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Institutional Economics Summary
Summary of the course Institutional Economics in the second year of Economics and Business Economics at Radboud University
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Institutional economics SummaryLecture 1
Neoclassical economics (NE);
- Actors are hyperrational
- Markets always exits and do never fail (pareto optimal)
- Prices reflect only relevant information (no transaction costs)
- The base is the individual trying to maximize their utility under certain constraints.
- Every point of friction/tension will be worked out by the market in the most efficient way.
- In NE, we consider institutions as exogenous (as taken). Institutions in neoclassical economics can be
percepted (waarnemen) as; static equilibrium, no institutions needed/external to economic system.
! in reality, it is much more complex. Institutional economics adds realism. We use institutional economics to
understand the complexity of real-life exchanges.
The neoclassical economics is not enough to understand the complex reality.
- Neoclassical economy saw our economy as standard macro; Investments capital and knowledge
accumulation productivity growth and development.
- BUT.. in reality;
o Economic actors are embedded in particular institutional environments.
o Economic actors are not perfectly rational
o Free markets are far from being perfect, so we need governance (and thus institutions)
o Institutions govern exchange
Why do we have institutional economics (IE)?
- Institutional economics exists because of the limits of the neoclassical economics (NE). Institutional
economics is all about trying to complement neoclassical economics to overcome the failure and limits of
neoclassical economics.
- Limits of the neoclassical economics that the institutional economics wants to improve;
o Methodological individualism and reductionism; says that the relevant object of the study can only
be the individual. Collective entities can be understood by analysing the actions of the individuals,
since ‘the whole is the sum of its parts’.
o Exogenous individual preferences; that are static and don’t change over time.
According to the institutional economists, preferences can change and are influenced by
political, social or cultural circumstances.
o Instrumental (perfect) rationality; in which the individual always chooses the strategy that
maximises its expected utility.
According to the institutional economists, there is bounded rationality, since economic
actors are embedded in different cultures and contexts.
o Perfect information; for every agent in the economy
According to the institutional economists, there is imperfect information
Differences Neoclassical economics New institutional economics
Fundamental Scarcity competition efficient Scarcity competition + institutions (rules of the
assumptions, theory outcomes game) and property rights efficient outcome
Institutions Exogenous, not independent Institutions do matter
don’t matter!
Rationality Fully/perfect rationality rational Bounded rationality limited mechanism
mechanism
Exchange Costless transaction Transaction costs
Human capacity Total capacity without constraints Limited mental capacity, facing various constraints
Time Static, frictionless (smooth) world Developing, changing world
Information Perfect information Imperfect information
Intervention Anti-interventionist in a perfectly Pro-interventionist. Market failure doesn’t matter
competitive market. Government institutions are in place.
intervention because of ‘market
failure.
,What are institutions;
- According to Douglass North, they are ‘Rules of the game’, more formally, the humanly devised constraints
that structure human interaction. They are composed of formal rules (statute law, common law, regulations),
informal constraints (conventions, norms of behavior
and self-imposed codes of conduct), and the
enforcement characteristics of both.
- Institutions are systems of man-made rules
(constraints) that structure behavior and social
interaction.
o Formal institutions; everything that is
cultivated (government/firm/religious etc)
Left side of the square
state-order institutions
o Informal institutions; everything about
culture/different norms etc.
Right side of the square
Private-order institutions
Institutions Examples
Economic institutions - Market perfection
- Rule of law
- Corruption control
Political institutions - Political stability
- Political competitiveness, constraints on politicians
- Professional and political independent bureaucracy
Value institutions - Trust and openness
- Self-initiative
- Individualism and post-materialism values
Lecture 2;
Old institutional economics (OIE) = the evolutionary approach / evolutionary institutionalism
- It appeared as a reaction to Neoclassical economics (NE) and it developed quickly in the beginning of the 20 th
century.
- They criticized Neoclassical economics’ static view of the economy. The Old institutional economists
considered the economy as dynamic and evolutionary. We need to understand the historical evolution of
institutions and systems of economic exchanges.
o Imperfections are part of free markets, that’s why we need institutions to govern exchanges
o We need empirical studies to understand complex realities (a diversity of methodologies and a focus
on multidisciplinarity)
- The central goal was to understand the transforming actions of institutions and market mechanisms over
time.
In institutional economics we consider that there is a dual direction between human action and institutions.
- Institutions are the result of human action (it is construct by individuals). Once they are instituted, these
institutions influence the way we individually behave.
- The whole is greater than the sum of its parts (holistic perspective); institutions play a role in going from
individual levels to aggregate ones.
Markets and capitalism are historically constructed with the following characteristics;
- Means of productions are privately owned
- Production for the market
- Profit oriented
- Profit motive
A market is a fundamental institution for the capitalist system to function. We need state intervention to turn this
market process towards the public purpose because markets were focused on self-interest.
, This dynamic approach resulted in two perspectives of economics;
Formal view of the economy; economics is the logic of rational action and decision-making, as rational
choice between the alternative uses of limited (scarce) resources.
Substantive view of the economy; an instituted process of interaction between human beings and their
natural and social environment.
Why do we organize the economy a certain way?
o Markets results from an institutional process.
Institutional economics explains how it is an accumulation through history that led to the
creation of markets. Markets are a type of institutions that have been built over time by
individuals and the society.
Ways to exchange
- Reciprocity; exchange between social entities for mutual benefit
o A B or B C or C A (multilateral exchanges in the society)
- Redistribution; the government raises taxes and redistributes wealth for social equality
o A <-> B or A <-> C or A <-> D etc. (A is the central authority, BCD are citizens citizens are giving
money to the government and the government redistributes to the citizens)
- Exchange; exchanging products for a particular price on markets
o A <-> B (exchange between two entities)
- Householding; about producing for yourself and for your family
o A A (when you produce for yourself)
- Locus; a particular position or place where something occurs or is situated.
- Dynamic; how the exchange works
- Motive; why we exchange
- Governance; the rules/control for the exchange
- Subjectivity
- Object; what is exchanged
- Loci classici; example
New Institutional economics (NIE); refining neoclassical economics with the understanding of institutions.
o Williamson, Coase, Hayek, Simon, Arrow, North, etc.
- We focus on New Institutional Economics when our economy is mainly about markets and capitalism. We
are concerned about exchanges in markets and opportunism of individuals.
o Douglas North; ‘Institutions are the rules of the game’
- It is a mix between Old Institutional Economics and Neoclassical Economics
- According to NIE, economics is the logic of rational action and decision-making, as rational choice between
the alternative use of limited (scarce) resources.
o How to conceive institutions to make economic exchanges efficient?
o Problems of market failures (transaction costs, bounded rationality, incomplete contracts)
- Game theory is an important method in New Institutional economics (It is not as simple as NE says)
o Game theory; an example of interdependent
decision-making, where your ultimate choice
depends on what others are going to choose.
o Prisoner’s dilemma;
Nash Equilibrium; optimal outcome after
considering an opponent’s choice.
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