A Critical Appraisal of New Institutional Economics

Written by Siyaduma Biniza *

New Institutional Economics (NIE) can be characterised as a neoclassical response to explain market failure. NIE operates in vast areas in order to endogenise and explain the influence of the non-economic (institutions) on the economic (exchange) in relation to market failure. From Akerloff (1970) whose work sought to explain why the market for lemons (second-hand cars) led to the failure of the market for new cars, to Keynes who contributed an understanding that states are important in the macro economy, to North (1991) whose work sought to reintroduce the importance of history and the path-dependency of institutions this theme is a common thread. So some of the main assertions are that exchange is determined by costs and benefits and when transaction costs are too high, no exchange occurs; or that exchange fails because there is an asymmetry of information between buyers and sellers. Therefore individuals establish institutions in order to minimise the cost of transactions or to balance informational asymmetry. Institutions can be understood as rules governing exchange which can be embodied by organisations or social norms. In sum, the presence of transaction costs and informational asymmetry is seen as a contradiction or inimical to perfectly functioning markets; and institutions are established to create perfect markets conditions which include minimal or no transaction costs and perfect information. I argue that the greatest contribution of NIE is that it allows us to understand how and why markets do not function perfectly. However what classifies as an institution is weakly defined. Moreover, even when there is a clear definition of an institution, such as perhaps a state, the variety and uniqueness of institutions across geographies, cultures and ideologies makes it difficult to theoretically define institutions. This is closely associated with the lack of a theory underpinning the function that institutions are given in NIE and the fact that there is no underlying theory that can explain the relation between and amongst institutions themselves. Thus NIE, which has been referred to as a mid-range theory, requires a deeper theory and its acquiescence to neoclassical economics does not adequately serve this purpose. This paper begins with a brief history on the emergence of NIE and explains NIE and its place in the discourse of economics. Then I unpack the two central principles of

methodological individualism and the role of institutions according to NIE. Throughout this paper, some of the arguments are illustrated through various examples of the state, which is a ubiquitous institution. The evolution of economics into what it is today has been greatly impacted by the Marginalist and Formalist Revolution. This revolution was significantly driven by the writings of Walrus, Jevons and Menger whose work contributed towards the dehistoricising, de-politicising and de-socialising economics; and the introduction of methodological individualism and mathematisation of economics (Milonakis & Fine, 2009a; Blaug, 2003). Tthe outcome was that economics became deductive, mathematical and embraced the foundational principle known as methodological individualism which asserts the pre-eminence of the individual over the collective in defining society and human behaviour; and therefore society became an aggregation of individuals (Milonakis & Fine, 2007). But this cannot explain behaviours that are inconsistent with the permissible individuals behaviour, such as collective behaviour and social norms. The dominant contemporary form of economics, neoclassical economics, only permits one motivation, or criterion, for human behaviour and choices which is the maximisation of utility (Varian, 2010). As a result, all behaviour and the economy are seen as a consequence of individual behaviour and choices which is defined as individualistic-utility-maximising. This is the way in which methodological individualism underpins neoclassical economics. However this is at odds with methodological holism which is the notion that individual behaviour is not the only source of human behaviour and that behaviour and choices are affected by structural characteristics such as history, society and politics. These considerations are no longer present in neoclassical economics. Moreover, neoclassical economics cannot explain many choices and human behaviour which seems to undermine the individualistutility-maximisation principle such as individuals decision to follow social norms even when dissent would result in higher utility (North, 1991). Group choices, altruism and adherence to social norms that lead to less than optimal utility for the individual are some of the classes of actions and human behaviour which fall under the definition of being non-individualistic-utility-maximising actions. These actions can be explained using historic, political and social considerations as part of the

decision-making matrix but neoclassical economics cannot account for these considerations because of its ahistorical, asocial and apolitical nature. Thus, NIE can be seen as a mid-range theory because it seeks to address the challenges of bridging the gap between agency, defined by neoclassic-economics-type methodological individualism, and structure as defined by structural approaches which require methodological holism (Milonakis & Fine, 2007). In this way, NIE can reintroduce the historic, political and cultural back into economics to explain the non-individualisticutility-maximising actions. NIE introduces the historical, political and cultural through the use of institutions which are defined in various ways. For example, institutions have been defined as humancreated solutions to the problems of asymmetric information and high transaction costs, which undermine markets resulting in market failure since these problems violate the neoclassical assumptions necessary for perfect markets (Akerlof, 1970). Or in the same vein, they have been defined as human-made ways of reducing the transaction costs of exchange due to uncertainty and asymmetric information since these too violate neoclassical assumptions of perfect information and no transaction costs which are definitive characteristics of markets according to neoclassical economics (North, 1991). Therefore, NIE has the central assertion that the existence and functioning of institutions is defined by the rational decision-making of individuals in order to facilitate market mechanisms or remedy market failures. So in a way individuals create rules to govern exchange whenever perfect market conditions do not hold. In other words institutions can be understood as consequences of market imperfections according to NIE. Alternatively institutions can be seen as human-made solution that helps in the functioning of markets meaning that sometimes markets depend on institutions. Institutions are defined as being either formal, such as a judicial system, or informal such as social norms or even language which serves the purpose of reducing transaction costs or overcoming informational asymmetries (North, 1991). Without interrogating the validity of this distinction I wish to point out that institutions are really just anything that has historic, social or political significance. And the central principle is that institutions are conducive to perfectly functioning markets. This is a controversial principle because it implies institutions, which include language, religion and art, are only utilised in the promotion of a perfect market environment.

Although institutions are asserted as helping towards the functioning of perfect markets, the variety of institutions makes it impossible to theoretically define how institutions in general function towards this end. For instance, a state might assist in defining and enforcing individual property rights under a capitalist democracy, which can intuitively be understood as functioning towards the asserted end of institutions; but a socialist or communist state might define and enforce collective property rights which cannot be intuitively understood as being conducive to perfectly functioning markets. Therefore, although institutions have been defined to function in a very specific way in NIE, the institutional mechanisms that contribute to this function are undefined. Nevertheless, NIE is an attempt to show how the historic, social and cultural impact the economic since these considerations have been removed from contemporary economics as discussed above. Consequently, the weakness of neoclassical economics is that it cannot define or account for the impact of institutions in any adequate way. Despite this, NIE takes neoclassical economic principles as a foundation. Also, NIE is a supplement to neoclassical economics since it tries to expound on the role of the noneconomic in explaining decisions that are non-individualist-utility-maximising. By noneconomic I mean those exchanges that cannot be explained in the framework or understanding that is given by neoclassical economics. As discussed above, NIE relies on methodological individualism even though NIE tries to respond to the various challenges associated with non-individualist-utility-maximising decisions, which cannot be explained in the neoclassical framework. However, the challenges that NIE tries to respond to are logically related to the failure of methodological individualism in explaining all rational decision-making; but as Milonakis and Fine (2007) argue, NIE relies on methodological individualism in response to these challenges. The existence and functioning of institutions is defined through rational decision-making of individuals or externally given without any explication in any NIE theory (Milonakis & Fine, 2007). Therefore NIE is acquiescent to neoclassical economics and logical framework. Thus there are two central principles in NIE namely, methodological individualism which is important in the existence and functioning of institutions since institutions arise as a consequence of rational utility-maximising individuals; and the perfect market inducing function of institutions which is an implication of the former principle.

NIE is ideologically acquiescent to neoclassical economics because it relies on methodological individualism. That means that institutions are simply the aggregate of individuals and the function of institutions being the maximising of individual utility (Milonakis & Fine, 2007). Institutions maximise the utility of individuals by encouraging perfect market conditions or remedying market failures. But there is a dimension where institutions are not just instrumentally useful in maximising the utility of the individuals. Institutions also act as agents thereby maximising their own utility instead of simply maximising the utility of their constituent individuals. This is necessary since without this qualification, NIE would not be able to account for persisting inefficient institutions (Milonakis & Fine, 2007). If institutions simply sought to maximise utility of individuals the persistence of inefficient institutions would be undermined. By inefficient I mean those institutions that do not function according to the way NIE defines institutions which is that they do not maximise the utility of constituent individuals or the individuals that created them. There are many inefficient institutions such as failed states which would not persist unless institutions are allowed to pursue their own utility. Therefore we can understand that poor states utilities are maximised by them getting re-elected which means that they would provide a minimal efficient amount of public goods and other Weberian state privileges because the provision of these privileges would lead to inefficient outcomes for the state. Hence failed states would not necessarily maximise the utility of its constituency even if public goods and other Weberian state privileges would lead to this. However if this is the case, NIE does not explain how this would occur. If we allow that institutions can have their utility maximised through actions that are not aligned with, and even opposed to, the maximally efficient actions for its constituency; the theory needs to have a deeper theory that explains how this happens. Moreover, this does not seem consistent the acquiesced foundation of methodological individualism because the collective would simply be the aggregate of its individual parts. This means that, given methodological individualism, all institutions should act in a manner consistent with the aggregate of their constituent individuals. But as history shows, this is not always the case. To continue with the example of the state (as embodied by government) and its constituency (as embodied by the citizens) methodological individualism cannot explain actions by states such as Apartheid South Africa which oppressed the majority of its citizens who were black Africans.

Nevertheless it can be contended that the actions of Apartheid South Africa are consistent with the underlying theory because the power was centralised in the minority for whom the oppression of the majority maximised utility. However, even if this is true, NIE cannot explain the transition to a democratic South Africa using its methodological individualistic foundations. One could argue that international pressures and the uprising of the black majority altered the utility maximisation matrix of the Apartheid state which lead to the political settlement. But this cannot be explained in NIE because there is no deeper theory to explain the interaction between institutions which presumably led to the transition to a democracy in South Africa. This is a weakness of NIE because it does not have a deeper theory that can account for the transition and even the action of institutional actors. Moreover, its acquiescence to neoclassical economics by using methodological individualism as a foundation cannot reconcile this limitation. However, this can be resolve through a deeper theory underpinned by methodological structuralism. Methodological structuralism would allow for the primacy of institutions in defining the decision-making actions of an individual in as much as those actions also define the institutions (Milonakis & Fine, 2007). In other words the relation between the action of an agent and the structure would be reciprocal. However the fact that NIE accepts methodological individualism as the starting point means that it doesnt allow for methodological structuralism. But this weakness of NIE does not mean that NIE has no strengths. NIE offers a way to understand why markets fail however rudimentary one might see that as being. Do we really need a theory to tell us that neoclassical assumptions do not always hold since the assumptions of neoclassical economics have been repeatedly criticised as being removed from reality? Nevertheless NIE shows, that because the assumptions of perfect information and costless transactions do not hold in reality, institutions have an influential role. This offers a way of understanding, at least for neoclassical economists, that history, politics and society has role to play in economics. Hence, the perfect market conditions can be understood as one possibility. However NIE goes a little further than that and adds that perfect market conditions are an ideal. Hence the assertion that institutions are used to resolve market failure in pursuit of perfect markets.

Therefore NIE asserts a very specific role for institutions. Institutions exist to lower transaction costs and reduce informational asymmetries thereby inducing perfect market conditions (North, 1991; Akerlof, 1970). This is why institutions can be understood as a consequence of market failure or as aiding the perfect functioning of markets. And this falls well within the NIE acquiescence to methodological individualism and neoclassical economics because this function of institutions implicitly assumes that perfect markets have maximal allocative efficiency in exchange. In other words, since individuals seek to maximise their utility and because perfect markets are seen as necessarily leading this outcome, according to NIE institutions are thus created to allow for perfect market conditions. But this is controversial claim given the breadth of what is considered an institution. It is difficult to undoubtedly assert that the development of cultures, society and politics, encompassing all non-economic activities, exists to pursue the perfection of markets. Firstly this assumes that capitalists markets, as defined in neoclassical economics, exist universally and that they are maximally efficient across space and time. This implies that a modern Western society would create institutions that function the same way as those of an enclave society in the Amazon in pursuing perfect market conditions which is not the case given that capitalist markets do not exist in remote places of the Amazon. Secondly, since there is no definitive boundary on what can be classified as an institution, this implies that things such as language, religion and art, are utilised in promoting a perfect market environment. This is simply absurd since it is plausible that those institutions have nothing to do with economic life and instead have something to do with human expression or non-economic. Furthermore, these institutions can be, and have been, utilised in the destruction of markets. Therefore NIE needs a theory explaining when and under what conditions these institutions encourage perfect markets. Moreover, institutions can exist separately from economics but the weak definition given for institutions does not allow for a distinct understanding of which institutions are related to economic life and which are not. However NIE and other forms of institutionalism simply end at the point of institutions relevance to economic life. This brings me to my last point which is that the asserted function of institutions greatly narrows human activity by focusing on how institutions and their creation simply relates to economics. This should not come as a surprise though given that various NIE writers have submitted all other areas of life to

the economic, interpreted many phenomena as being economic and been characterised as economics imperialism (See Milonakis & Fine, 2009b; Becker, 1968; Becker, 1991) . Again, keeping with the example of a state, the NIE function of institutions is challenged by the diversity of institutions even if we take one form of institution. In other words, even if when we analyse one form of institution, the variety of actions taken by one form of institution are not always consistent with the asserted function of institution. For instance, a state might assist in defining and enforcing individual property rights under a capitalist democracy, which can intuitively be understood to function towards reducing transaction costs thus aiding the functioning markets (North, 1991; Coarse, 1960), but under a socialist or communist state might define and enforce collective property rights which cannot be intuitively understood as being conducive to perfectly functioning markets. NIE offer neither a theory of when institutions induce or encourage perfects, nor does it offer any conditions needed for functions to operate according to the NIE assertion. But it may be contended that markets do not simply function with perfect markets as an end, and instead function in order to maximise the utility of individuals. Yet still this does not avert the theoretical challenges associated with methodological individualism as discussed above. However, the role of the state represents area where there has been considerable work done by NIE in this regard. The development of the macro-micro economy distinction following the work of Keynes is evidence of this. But no other institution has garnered this much attention except indirectly in branches such as behavioural economics. Nevertheless, with regards to the state as an institution, NIE has gone to great lengths and contributed greatly towards the economic discourse. However a consequence of this focus on the state has dichotomised the economics discourse as evidenced by the public-private, state-intervention and capital-labour debates. Many institutional economic theories focus on two diametrically opposed institutions even though there is a myriad of institutions. A final response to the previous example of a democratic and socialist state might be that the difference between the states used in this example is that they are founded on different ideology which proves the point about the significant of institutions; moreover, even though both states would not strictly pursue perfect markets they

reduce transaction costs and asymmetry of information somehow. This brings the spotlight towards the elephant in the room how do institutions relate to one another? In this example, how does the ideological institution relate to the political institution in the state? Moreover, how does the interaction or relations between and amongst institutions affect their net effect in reducing transaction costs or informational asymmetries? Therefore NIE does not offer any deeper theory on how institutions relate to one another. Surely in reality the myriad of institutions interact with one another. For instance the institution of political rhetoric has to have some relation to the institution of bureaucratic norms and governance in the interactions between state and citizenry. So when the state promises certain things to citizens these promises have to be related to the ambit of state capacity. But this is not explained in NIE and institutions seemingly operate in vacuums which is problematic. Institutions are weakly defined, and even if we have a clear definition of an institution the variety and uniqueness of institutions, makes it difficult to offer a widely and theoretically applicable definition of an institution. Moreover, there is no explanation as to how institutions affect one another. However, NIE offers an understanding as to why markets fail but it has limitations in its fundamental principles. Firstly, its fundamental principle of methodological individualism cannot convincingly account for collective action; and is challenged by the aggregation problem since institutions do not always act consistently with the aggregate behaviour of their constituent individuals. Also, methodological individualism cannot explain the evolution of institutions. But this challenge can be overcome with an underlying methodologically structuralist theory. Secondly the function given to institutions is challenged by the uniqueness and diversity of institutions which means NIE cannot offer a theoretically decisive definition of their function or their characteristics. This means that even though institutions may matter when markets are not perfect, institutions may not matter in the way that NIE asserts. In conclusion, the greatest contribution of NIE is that it allows us to understand how and why markets do not function perfectly. But NIE is limited by its principle of methodological individualism due to aggregation of problem since we observe institutions that do not pursue the maximisation of the constituent individual utilities and some institutions that do not pursue perfect markets. Furthermore the relations

amongst institutions are not expounded upon. Thus NIE, which can be seen as a midrange theory, requires a deeper theory and its acquiescence to neoclassical economics does not adequately serve this purpose.

Bibliography Akerlof, G.A., 1970. The Market for 'Lemons': Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics, 84(3), pp.488-500. Becker, G.S., 1968. Crime and Punishment: An Economic Approach. Journal of Political Economy, 76, pp.169-217. Becker, G.S., 1991. Habits, Addictions, and Traditions. Working Paper No. 71. Chicago: Center for the Study of the Economy and the State University of Chicago. Blaug, M., 2003. The Formalist Revolution of the 1950s. Journal of the History of Economic Thought, 25(2), pp.145-55. Coarse, R., 1960. The Problemof Social Cost. Journal of Law and Economics, 3(1), pp.1-44. Milonakis, D. & Fine, B., 2007. Douglass North's Remaking of Economic Histrory: A Critical Appraisal. Review of Radical Political Economics, 39(27), pp.27-57. Milonakis, D. & Fine, B., 2009a. Chapter 6: Marginalism and the Methodenstreit. In From Political Economy to Economics: Method, the Social and the Historical in the Evolution of Economic Theory. London: Routledge. pp.91-117. Milonakis, D. & Fine, B., 2009b. Chapter 9-10. In From Economics Imperialism to Freakonomics: The Shifting Boundaries Between Economics and Other Social Sciences . London: Routlege. North, D.C., 1991. Institutions. Journal of Economic Perspectives, 5(1), pp.87-112. Varian, H.R., 2010. Chapter 3: Preferences. In J. Repcheck, ed. Intermediate Microeconomics: A Modern Approach. 8th ed. New York & London: W. W. Norton & Company. pp.34-52.

Personal Insights and Conjecture abour Institutions Perhaps the prominence of the state-private-sector dichotomy is done to submit class dynamics and suppress the individual. The absence of a clear definition of an institution would readily lead to misclassification of institutions and even result in a plethora of institutions but the outcome in the economic and governance discourse should raise concerns. Firstly the definition of institutions is wide enough to encompass everything that neoclassical economics successfully excluded from economics through the Marginalist and Formalist Revolution. However the acquiescence of this new approach to neoclassical economics still allows one kind of behaviour which means that everything that is non-economic now has to be submitted to the economic. Secondly the preoccupation with the state is another higher-level submission of the individual under representational, coerced and even elected bodies that are assumed to act in the best interests of individuals who behave a certain way. In other words the prominence of the state and private sectors (firms) excludes the individual. Moreover, since the general individual does not feel as though firms are something he contributes towards establishing unless he is part of the capitalist class, individuals are left to take ownership in the state. But since the state does not act in the interest of non-individualistically-utilitymaximising citizens; the state benefits only some of the citizens. Thirdly, the fact that institutions are asserted as establishing rules that maximise its own utility means the state can be hijacked through the use of other institutions. Lastly, there is no mention as to the greatest institution, economics itself, and as all this occurs discussion about class struggles and labour exploitation has been replaced by discussions about which institution best serves the interest of firms. Is it the state? Is it private interest? This is a false dichotomy since both institutions work towards conditions that favour firms, which are owned by a few individuals. As all this occurs, the economics discourse is restricted to the state, firms and excludes individuals who are seen as mere consumers. The economics discourse has thus suppressed the individual and moreover, it has obscured the fact that the whole economy ends up serving the interest of firms regardless of the public-private debate. Recommended Reading: Grabel, I., 2000. The Political Economy of 'Policy Credibility': The New-Classical Macroeconomics and the Remaking of Emerging Economies. Cambridge Journal of Economics, 24, pp.1-19. Yours truly,

Mr Siyaduma Biniza
*Siyaduma Biniza is currently a B.Com. (Hon) in Development Theory and Policy student at the University of the Witwatersrand, holding a B.Soc.Sci in Politics, Philosophy and Economics from the University of Cape Town.