The New Institutional Economics

First Quarter 2003

by Gerald W. Brock

Gerald Brock, Professor of Telecommunication at George Washington University, is the author of a very helpful introduction to what is called the New Institutional Economics (NIE). His article, by that title, appears in the Spring 2002 issue (no. 39) of Faith and Economics, a review published by the Association of Christian Economists. The NIE is decidedly pluralistic in its approach to economic life, paying close attention to a diversity of institutions, practices, and underlying conditions for economic activity. Among other things, those who have given shape to NIE ask serious questions about human nature; about the cultural and religious roots of society; about the identity of and reasons for firms and enterprises; and about the essential economic conditions established by law and government policies. These concerns are precisely the ones that gave rise to this series of articles. The following edited text has been excerpted from Dr Brock 's article.—Ed.
 

The essential idea of the New Institutional Economics (NIE) is that the success of a market system is dependent upon the institutions that facilitate efficient private transactions. Chief contributors to the emergence of NIE have been Ronald Coase, Oliver Williamson, and Douglass North [note publications listed below]. The NIE does not assert that neoclassical theory is wrong, but simply that it is incomplete. When institutions work well, they can be largely ignored for economic analysis and standard neoclassical arguments remain valid. However, when institutions work poorly, they must be considered explicitly. The NIE is not really a separate field or approach, but is a new focus and definition to matters that have been earlier considered under the categories of law and economics, applied industrial organization, public policy studies, and other specialties.

The NIE sees greater uncertainty in the world than neoclassical economics. It assumes that people do not know the possible events of the future in order to construct probability distributions about them and do not necessarily perceive the current or past states of the world in the same way. Economic agents with bounded rationality facing great uncertainty use both ideologies and institutions to structure their world and to focus their decision making on a limited set of alternatives. The world is complex enough that inconsistent ideologies may continue to exist without their proponents perceiving any contradiction between their ideology and their empirical observations. The NIE maintains that people make rational decisions within their own frameworks, but that those decisions may appear irrational to a person with a different understanding of the world.

Four Levels of Analysis

In Oliver Williamson's description, the NIE consists of four different levels of analysis. Each level has a controlling influence on the level below it and there are also some feedback effects from lower levels to higher levels. The highest level is called "embeddedness" or "social theory." It includes informal institutions, customs, traditions, norms, and religion. That level changes very slowly and does not have a; rational maximizing character, but does significantly affect both the shape and the operation of the lower levels.

The second—next highest—level is the institutional environment or formal rules of the game, including the formal rules of property ownership and judicial recourse for settling disputes. The third level is governance or play of the game, including transaction costs to align governance structures with the nature of transactions. The fourth level is resource allocation and employment or neoclassical economics with its continuous maximizing activities.

The NIE recognizes a much more fundamental place for religion than the standard economic approaches. Religion is a fundamental characteristic of a society and influences the institutions that are created and the operation of those institutions in controlling economic activity. While it is correct to place religion in the controlling rather than derived role, the difficulty with the current formulation is that there is very little specific content to the category. It would be useful, therefore, to clarify specific connections between religious beliefs and the operation of the economy.

The NIE also opens the way to a more adequate understanding of human persons, refusing to treat them as merely selfish utility maximizers. Further improvements could come from a more accurate understanding of persons as the Bible and Christian theology portray them. The NIE not only provides specific insight into the factors other than capital and labor that affect the success of the economy but also emphasizes that economic problems are complex and not fully explained by any particular economic model. Bounded rationality applies to economists who provide advice as well as to the economic agents assumed by the NIE. We should not refuse to provide advice because of the risk that following our advice will lead to bad results, but should work diligently to understand the problems as thoroughly as possible before offering advice on how to improve matters and recognize that there may be relevant factors not included in the standard form of economic analysis.

Evaluating the NIE

I find the NIE useful in my work as an applied economist concerned particularly with telecommunication policy because it provides a way to integrate my understanding of market economies and government actions. It allows the utilization of the wide range of tools from mainstream economics while also providing a substantial role for the government and other institutions. It allows the development of policy prescriptions and implementation strategy in a more unified framework than the practice of developing the economic analysis in a "pure economic" neoclassical manner and then trying to decide what implications that has for policy.

While I do not view the NIE in itself as any more or less Christian than alternative approaches to economics, I think the NIE does provide a useful framework and some useful lessons for Christian economists. As a framework, the NIE explicitly assumes that religious beliefs and culture affect the economic institutions and the operation of the economy, but the exact form and empirical relevance of those connections has not been fully developed.

With regard to the role of the government, the NIE teaches that government has a critical role in a smoothly functioning economy. Adam Smith's invisible hand is not an automatic force that turns self interest into mutually beneficial trades and increased welfare if the government will only stay out of the way. Markets only function well when embedded in a set of institutions that define and enforce property rights and resolve disputes peacefully. Governments can also be harmful to the economy and create incentives to dissipate resources on redistributive activities. Many conservative Christian writers have emphasized the harm that government can do and advocate minimal government. Alternatively, some Christian writers have advocated a much greater redistributive role for the government with an implicit assumption that the redistribution can be undertaken without cost. The NIE does not provide a specific guide as to the proper size and role of the government, but it does show that the interaction of government and the economy is complex and provides tools to help in understanding the role of the government in particular cases.

With regard to improving the economic prospects of low-income countries, the NIE analysis suggests that there is more room for improvement in many economies than would be expected from neoclassical economics. Neoclassical economics assumes that individual optimizing decisions and mutually beneficial trades occur easily and automatically and that, consequently, economies are always operating on some kind of a maximum position. The NIE suggests that the combination of bounded rationality, opportunism, and institutional flaws may cause an economy to operate far below its potential. The wide gap between actual and potential performance means that careful economic analysis and advice could create great benefits. Additional capital is neither necessary nor sufficient for improved economic performance. Thus getting the analysis right is very important as well as very difficult.

For further reading:

Ronald H. Coase, The Firm, the Market and the Law (University of Chicago Press, 1988).

Douglass C. North, Institutions, Institutional Change and Economic Performance (Cambridge University Press, 1990).

Oliver E. Williamson, The Mechanisms of Governance (Oxford University Press, 1996).

_____, "The New Institutional Economics: Taking Stock, Looking Ahead," Journal of Economic Literature, vol. 38 (September, 2000), pp. 595-613.

Other articles in this series:
First: Law, Politics, and Corporate Enterprise (1st Q., 2002)
Second: What is Corporate Enterprise? (2nd Q., 2002)
Fourth: Owning Capital or the Enterprise? (3rd Q., 2003)