It's the Institutions, Stupid

I am currently taking an economics course with a professor whose primary research areas are Fair Trade Coffee, economic organization in agrarian communities, and New Institutional Economics, or NIE. Here is a 2007 article (.pdf) about some of Matt Warning's work from Fresh Cup Magazine.

I thought I would survey some of the important theorists who are known for their work in the NIE perspective because I find it fascinating and I'd like to know more about it myself. The underlying focus of NIE is to show that "neoclassical" models which demonstrate institutions as either 'efficient' or 'inefficient' may not predict actual market preferences when we take into account other concepts that neoclassical models take for granted.

The success of NIE in many ways is the discovery of the many exogenous institutions that neoclassical economics took for granted, and providing modeling tools which have developed to accommodate concepts hitherto unfriendly towards models. This has sparked research in lots of areas, and spawned a new generation of researchers with NIE tools at their disposal. The the addition and contemplation of effects like 'transaction costs' and 'informational economics' are probably NIE's greatest contributions.

Here are just a few names from various disciplines within economics that have been effected by the NIE perspective.


Economics of Information


George Akerlof, Michael Spence and Joseph Stiglitz won the 2001 Nobel Prize in economics "for their analyses of markets with asymmetric information". Akerlof is probably best known for his "Market For Lemons" (.pdf) article in which he showed that owners of better products are less likely to sell their products in 'used' markets because of asymmetric information problems. The market for "lemons" is supposed to not exist according to a neoclassical analysis. But with an institutional analysis (with institutions like warranties) the problem is allegedly solved. Stiglitz, former Chief Economist at the World Bank wrote a series of diatribes against the Bank and the IMF, but is known in academic circles for his research on screening and information asymmetry. The breadth of his work is far-reaching as his latest book (and blog) about the Iraq War testifies. Spence is most known for developing the "job market signaling"(jstor) model which discusses ways that agents (employees) can convey information to principals (employers).


Transaction Cost Economics (TEC)


The first time the notion of "transactions costs" came up was in Ronald Coase's book The Nature of the Firm (1937). There it was explained that a firm would decide to 'outsource' production or services, etc. when the cost of providing them within the firm were too high. These costs were identified primarily as transaction costs, and the concept has since migrated to lots of other places in economics. Oliver Williamson was actually the first economist to call what these academics do "Institutional Economics". A student of Coase, Williamson pioneered concepts like information impactedness and the incomplete contracts approach to microeconomics and corporate finance. Finally, the other big name here is Douglass North. He is just an amazing economist who among other things brought the department of economics at the University of Washington fame for economic historianism.


Social Capital


Social capital theory in economics came largely out of transaction costs economics. One way to measure it is by looking at the depth of contracts and strength of social networks. For example, if a contract specifies every possible breach one can think of, then the context in which the contract arose is probably low in social capital. If a contract specifies very few possible breaches, social capital may is probably high. The key point: the cost of low social capital is a transaction cost. Though he is not an economist, Robert Putnam, author of Bowling Alone, is the leading pioneer of this perspective.


New Social Economics


An economist from the Chicago School is most known for pioneering this work. In 1992 Gary Becker won the Nobel Prize in economics for various applications using the NIE methodology, including ideas like the microeconomics of fertility, which dissected the decision to produce offspring into questions about old age security, altruism and manipulation. He also came up with the "rotten kid theorem", the "economics of discrimination", and was given the Presidential Medal of Honor in 2007 by George W. Bush. The work of Becker and many others spurred an interest in family economics, the economics of suicide, and other subjects formerly talked about only in psychology or sociology departments.


Critique of the Neoclassical Paradigm


The research of NIE has consistently over the years demonstrated that neoclassical models of economic behavior are insufficient. When we analyze decisions essentially in terms of price and marginal utility alone, without considering their institutional context, we yield results that are often nonsensical. In the market for lemons example, the neoclassical model suggested that nobody would buy or sell cars because of the problems it generated. But the institutional models add the context necessary to understand why markets are actually possible.

There are plenty of other theorists in this perspective not discussed here. Topics in the New Economic History include Robert Fogel's analysis of slavery as an institution. Topics in Political Economy are covered by Malcolm Rutherford.


For further reading:


International Society for New Institutional Economics -->
Ronald Coase Institute -->