New Institutional Economics (as opposed to the old “American Institutionalism”), has its origins in Ronald Coase’s “The Nature of the Firm” (1937). It seeks to get past the inability of mainstream economics (primarily microeconomics) to apply their theories to what goes on in the real world. The focus of NIE is the manner in which institutions in society determine transaction costs, and transaction costs determine economic growth. Adherents to the school study the behaviour of institutions, and how institutions change over time.

What is meant by institutions is “man-made restrictions of human interaction” (Douglass C. North). They are the constitutions, laws, customs, moral and ethical rules that determine or regulate the behaviour of individuals, groups, firms and societies. Crucially, an institution is defined as a rule AND its enforcement mechanism.

The Nobel prize winner, Douglass North, described the existence of formal and informal institutions – the former being written laws and constitutions, the latter non-codified social norms. Both have equal importance. Historically, many societies have lacked a codified legal system, but this does not mean they were lawless. They may instead have had strong informal institutions government human behaviour.

Similarly, Kiwit, D. and Voigt, S (1995) separate internal and external institution. Internal institutions are those which are enforced by private actors in the system, and external institutions are those which rely upon enforcement by the state, with its monopoly of the use of force. This separation is important because historically, the existence of a state which holds a monopoly on the use of force cannot be taken for granted.

Whilst mainstream neoclassical economics views us (all individuals) as rational egoists, NIE sees us as creative egoists who are only boundedly rational. Our rationality is bounded in the sense that we never possess all the information that may be relevant to the economic decisions we make, and so economists should not assume all our decisions are always perfect. Instead, individuals make up for their lack of rationality with creativity – over time we experiment with different solutions to given sets problems. We try and make our choices economically efficient through using the combination of our past experiences and what imperfect information we possess, via a theoretically infinite process of trial and error. Therefore, we can never actually hope to maximise utility.

NIE holds that what is exchanged in the market is not goods, but rights which apply to them. This may include “Usus”, the right to use a good, “Usus fructus”, the right to enjoy the returns of the good (i.e. interest on money), and “Abusus” - the right to change a good’s appearance, substance or location.

When people talk about “private property”, they are referring to a very wide bundle of property rights, but often individuals do not have quite the range of property rights they believe they have. For example, although individuals may refer to their homes as their own “private property”, it may be the case they require the permission of the local authorities if they wish to knock down their house, or else to build extension in their garden. There may also be restrictions on what otherwise legal commercial activity one is allowed to carry out from ones home – you may need permission to let out rooms of your house to tenants, and one is not normally allowed to run a shop from ones house if it is in an area designated as residential by the local planners.

Private property is however important in the manner in which it internalised externalities. Economic activity is under normal conditions frustrated by actors not experiencing the consequences of their behaviour. The result of this is economic goods may be under provided where the producer does not see the benefit of his endeavours, and economic bads (crime and pollution) are over provided, as those responsible for them do not suffer the full consequences of their actions.

Private property is one manner in which externalities can be internalised. If the producer of a good has full ownership of what he produces, including the right to sell it and enjoy the benefits of his earnings, then he will produce that good at the socially optimum level. Suppose there is a river that runs by the producers factory, which a village down stream uses for drinking water. If the villagers have property rights over the river, they will be able to force the factory owner not to pollute the river, or to compensate them fully for the harm caused by the pollution. This will ensure that pollution occurs at the socially optimum level – the factory owner will only pollute the river if it reduces his costs my an amount greater than what he must pay the villagers.

However, the draw back to this is transaction costs. To exchange property rights individuals incur search costs whilst trying to find a partner, negotiation costs when devising a contract, and enforcement costs in making sure that the contract is not broken. All these three together make up transaction costs.

Transaction costs determine the level of benefits which can be experienced through trade. They themselves are determined by the level of technology available, and the social institutions which govern human actions.

Institutions change as a result of individual and collective decisions. When the state of technology or the availability of different factors of production change, there may emerge a situation where society as a whole would benefit from a change in institutions. However, institutional change may be costly, and requires collective action in the face of what may be determined individuals who benefit from the status quo. This gives institutions the characteristic of being conservative, frequently lagging behind the needs of the day.

Nonetheless, returns to land, labour and capital are different under different institutional conditions. As relative factor prices in the economy change, and new technology becomes available, the interests of different groups in society change and the result can be pressure for a change in institutions, resulting in political upheaval, or revolutionary change. If all goes well, this change leads to a decline in transaction costs, and allows the factors of production available to be used more intensively, driving forward economic progress.


R. Coase,

O. Volckart - Central theoretical elements of NIE, What are New Institutional Economics (NIE)? A brief introduction, What view of man and society is at the basis of NIE?

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