a major role in the performance of an economy.27 It reduces the
uncertainty of human interaction and, thus, the costs of cooperation.28 Persistent changes in
relative prices, due to lasting exogenous changes (such as changes in total population,
knowledge or ideology29), will lead actors to realize that they could be better off under
alternative institutional arrangements and result in institutional change. Yet, institutional
change is path dependent and shaped by the feedback between economic and political
markets. Due to the high (political and economic) transaction costs, inefficient institutions
may persist for long periods of time.30
24
In this context, „casuistic“ means that typical cases are identified and studied – as, e.g., study is conducted in
case law or medicine.
25
North (1981, 3).
26
North (1990, 67). Clearly, the rights of disposal over certain real resources and knowledge are described by the
institutional framework (or governance structure).
27
North (1990, 69)
28
“Institutions provide the structure for exchange that … determines the cost of transacting and the cost of
transformation.” (North 1990, 34) “Under conditions of limited information and limited computational ability
[bounded rationality], constraints reduce the costs of human interaction as compared to a world of no
institutions.” (loc. cit. 36) However, the share of US transaction costs of GNP grew from roughly a quarter in
1870 to over one-half in 1970 (Wallis and North, 1988, 120).
29
North (1981, 207 f.; 1990, 111).
30
North (1990, 92 ff.).
PaperNIEH24.doc 11/15/05 13
Institutional constraints comprise informal and formal rules of behavior.31 Formal rules
consist of political rules (example: the constitution32), economic rules (examples: property
rights,33 contract laws) and contractual agreements between actors (example: sales contract).
Political rules would lead to economic rules, "though the causality runs both ways."34 The
enforcement of rules matters. Self enforcement would be ideal but is frequently not
promising.35 In general, legal enforcement is more effective.36 However, the coercive force
given to the state may be used by those in power to their own advantage.37 In a simple model,
North (1981, 28) interprets the state as a ruler who maximizes his profit subject to basically
two constraints: the degree of political competition with rivals and with other states, and
transaction costs. For both reasons, the property-rights structure, which maximizes the social
product, may not maximize the ruler's (long-term) monopoly rents. North's judgment is rather
pessimistic. He says that to stabilize his power the ruler will agree to a property rights
structure that is favorable to those groups with close access to alternative rulers, regardless of
its effects upon efficiency. And because of the costs of determining and collecting taxes, a
less efficient property-rights structure may be more favorable to the revenue maximizing
ruler.
North’s concept of the NIEH aims at a general theory of the interaction between polity and
economy. It is, insofar, an application of the economic theory of politics to economic history.
However, in contrast to public choice theory and the theory of collective action,38 North
assumes imperfect individual rationality and emphasizes the role of ideology. He rejects
“rational choice and efficient market hypotheses”.39 Rather, he opines that because of
imperfect individual rationality
Mental models, institutions and ideologies all contribute to the process by which human beings interpret and
order environment. Mental models are, to some degree, unique to each individual. Ideologies and institutions are
created and provide more closely shared perceptions and ordering of the environment. (North and Denzau 1994,
21)
2.3 Comparing the Williamsonian and the Northian approach to the NIE
Both deal with the same object: “institution.” Williamson (1985) prefers to speak of
“governance structure,” North (1981, 1990) uses terms like “rules of behavior”, “institutional
31
North 1990, 36.
32
“Political institutions constitute ex ante agreements about cooperation among politicians.” (North 1990, 50)
33
The establishment of "well specified and well-enforced property rights" account for the unprecedented growth
of Western economies (North 1989, 1320).
34
North (1990, 48).
35
Regarding contracts: „…neither self-enforcement by parties nor trust can be completely successful.” (North
1990, 35)
36
„...there are immense scale economies in policing and enforcing agreements by a polity that acts as a third
party and uses coercion to enforce agreements.“ (North 1990, 58)
37
„...if the state has coercive force, then those who run the state will use that force in their own interest at the
expense of the rest of the society.“ (North 1990, 59)
38
Public Choice Theory applies the neoclassical economic style of reasoning to the analysis of politics – as
reviewed by Mueller (1979). For an empirical study of the politico-economic interdependence see Schneider,
Pommerehne and Frey (1981).
39
North (1990, 111).
PaperNIEH24.doc 11/15/05 14
2.4 What Critics Said About the Williamsonian and Northian Approach
We are concentrating our discussion on some of the better known criticisms of Williamson’s
transaction cost economics and North’s new institutional approach to economic history. Space
does not permit us to go into the debate of “old” versus “new” institutional economics.42
We should begin by mentioning that the only “positive criticism,” that is the kind of criticism
that tries to replace the attacked theory by another – better one – comes in both cases from
mathematical economists. The rest limits itself to a criticism of assumptions.
2.4.1 Some Criticisms of TCE
Widely known criticisms come from scholars of mathematical economics, sociology and law.
40
Williamson (1993, 56) concedes: “Transaction cost economics mainly works out a dyadic set-up.”
41
Binger and Hoffman (1989, 68 f.).
42
For a more recent defence of old institutionalism see, e.g., Hodgson (1998). For an excellent comparison
between the two views see Rutherford (2001, 185 – 190).
PaperNIEH24.doc 11/15/05 15
1. Mathematical economists such as Grossman and Hart (1986) have criticised the
imprecision of TCE. They tried to develop, instead, a formal version of transaction cost
economics. But their theory of incomplete contracts, as it became known, does not really deal
with the central problem of TCE: ex post opportunism. Grossman and Hart explain rationally
only who should acquire a (private) property right, in their case who should become the owner
of the residual decision right of a contractual relation between a supplying and a buying firm
(Hart 1995, 5 ff.). The solution of their theory of incomplete contract theory is again, legally,
a complete contract. Thus, in Grossman and Harts model, the owners of the residual decision
right face no problems in proving their ownership before a court and therefore rely on legal
compulsion. It puts aside Williamson’s problem of what happens after contract conclusion.
Irrespective of this, Gosssman and Hart’s approach opened up a new and attractive area of
contract theory - the theory of incomplete contracts. Leading representatives of this approach
are, in Germany, G. Nöldecke and Klaus Schmidt (1995), both from the Bonn school (see
Schweizer 1999). Closer in spirit to the TCE may be the paper by Bajari and Tadelis (1999).
2. Granovetter’s (1995a, 63 ff.) sociological critique is centred upon Williamson’s
assumptions of his “markets and hierarchies” analysis (Williamson 1975). Granovetter argues
that Williamson’s appeal to authority relations “in order to tame opportunism” constitutes a
rediscovery of Hobbesian analysis, an over-emphasising of hierarchical power (Granovetter
1995a, 65). Williamson disregarded the “embeddedness” of the individual in a net of personal
relationships. In the creation of trust, social structures or networks are of significance. They
discourage malicious behaviour (Granovetter 1995b, 200). Williamson “vastly overestimates
the efficacy of hierarchical power … within his organizations.” (Granovetter 1995a, 68).
However, Granovetter's criticism of TCE is besides the point because Williamson deals on
purpose only with bipolar relationships that are not subject to social control – the case of the
fundamental transformation. Williamson's claim that opportunism is prevalent is widely
reflected by the facts. Examples are provided, not least, by the problems of corporate
governance that are attracting growing attention recently in the United States and Germany
(vide the Enron, WorldCom, and Berliner Bank affairs).
3. Posner (1993), a well known representative of the Economic Analysis of Law of the
Chicago School, attracted much attention by his paper on “The New Institutional Economics
meets Law and Economics.” He offers a very individual interpretation of the assumptions of
TCE in sharply rejecting Williamson’s (1985a, 189 f.) criticism of the Chicago School's
doctrine, and emphasises that the law and economics work at Chicago would as well be
occupied “…with problems of uncertainty, bilateral monopoly, and opportunism and with
how legal and economic institutions try to solve them.” (Posner 1993, 81). All that
Williamson's “opportunism” would mean is advantage taking under conditions of a temporary
monopoly, or through informational advantages in a situation of asymmetric information
(1993, 80). That is not quite correct either. Williamson's point is that the bilateral monopoly
situation exists not ad ovo but is the unavoidable side effect of the conclusion of an exchange
contract between two individuals that requires specific investments. Finally, Williamson does
not only criticise the assumptions of Chicago style (i.e., neoclassical) microeconomics, he
suggests also to replace the attacked theory by another theory that is better equipped to
explain non-standard exchange contracts like vertical integration that influenced antitrust
PaperNIEH24.doc 11/15/05 16
policy considerably. Of course, Williamson's TCE is not based on a formal model. However,
that is a price to be paid (so far) if one leaves the sphere of perfect individual rationality and
perfect foresight - as do all representatives of the NIE in the sense of this paper.43
But the Nash equilibrium is a static concept. It explains the logic of self-enforcing social
orders (the persistence of institutions) but not their change.44 For North (1990, 54), the ability
of societies to develop "effective, low-cost enforcement of contracts is the most important
source" of economic development. Institutional change comes about through the visible hand
of “entrepreneurs in political and economic organizations” who realize that they could do
better by changing the institutional framework. We interrupt here to resume the equilibrium of
game view in the following chapter.
2. Another branch of criticisms is related to the age old controversy of economists or social
scientists between individualism and socialism (or holism). Schumpeter tried to defuse the
debate by suggesting to distinguish sharply between "political" and "methodological
individualism (Schumpeter 1908, 90). The latter was thought to be used, within narrow limits,
for the description of certain economic processes (1908, 94), however not in organization
theory or sociology (1908, 95). To day, the term is used for a much wider purpose than
Schumpeter had in mind. In any case, it became an axiom of the NIE and is represented in
North's new institutional economic history. This is seriously criticized by economists like
43
On Williamson's reply to Posner see (1993c)
44
Greif and Laitin (2004) have shown a way out: The hypothesis of a self-undermining Nash equilibrium of
repeatedly played games.
PaperNIEH24.doc 11/15/05 17
Fine and Milonakis45 as being North's "most sacred analytical principle" (Fine and Milonakis
2003, 561). They rightly ask, how the concept of methodological individualism would square
with North's assumption of ideology (a social phenomenon) as the explanatory factor in his
theory of institutional change. 46 His treatment of institutional change and stability would be
exogenously determined because North does not provide a theory of ideology (see Rutherford
1994, 46). This argument relates to the problem of infinite regression which is contained in
both, the visible and the invisible hand approach to institutions. It is an unavoidable, ever
debatable issue of any theory.
45
See Fine and Milonakis (2003), Milonakis and Fine (2005).
46
For a brief review and assessment of the criticisms of North's NIEH see Zouboulakis (2005).
47
As opposed to chapter 10 in Furubotn and Richter (2005).
PaperNIEH24.doc 11/15/05 18
As mentioned above, Aoki (2001) argues in a similar vein. Institutions would be explainable
as a salient Nash equilibrium of the way by which an underlying game is repeatedly played.
But since nobody can escape from the problem of infinite regression, one cannot start to
explain institutions from an institution-free world. Going back to North's path dependency
argument, Aoki suggests
…to seek to direct the infinite regression toward structures inherited from the past…(Aoki 2001, 15)
48
They may be interpreted into games of incomplete information or, more general, into the properties of the
“underlying game” of a recursively played game.
49
His “historical and comparative institutional analysis” is excellently reviewed in Greif (1998a).
PaperNIEH24.doc 11/15/05 19
But the Nash-equilibrium, being a static concept, does not explain how it comes about or how
the invisible hand “works”. On a trial basis this is done by dynamic approaches like
evolutionary game theory50 or the theory of (individual) learning in games.51 They are used to
formally illustrate how a spontaneous order might evolve and, thus, provide a mathematical
background to the considerations in the tradition of Hume, Menger, Hayek.
In real life we find hardly any institutions of purely "invisible-hand" origin. Menger (1883)
himself agreed that the (usual) "pragmatic" interpretation of institutions is just as
indispensable as his "organic" view (1983, 148). It therefore seems advisable for practitioners
like managers, law makers, business or policy analysts to use a suitable mix of both
approaches - the visible and the invisible hand approach. Take the problem of predicting the
effects of a new law, a "made" order. As for its probable effects two types of questions may
be asked, a simpler and a more complicated one. The simpler question concerns the direct or
"visible hand" effects and the enforcement requirements of a new rule (e.g., the direct effect
of a ban on interest on loans). The more complicated question is: What are the "invisible
hand" effects? (In our example: what evasive financial arrangements are imaginable?). Since
no law is perfectly tight, there is always some room for strategic (opportunistic) maneuvers of
the constituents. The general question then is: What set of informal rules might grow
spontaneously into the gaps of a legal framework, and how long will the spontaneous growth
process continue? Is it likely that some stable endpoint will be reached that represents an
institutional arrangement? Can the end point be viewed as a self enforcing equilibrium? Or
will the law undermine itself and collapse? For an example of the latter case see Fururbotn
and Richter (2005, 29 f.).
If both, the invisible hand and the visible hand approach, are reasonably applied uni sono, it
seems advisable to count both approaches among the methods defined by the term NIE.
50
cf. Mailath (1998).
51
cf. Fudenberg and Levine (1999).
52
For a comparison of NES and NIE see Richter (2001).
PaperNIEH24.doc 11/15/05 20
53
”Economic Sociology Section in Formation”, Mission Statement (21.12.2000),
see http://uci.edu/econsoc/mission.html
PaperNIEH24.doc 11/15/05 21
market equilibria. The first is a classical economic market equilibrium. The parties agree on
the price at which demand is equal supply - given the rules of the market. The second is an
interventionist market equilibrium in which two markets – the economic and political market
– are equilibrated: On the economic market (e.g. the labor market) a price is agreed upon
which equals legally restricted demand to legally restricted supply – the unsatisfied parties
(e.g., the unemployed and consumers) are bribed or forced to accept. On the political market
an intervention is agreed upon which organized interest groups and those in power find
acceptable. The second case might reflect the situation on the (West-) German labor market
since the first oil crisis 1974 until, say, reunification.
Noteworthy in this context is a remark by Olson (1984): Instead of asking, “why is there
unemployment?“ he writes, one should ask “who benefits from unemployment?” At all
events, the above interpretation has recourse to particular interest groups (trade unions as the
representatives of the owners of jobs and employers’ associations as representatives of owners
of capital and managers) in the pursuit of their special interests. From this viewpoint,
unemployment can be a interpreted as a Nash equilibrium. In such a state, no actor of the
political parties, the trade unions, the employers’ associations, the media, the labor courts
would have an incentive to deviate from his present plan of action as long as other actors do
not do so, even if they all realized to be in a bad equilibrium. As for the Chancellor, he could
not seriously put his foot down. He is part of the game himself.
Instead of using a game equilibrium approach to tackle the above problem, one might as well
use a transaction cost approach as suggested by Dixit (1996) in form of his “transaction-cost
policy framework”, a combination of the Williamsonian and Northian concepts of the NIE.
4. Conclusion
To summarize: It would be more appropriate to use the term "economics of institutions"
instead of "institutional economics". In any case, the term "NIE" defines various kinds of
economic explanations of institutions. According to our findings, it comprises property rights
analysis, transaction cost economics, contract theory and the new institutional approach to
history. All these theories belong to the "visible hand approach to institutional economics",
which describes, in the terminology of Hayek, "constructed" orders. Next to Ronald Coase,
who first realized the institutional consequences of transaction costs, are Oliver Williamson
and Douglass North as the leading representatives of the NIE. Both stress the importance of
transaction costs, uncertainty, imperfect rationality, methodological individualism. Otherwise
their approaches differ considerably regarding their methods and objects of research.
Williamson concentrates on the limited task to show that nonstandard sales contracts need not
result from monopolistic machinations. He turns his attention to the, so far by economists
ignored, behavior of the parties after contract conclusion, i.e., to the process of execution,
control and enforcement of contracts. The underlying problems result from contract specific
investments, Knightian uncertainty, and the therefore unavoidable incompleteness of
contracts. To minimize ex post opportunism of the partners to the contract, both parties are
complementing or even supplementing potential legal enforcements by private orderings.
PaperNIEH24.doc 11/15/05 24
While Williamson deals with microeconomic problems and abstracts from political decision
making, North, an economic historian, is concerned mainly with macro economic issues. His
central object is the development of a useful theory of institutional change. He aims at a
general theory of the interaction between the polity and the economy. In fact, his approach is
basically an application of the new theory of political economics to economic history. North
broadens the assumption of imperfect rationality by the concept of ideology and results of
modern cognitive science.
However, the interest in an explanation of institutions is not limited to the NIE. Game
theorists became interested in the illustration of the workings of the "invisible hand"
mechanism and the logic of "self enforcement", i.e., in a revival of research in the invisible
hand approach to the economics of institutions along the line of Hume - Menger - Hayek. The
equilibrium-of-game view of institutions was developed. However, in real life we find hardly
any institutions of a purely "invisible-hand" origin. "Constructed" orders (e.g., new laws) play
an important role. Because of unavoidably incomplete information they leave gaps into which
informal rules grow spontaneously. This has to be taken into consideration if one wants to
predict the effects of new formal orders, e.g., new laws. It seems worthwhile for practitioners
working in this area to learn some game-theoretic style thinking.
Together with economics, sociology and political science experienced a revival of interest in
the theory of institutions. It is interesting for economic or legal analysts to learn the
sociological background of such everyday concepts as institutions or organizations, of social
relations, social capital, ideology – as well as by economists less applied concepts such as
social network analysis, social exchange, national culture – and simply to learn how to "look
and see".
Political scientists demonstrate that the polity and economy are a narrowly linked system –
both, nationally and internationally. This perspective is still widely disregarded by economists
in spite of the work of representatives of the new political economy like Buchanan, Olson or
the work of North. Economists’ lost their innocence once they turned away from the
principles of the classical liberal state57 in favor of some, however colored, welfare state.
Surprisingly, the application of the NIE remained so far rather limited: on the micro-level to
issues of industrial organization, on the macro-level to economic history and development
economics. Its potentialities are by far not exhausted. Extended by game-theoretic thinking
the Williamsonian and Northian new institutional economic methodology can be applied to
virtually all problems of economic life – be it on the national and or the international level. I
am particularly thinking of the present German macro-economic situation and the helpless
attempts of economists to advise politicians, interest groups and voters on the basis of good
old static or dynamic macro models (cf. Institut der deutschen Wirtschaft 2005).
57
The classical liberal state is supposed to abstain from all attention to the personal wealth of its citizens and to
go “not a step further than necessary to secure its citizens against themselves and foreign enemies; for no other
final purpose should the State restrict their freedom” (Humboldt (1792/1967, 52).
PaperNIEH24.doc 11/15/05 25
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