New Institutional Economics: A brief introduction

By Pritika Fernandes

An understanding of human institutions is imperative for understanding and creating policies and rules that govern it.

Much like scientists attempt to understand the working of the physical world in order to control and predict outcomes, social scientists have attempt to understand and explain the complex nature of human behaviour and interactions in order to control and predict the outcomes of such interactions. Institutions form the structures upon which societies are built and are run by and hence are studied in order to either identify structures that work well and hence one would want to replicate or to identify structures that need to be dissolved or even to identify the need for structures where none previously existed.

Institutions are defined as mere constructs formulated by humans over time to bring about order in the structure of social, political and economic transactions (North, 1991). Since time immemorial institutions have been set in the bid for social order. These structures have been in the form of informal institutions such as social norms, taboos, customs, and traditions and also in the form of formal institutions like laws and constitutions. The need to find the method in the madness, the want to reduce uncertainty all arise from the want for profitability, for the feasibility of economic transactions, social interactions which must all adapt and function under the purview of political structure and stability. Institutions are a result of a continuous evolution of a society with changes arising from mistakes and triumphs of the past, needs of the present and aspirations for the future.

Reviewing the blueprints

Reviewing the blueprints

In the realm of economics, the study of the flows of and structures of production, consumption, and distribution of goods and services there lies a wicked problem. A problem that is complex because of the continuously changing characteristics of its nature, its complex interdependencies that would lead to a new problem when one aspect if the problem is dealt with. The method to tackle such a problem was to break it down. To focus of smaller aspects of it in order to turn the wicked problem into a tame one, a problem that can be easily defined and hence easily tackled. The deep interdependence on political, social, anthropological, psychological effects on those simple acts of production, consumption, and distribution was so complex that it needed to be broken down and turned into a tame problem. Hence assumptions were made, assumptions of perfect information, rationality, and the universal want for profit maximization (Kapp, 1968) Main stream economics is built on the foundation of these assumptions and more. As a result, economics over time has been growing more and more abstract. Economists study the relation between the demand and supply of goods and services but fail to take into consideration the reason behind those particular goods and services being traded and in turn their price levels. The economic phenomenon studied in books are seldom observed in real life. The success of main stream economics despite these flaws is solely due to the theoretical underpinnings it abides by which although strong on theory is weak in facts (Coase, 1998).

New institutional economics arose from this disconnect between theory and reality. A productive economic system leads to a healthy flow of goods and services and in turn increases the welfare of human society. Adam Smith talked about productivity being dependent on specialization of labour however specialisations of this kind lead to the need for exchange. The costs of exchange or transaction costs dictate the level of specialisation with higher costs leading to lower levels of specialisations and vice-versa. Transaction costs are furthermore costs dependent on the institutions of a nation and hence institutions run the performance of a nation (Coase, 1998). The recognition of the importance of the existence and effects of transaction cost as well as property rights have led to the formation of this branch of economics.

Pritika Fernandes (@pritikafernan) is an intern with the Takshashila Institution and is pursuing her masters in applied economics from Christ University, Bangalore.