the new institutional economics

PaperNIEH24.doc 11/15/05 1

Revised 9 November, 2005. An earlier version appeared in: The European Business Organization Law Review (EBOR), 6:2, 161 – 200; 2005.

The New Institutional Economics - Its Start, Its Meaning , Its Prospects 1-

by

Rudolf Richter* Abstract: This article first describes the history of the use of the term "new institutional economics" (NIE) from the time it was introduced by Oliver Williamson. It shows how the term has evolved from a generic to a standard term on the basis of NIE conference issues and collective volumes which appeared between 1984 and 1997. In 1997 the International Society for New Institutional Economics was founded. Ronald Coase, Douglass North and Oliver Williamson were the driving forces of this development. In the second part of this article, the meaning of the NIE is outlined following the basic concepts of Williamson and North. The ideas of these two protagonists are compared with each other and their better known criticisms are described and assessed. The final part of the article deals with possibilities of broadening and deepening the objectives and analytic style of the NIE. The article concludes with the observation that the potentialities of the NIE are by far not exhausted.

Key words: transaction cost economics, new institutional economics of history, criticism of the new institutional economics, ‘equilibrium of game’ view of institutions, new institutionalism of sociology, new institutionalism of political science.

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This article deals with the early stages, meaning, and prospects of a field known under the name of “New Institutional Economics” - a generic term introduced by Oliver Williamson (1975, 1). It soon became a standard (or banner) under which a diverse group of economists assembled, who shared one common intellectual ground: institutions matter, the relationship between institutional structure and economic behavior requires attention, the determinants of institutions can be analyzed with the aid of economic theory.

1 Revised version of a paper written at the Hoover Institution, Stanford University, Fall 2003 and first presented at the Center of New Institutional Social Science, Washington University St. Louis, MO, USA, 4 December 2003 and later at the School of Management of the Saint-Petersburg State University, St. Petersburg, Russia 19 October 2005. Financial support of the Fritz Thyssen Foundation is gratefully acknowledged. I thank John Drobak (Washington University), Jan Kmenta (University of Michigan) and Eirik G. Furubotn (Texas A&M), Valery Katkalo and Natalia Drozdova (Saint-Petersburg State University) for valuable comments. I also thank Rainer Kulms (Editor-in-Chief of EBOR) for his thoughtful suggestions. Any remaining mistakes are the sole responsibility of the author. *Professor of Economics (em.), Universität des Saarlandes, Rechts- und Wirtschaftswissenschaftliche Fakultät, P.O. Box 151150, D-66041 Saarbrücken, Germany, e-mail: [email protected]


1. The Evolution of the Field of the New Institutional Economics Introductory Remarks: That institutions matter for economic performance is an old and inherently plausible intellectual position. However, during the first half of the 20th century, as the mathematical development of neoclassical theory has progressed and economic models have become increasingly abstract, institutional phenomena have received less and less attention. Thus, in what may be regarded as mainstream theory through the 1980s (exemplified by welfare economics and the general equilibrium models of Arrow-Debreu), institutions play virtually no role at all. In other words, it does not matter whether goods and services are exchanged by the use of money or otherwise (Samuelson 1968) or how production is organized - by the price mechanism across markets, or within a hierarchically organized firm (Coase 1937) etc. Not surprisingly, these extreme views were soon opposed by various strands of a renewed kind of economic institutionalism. Among its outstanding contributors are Coase (1937, 1960), Alchian (1961), Buchanan and Tullock (1962), Olson (1965), Williamson (1971, 1975), North and Thomas (1973) - to name but a few of the pacemakers. Linked with these names are theories such as property rights analysis, the economic analysis of the law, public choice theory, constitutional economics, the theory of collective action, transaction cost economics, the principal-agent approach, the theory of relational contracts, and comparative economic systems. Common to all these approaches is that they, unlike neoclassical economics, do not assume the institutional framework as given but make it into the object of research and also seek to consider the implications of any given institutional arrangements for economic behavior. They do not ask “What would self-interested rational actors do?”, but “How could rational actors be constrained (or constrain themselves) not to pursue their self-interest?” (G. Miller 1997, 1196). The term “New Institutional Economics” is used as a generic term by different authors for different combinations of the above mentioned and other fields. In this section, we shall briefly survey the history of the kaleidoscopic use of the term “New Institutional Economics” (NIE) to illustrate the evolution of a new and, as we are convinced, widely applicable bundle of methods of economic research.

1.2. The NIE, its First Understanding: Oliver Williamson, creator of the term “New Institutional Economics”, understands the term rather broadly. He subsumes under the NIE

Aspects of mainline microtheory, economic history, the economics of property rights, comparative systems, labor economics, and industrial organization….

The common threads tying these studies together were:

(1) that received microtheory …operates at too high a level of abstraction to permit many important microeconomic phenomena to be addressed in an uncontrived way; and

(2) that the study of “transaction” ………. is a core matter and deserves renewed attention.2 2 Among the studies that deal, directly or indirectly, with the NIE Williamson mentions (1975, 1, n.1): Alchian and Demsetz (1972, 1973), Arrow (1969, 1974), Davis and North (1971), Doeringer and Piore(1971), Kornai (1971), Nelson and Winter (1973), Ward (1971) and his own contributions Williamson (1971, 1973).


A few pages later Williamson (1975, 7) describes the principal differences between the earlier literature and his approach as follows:

(1) I am much more concerned than are prior treatments with tracing out the ramifications of bounded rationality;

(2) I expressly introduce the notion of opportunism and am interested in the ways that opportunistic behavior is influenced by economic organization; and (3) I emphasize that it is not uncertainty or small numbers, individually and together, that occasion market failure but it is rather the joining of these factors with bounded rationality on the one hand and opportunism on the other that gives rise to exchange difficulties.

Williamson concentrates in his work on what he later calls transaction cost economics (TCE), which he says is “part of new institutional economics” (Williamson 1985b, 16).

The term NIE seems to have remained largely dormant during the following five or so years. However, Leonard Silk mentioned the word in the New York Times of September 24, 1980 as a possible “new direction that will gradually draw economists away from their tired repetition of stale and sterile arguments.”3 I myself “discovered” it around the same time on page one of Williamson’s 1975 book. Shortly before I had become editor of the time-honored Zeitschrift für gesamte Staatswissenschaft (founded in 1844), at that time still a German language journal on general economics.4 I wanted to “internationalize” the Zeitschrift and looked for a suitable specialty, a niche, coming close to its original field, the “entire science of the state.”5 Public Choice and Law and Economics were already well covered by journals, thus the New Institutional Economics in the sense of Oliver Williamson appeared to be a promising choice. Eirik G. Furubotn was prepared to help me, and, without thinking twice, we started together a series of international seminars on the NIE with the aim to help the old Zeitschrift on its feet. That was in 1983. The series became known as “Wallerfangen Conference” and is held annually – with different organizers and at changing places, up till now. Papers and discussions are published in the Journal of Institutional and Theoretical Economics (JITE) since 1984.6

1.3 A Brief Interlude: Two Strands of Thought

Among the various approaches to institutional economics, two strands of thought are of interest for an assessment of the NIE. They are (by use of gentle force):

1. A line of thought from, say, David Hume (1739/40) to Carl Menger (1883), F.A. Hayek (1948, 1967), R. R. Nelson and S. G. Winter (1982), M. Kirzner (1973), D. Lewis (1969), A. Schotter (1981), R. Axelrod (1984), K. Binmore (1994, 1998), A. Greif (1998), M. Aoki (2001). This line is characterized by self-adjusting processes. Transaction costs play no explanatory role. We call it the "invisible-hand approach to institutional economics".

3 See Langlois (1986, 1). 4 Among them, after all, the 1965 paper by Reinhard Selten for which he later (in 1994) received the Nobel Prize. 5 On the German science of the state see Lindenfeld (1997). 6 An overview of the names of the organizers, topics, contents and participants of the so far held 21 NIE seminars can be found in the internet under http://www.mpp-rdg.mpg.de/oekinst.html

http://www.mpp-rdg.mpg.de/oekinst.html


2. Another line of thought leads roughly from Frank Knight (1922) and John R. Commons (1934) to Chester Barnard (1938), F. A. Hayek (1945), Ronald Coase (1937, 1960), J.M. Buchanan and G. Tullock (1962), M. Olson (1965), A. Chandler (1962, 1977), Herbert Simon (1957, 1987), A.A. Alchian (1961), K. J. Arrow (1969), O. E. Williamson (1975, 1985), L. Davis and D.C. North (1971), and D.C. North (1981, 1990), J. Knight (1992). In this approach, transaction costs (or information costs) are essential as an explanatory element. For want of a better term, we dub this line the "visible-hand approach to institutional economics".

Note: By any means, the two lines of thought are not to be taken as an indication of the historical roots of the NIE. That is a rather complicated issue which cannot be dealt with here. As for the history of the NIE itself we limit ourselves to one single question, viz., how the term „new institutional economics” evolved to an unifying standard.

1.4 The Development of the Term “NIE” to a Unifying Standard

As mentioned above, the term “new institutional economics” became a more widely known term around 1980, i.e., five years after it had been coined by Oliver Williamson (1975, 1). It took another three or four years until economists used it in topics or titles of their publications. In EconLit, the term NIE does not appears before 1984, but then increasingly in titles of journal articles, books, papers in collective volumes or conference issues.7 One simple way to feel the pulse of our profession is to read editorial prefaces. Editors are supposedly the brokers (or switchmen) of our profession. So, why not apply their judgments as a measuring instrument for the development of the use of the term NIE. Following this strategy, I am going to offer a brief report and evaluation of the editors’ comments to six successively published collective volumes, starting with above mentioned first publication in which the term NIE appeared, edited by Furubotn and Richter (1984), and continuing with the collective volumes edited by Langlois (1986), Nabli and Nugent (1989), Harris, Hunter and Lewis (1995), Drobak and Nye (1997), and Clague (1997).

1.4.1 Which Institutional Economic Fields do Belong to the NIE?

A first, somewhat simple question to ask is: Which special fields do editors of the listed collective volumes consider to be part of the NIE? The answer is: 1 property rights approach, 2. transaction cost approach, 3. evolutionary economics, 4. constitutional choice, 5. collective action theory, 6. public choice theory, 7. economic contract theory, 8. new institutional approach to economic history, 9. modern Austrian economics.

Table 1 shows which fields are ascribed by whom to be parts of the NIE.

7 I found 395 records until end of 2002, starting 1984 with four papers which appeared in the conference issue of the first International Seminar on the New Institutional Economics of 1983 (Furubotn and Richter 1984).


Furubotn/

Richter (1984)

Langlois (1986)

Nabli /Nugent (1989)

Harriss etc. (1995)

Drobak/ Nye (1997)

Clague (1997)

Transact. Costs Ecs.

X X X X* X Χ

Property Rights

X X X X* X Χ

Evolut. Econ.

X** X

Public Choice Political Ecs

X X

Contract Th. X X NIE History X X Modern Austrian

X

Constitutional Choice

X

Collective Action

X X

Table 1 Fields assigned by editors of collective volumes on the NIE.

(* transaction costs and property rights mentioned implicitly by emphasizing Coase [1937, 1960] and North [1993]; ** Furubotn and Richter dropped this field in their subsequent eleven collective volumes8).

Certainly, our six collective volumes and their editors are no representative sample. Still, it may not be all wrong to guess that table 1 reflects the prevailing view of our profession, which fields, and with what weight, should be considered part of the NIE. Property rights and transaction cost economics are quite certainly among them. In fact, they were “voted” for by the editors of all six volumes. A distinct minority of editors’ comments (2 out of 6) name contract theory, collective action, public choice, evolutionary economics, and the new institutional economics approach to history as part of the NIE. The fields of modern Austrian economics and constitutional choice fall far behind with only one vote for each. The great weight given to the property rights and transaction cost economics speaks for our earlier presumption that the end piece of the visible-hand approach to institutional economics is regarded as belonging to the methods of the “new institutional economics”.

1.4.2 What is the Intellectual Bond of the Fields of the NIE?

A more demanding questions to ask is: What is the common pattern of reasoning used – or what is the intellectual bond of economists who belong to the practitioners of the NIE? Again we are following the judgment of the editors of the six collective volumes under consideration. Proceeding in chronological order, we’ll report briefly on how they justify their understanding of the NIE:

8 See: http://www.uni-saarland.de/fak1/fr12/albert/mitarbeiter/richter/institut/waller.htm

http://www.uni-saarland.de/fak1/fr12/albert/mitarbeiter/richter/institut/waller.htm


Furubotn and Richter (1984) argue that the foundation stones of the NIE would consist of the traditional ones of neoclassical theory, viz., methodological individualism and self interest principle. But while in neoclassical economics the influence of the institutional framework was disregarded completely or specified only in perfunctory a way, the NIE would seek to demonstrate that institutions matter. Beyond this, institutions themselves would be regarded as legitimate objects of economic analysis. In other words, the unifying elements of the NIE would be its basic methodology and its analytical objects. It would not matter that a number of different approaches are employed in attempting to integrate institutional considerations into economic theory. The authors stress that the study of “transactions” themselves and of transaction costs is crucial and that another important shift in thinking relates to the way in which property rights structures are perceived. The participation of Armen Alchian, Ronald Coase, Douglass North and Oliver Williamson underline these judgments.

Langlois (1986) argues that the NIE consists of a number of identifiable strands. Principal among these are, in the first place, evolutionary theory and the modern Austrian school9 as influenced by F. A. Hayek. Historically, Carl Menger would have

... perhaps more claim to be the patron saint of the new institutional economics than any of the original institutionalists [like John R. Commons who is quoted by Williamson]. (loc. cit. 5)

Finally, Oliver Williamson, Ronald Coase and Herbert Simon are mentioned (in this order). The Austrian and evolutionary prioritization by Langlois is underlined by conference participants such as Brian J. Loasby, Andrew Schotter, Richard R. Nelson, Gerald P. O’Driscoll, Jr.

Nabli and Nugent (1989) edited a collective volume on the application of the NIE to Development Economics. While there is as yet no consensus on what is included in the NIE, Nabli and Nugent find that two broad and general approaches would be salient, "…namely transaction and information costs, on the one hand, and the theory of collective action on the other" (loc.cit. 10).

The transaction cost approach is targeted, in the first place, at private goods. It contains the property rights economics, transaction cost economics proper, and the more mathematical oriented agency (or contract) theory. 10

The theory of collective action, is targeted at public goods of both, physical character such as pollution or highways, and of an abstract character such as a "… higher wage rate, a higher price, …, a regulation, a lower tax rate or a policy rule." (loc. cit. 14).

The two general approaches would be complementary. As long as transaction costs are not be prohibitively high, external effects of individual actions could be compensated by contractual arrangements between individual parties. Otherwise, collective action would obtain (loc. cit.

9 In fact, a considerable part of this introductory essay is devoted to the defense of the Austrian view of “competition as a process”(loc. cit., pp. 7 – 15). 10 As for the latter the authors speak of themes “concerned with incomplete information and asymmetric information in particular.” (p. 12)


18). Contributors to this volume include the editors themselves and Samar K. Dutta, Timur Kuran, Bruce H. Herrick.

Harriss, Hunter and Lewis (1995) edited another conference issue on development economics11. Proof of the importance of the NIE would be the award of the Nobel Prize for Economics first to Ronald Coase in 1991 and to Douglass North in 1993. The NIE would be able to explain non-market forms of organization as rational consequences of market failures. It would, thus, challenge the dominant role ascribed to the market by the orthodoxies of the last ten years or so (loc. cit., 1). North, who participated at the conference, emphasized that the NIE retains the neoclassical assumptions of individual choice subject to constraints. The constraints, however, would include also institutions. Transaction costs would play an important role as well as ideas and ideologies. The latter would be “… a critical factor in the performance of economies, as the source of the diverse performance of economies, and the explanation for ‘inefficient’ markets.” (North 1995, 19). Keynote speakers at this conference were Douglass C. North, Robert H. Bates and John Toye.

Drobak and Nye (1997) edited a collection of papers that were presented at a celebration of the award of the 1993 Nobel Prize in Economics to Douglass North. The editors say, the NIE would be less a distinct school “…..than a particular set of shared concerns grounded in existing economic theories and doctrines” (loc. cit xv). New institutional economic historians, like North, would begin with an appreciation of neoclassical price theory as a powerful tool for predicting many economic outcomes in the real world. But the neoclassical assumption of perfect individual rationality would have to be watered down or even replaced by other assumptions about human behavior.12 Central fields belonging to the NIE would be transaction cost and property rights economics, political economy and public choice, quantitative economic history, cognition, ideology, and the role of path dependency. Speakers at this conference were, i.a., Douglass C. North, Robert William Fogel, Avner Greif, Gary Libecap, Barry R. Weingast, Paul A. David.

Clague (1997) edited also a collection of papers on the application of the NIE to development issues. He describes the NIE as an expanded economics. It would relax some of the strong assumptions of traditional economics with respect to the motivation of, and the information available to, individual decision makers, and it would widen the scope of economics to include political phenomena and the evolution of institutions. The NIE would have called attention to the vital role of government administrative capacity in shaping the institutional environment of business. It might help to explain why bureaucracies perform well or badly and how the inefficient and corrupt ones could be reformed. Among the conference contributors were, i.a., Mancur Olson, Philip Keefer, Elinor Ostrom, and Margaret Levi.

11 Held at the London School of Economics and Political Science in September 1993. 12 North suggests to use what is known from other disciplines such as cognitive science or learning theory (loc. cit. xix).


Summing up: All editors of our sample seem to agree that the NIE is not characterized or defined by a selection of fields but by the intellectual bond of its basic methodology. A clear majority favors contributions that belong to the "visible-hand approach to institutional economics". Only a small minority (one out of 6 in our sample) prefers components of its counterpart, the “invisible hand approach” (Langlois).

Those favoring the visible hand approach agree that the foundation stones of the NIE are the same as the ones of neoclassical economics: methodological individualism and individual rational choice given a set of constraints. However, due to transaction or information costs, information is limited and, thus, institutions matter.

Like the old institutionalists,13 the new institutionalists start from a criticism of current economic theory for its “too high level of abstraction” (Williamson 1975, 1). But while the old institutionalists clearly refuse the abstract assumptions of classical or neoclassical economics, the new institutionalists tend to accept them, though, in a watered down form because of transaction costs, Knightian uncertainty, bounded rationality etc., and from the perspective that institutional arrangements tend to substitute, to some extent, for these qualifications. In any case, all editors of our sample keep their distance from old institutional economics - most of them expressis verbis,14 There are clearly major differences between the old and new institutional economics, nevertheless, as Rutherford (2001, 187) rightly points out, some aspects of the new institutionalism “… do connect back to the old – including a tendency to spread beyond the standard neoclassical boundaries.”

Finally, all editors of the six collective volumes under consideration seem to agree that the composition of the fields of the NIE depends mainly on the particular object of research. In this respect, our sample is somewhat one-sided. Most of the six volumes are concerned with macro issues: Three deal with issues of development economics, one with new institutional economic approach to history, another one with issues of evolutionary economics. Only one issue includes also micro economic problems. Certainly, that is no representative mix of applications, in particular since a great deal of new institutional economic studies are on micro economic issues such as firms15, industrial organization16, antitrust17, contractual relations18, market organization19 etc.. Still, our sample gives some insight into how the generic term “new institutional economics” became a standard (or banner) under which a diverse group of economists assembled.

13 As represented by the German Historical School and American Institutionalism. 14 Furubotn and Richter (1984, 1), Langlois (1986, 2 - 5), Nabli and Nugent (1989, 10), Drobak and Nye (1997, xv). 15 JITE (1986). 16 JITE (1985). 17 JITE (1990). 18 JITE (1987). 19 JITE (1994).


1.5 The Foundation of the International Society for New Institutional Economics (ISNIE)

With the foundation of the International Society for New Institutional Economics (ISNIE) - its first conference was held at Washington University, St. Louis, MO20 in September 19 – 21, 1997 - the NIE came “of age.” The organizers advertised in the internet the conference to scholars “…..working on transaction costs, contracting, political rules of the game, the rules of law, norms and culture, and who pursue these interests using standard scientific methods.” (Furubotn and Richter 1997, 780).

At the inaugural conference, North, Williamson and Coase – in this order – described the NIE basically as above. Although the immediate objective of the NIE is to replace the abstract, static models of neoclassical economics, Coase cautioned that a frontal attack on neoclassicis m would be neither needed nor desirable. For appropriable theoretical development to be achieved, it is sufficient to focus on factual matters. Somewhat later Coase (1999, 1 ff.) said, ISNIE would have a mission, viz “…to replace the current analysis with something better, the New Institutional Economics…..The Influence of the New Institutional Economics will be exerted in the various sub-disciplines [of economics]. Guerilla actions will take place, which will result in the New Institutional Economics dominating first one and than other of these sub-disciplines, as indeed is beginning to happen.” But he adds “We will not replace price theory (supply and demand and all that) but will make it vastly more fruitful.”

A selection of the papers presented at the second annual conference of ISNIE at Paris in September 1998 has been published by Claude Ménard (2000), among them again contributions by the old guard: Ronald Coase, Douglass North, Oliver Williamson, Harold Demsetz, Yoram Barzel but also by Masahiko Aoki who supported the concept of the institution-as-equilibrium-of-a-game concept. Coase and North stress again that the representatives of the NIE don’t want to replace neoclassical theory but are trying to use these analytical tools “to study the working of the economic system” (Coase 2000, 4, or Coase 1999, 5 as quoted above). But that appears to contradict North’s concept of the “cognitive science/institutional approach to history” or Williamson’s casuistic technique to broach bounded rationality. Why not admit that a change in paradigm is already under way?

20 See the brief report by Furubotn and Richter (1998).


1.6 Summary and Comments

Williamson (1975, 1) introduced the “NIE” as a generic term for a divers group of already existing modern economic studies of institutions. The term was later mentioned here and there but it took eight years until it was first used by conference organizers. After some 10 or 15 years it became a standard under which economists assembled who are interested in aspects of the economics of institutions. As it turned out, the term NIE is generally used as a name of what we called the ”visible-hand approach to institutional economics”.

Table 1 shows the nine modern institutional economic fields which were mentioned as part of the NIE in the above quoted literature. These theories were developed by different scholars during the 1960s and early 1970s. Core fields of the NIE became:

• Transaction cost economics (Coase, Williamson),

• Property rights economics (Coase, Alchian),

• Economic contract theory (formal: Spence, Mirrlees, Stiglitz, informal: Williamson, Macneil) and

• New institutional approach to history (North).

There are reasons to follow Nabli and Nugent (1989) and to count the theory of collective action (Olson 1965) among the NIE. While property rights economics, and the formal part of contract theory still assume perfect rationality this is not the case with transaction cost economics and the new institutional approach to history of North.

Williamson (1975, 4) assumes men to be only boundedly rational, North (1995, 18 f.) writes that a theory of institutions has to begin with a “modification of the instrumental rationality assumption”, Coase (1984, 231) regards the assumption “that man is a rational utility maximizer” to be both “unnecessary and misleading.” Thus, the assumption of perfect rationality is being abandoned by leading neoinstitutionalists.

Two branches of the NIE developed after Coase’s (1937, 1960): The transaction cost economics (TCE) of Oliver Williamson (1985) and the new institutional economics of history (NIEH) in the sense of Douglass North (1986). Next to Coase, Williamson and North, became the two leading representatives of the NIE. The difference between the “Williamsonian” and the “Northian” approach is described by Ensminger (1992, 21 f.) as follows:

While Williamson (1981) “…takes the position that institutions are expressly designed to reduce transaction costs and that, in competitive markets, those that fail to do so will not survive.” On the other hand, North (1981, ch. 3, 1990, 8, 52) argues vehemently against the view: “…that institutions are created only to reduce transaction costs and increase economic efficiency.” The reason for inefficient institutions are inefficiencies of political markets, “…democracy in polity is not to be equated with competitive markets in the economy.” (North 1990, 51).21

21 As North (1986, 236) rightly remarks: “Pareto efficiency … simply don’t make sense a great deal” (in the economics of institutions). For details see Furubotn and Richter (2005, 108 – 110).


However, both approaches hardly square with the constantly referred to neoclassical economics and seem unwilling to make the break to a fundamentally new paradigm.22 While this is not achieved, one should at least be ready to apply different, problem related analytical methods for different objects of economic research and define the science of economics by its objects, instead of its method - as is done in other applied sciences. Economics is more appropriate to compare to engineering or medicine instead of physics or biology (Varian 1993, 2 f.).

The Williamsonian approach to the NIE is mainly applied in microeconomic fields like the theory of firm, of industrial organization, antitrust, the economics of organization. The Northian approach is used to tackle macroeconomic issues as those of the history of national economies, of development economics or transformation economics.

2. Meaning of the NIE I shall restrict myself to the meaning of the Williamsonian and the Northian approach to the NIE and shall proceed in this section as follows: First, I am giving a brief description of the analytical core of Williamson’s TCE and North’s NIEH. Second, I compare the two approaches with each other. Third, I shall discuss briefly what some of their critics said.

2.1 The Analytical Core of Williamson’s Transaction Cost Economics (TCE)

Oliver Williamson points out, i.a., that non-standard contracts may, but need not, result from monopolistic practices. The reason is that transaction specific investments can play an essential role after conclusion of contract. Williamson illustrates this by use of the concept of fundamental transformation: After contract conclusion the parties find themselves locked into a bilateral monopoly situation, whereas before they were free to choose with whom to trade. Transaction specific investments of whatever kind (if only in form of time invested in search, inspection, and bargaining) are the reason for this transformation. In addition, Williamson takes into account the fact that we don’t know what the future will bring. Under Knightian uncertainty it is impossible to write a complete contract that details all possible future contingencies – even if transaction costs were zero.23 Therefore, contracts contain unavoidably loopholes and the lock-in of the parties may invite opportunistic behavior of the other side because, due to information costs (a special kind of transaction costs), the parties may be unable to verify their case to a third party (e.g., a court). Thus, court ordering may have to be supplemented or even substituted by private ordering to effectively protect the parties against opportunism of their trade partners. There exist various ways to organize the governance structure of a contractual relationship. Their efficacy depends on particular circumstance, inter alia, the size of specific investments and the frequency of transactions between the parties. Transaction cost economics has been supported by numerous empirical studies (overview: Shelanski and Klein 1995).

22 Selten (2001) and Gigerenzer (2001, in this sense, are the boldest and call for heuristics rather than optimizations. 23 For lack of knowledge of what the future will bring, i.e., of all the stochastic variables.


Williamson’s TCE is a theory of contracts under conditions of uncertainty and asymmetric information, where legal enforcement and self enforcement complement each another. Both, court ordering and private ordering characterize the governance structure (or “organization”) of non-standard contractual relationships. Attentive actors agree before they come to terms on a governance structure that they regard suitable. Market and hierarchy are two of the imaginable ideal types of possible governance structures. Important to see is that the choice of an efficient (better “efficacious”) governance structure results not from optimizing some target function subject to a set of constraints. It may rather be understood as a form of boundedly rational or “suitable” choice from a set of governance structures in the sense of Selten’s hypothesis of the casuistic structure of boundedly rational strategies (see Furubotn and Richter 2005, 180).24 Which governance structure the parties choose depends on the particular situation. The problem for the parties then is to agree about both the “right” diagnosis (of the situation) and the “best” cure (the governance structure). Williamson’s (1985, 79) table of “efficient governance” may be understood as an example of how to think, not as an answer to the parties’ decision problem. - The idea is, to think less like a physicist - more like a physician.

2.2 The Analytical Core of North’s New Institutional Economics of History (NIEH)

Douglass North aims at an economic explanation of the structure and performance of economies through time.25 He starts from the simple observation that human cooperation requires rules of behavior, viz. institutional constraints, which, in the final analysis, define the opportunity set of individuals.26 In the world of costless transactions and perfect foresight the nature of institutional constraints (as, e.g., full ownership or rent of land) does not matter. It is without influence on the economic performance of the polity. That is no longer true for a world with positive transaction costs and imperfect foresight. Here, the nature of the institutional framework plays a major role in the performance of an economy.27 It reduces the uncertainty of human interaction and, thus, the costs of cooperation.28 Persistent changes in relative prices, due to lasting exogenous changes (such as changes in total population, knowledge or ideology29), will lead actors to realize that they could be better off under alternative institutional arrangements and result in institutional change. Yet, institutional change is path dependent and shaped by the feedback between economic and political markets. Due to the high (political and economic) transaction costs, inefficient institutions may persist for long periods of time.30 24 In this context, „casuistic“ means that typical cases are identified and studied – as, e.g., study is conducted in case law or medicine. 25 North (1981, 3). 26North (1990, 67). Clearly, the rights of disposal over certain real resources and knowledge are described by the institutional framework (or governance structure). 27North (1990, 69) 28 “Institutions provide the structure for exchange that … determines the cost of transacting and the cost of transformation.” (North 1990, 34) “Under conditions of limited information and limited computational ability [bounded rationality], constraints reduce the costs of human interaction as compared to a world of no institutions.” (loc. cit. 36) However, the share of US transaction costs of GNP grew from roughly a quarter in 1870 to over one-half in 1970 (Wallis and North, 1988, 120). 29 North (1981, 207 f.; 1990, 111). 30 North (1990, 92 ff.).


Institutional constraints comprise informal and formal rules of behavior.31 Formal rules consist of political rules (example: the constitution32), economic rules (examples: property rights,33 contract laws) and contractual agreements between actors (example: sales contract). Political rules would lead to economic rules, "though the causality runs both ways."34 The enforcement of rules matters. Self enforcement would be ideal but is frequently not promising.35 In general, legal enforcement is more effective.36 However, the coercive force given to the state may be used by those in power to their own advantage.37 In a simple model, North (1981, 28) interprets the state as a ruler who maximizes his profit subject to basically two constraints: the degree of political competition with rivals and with other states, and transaction costs. For both reasons, the property-rights structure, which maximizes the social product, may not maximize the ruler's (long-term) monopoly rents. North's judgment is rather pessimistic. He says that to stabilize his power the ruler will agree to a property rights structure that is favorable to those groups with close access to alternative rulers, regardless of its effects upon efficiency. And because of the costs of determining and collecting taxes, a less efficient property-rights structure may be more favorable to the revenue maximizing ruler.

North’s concept of the NIEH aims at a general theory of the interaction between polity and economy. It is, insofar, an application of the economic theory of politics to economic history. However, in contrast to public choice theory and the theory of collective action,38 North assumes imperfect individual rationality and emphasizes the role of ideology. He rejects “rational choice and efficient market hypotheses”.39 Rather, he opines that because of imperfect individual rationality

Mental models, institutions and ideologies all contribute to the process by which human beings interpret and order environment. Mental models are, to some degree, unique to each individual. Ideologies and institutions are created and provide more closely shared perceptions and ordering of the environment. (North and Denzau 1994, 21)

2.3 Comparing the Williamsonian and the Northian approach to the NIE

Both deal with the same object: “institution.” Williamson (1985) prefers to speak of “governance structure,” North (1981, 1990) uses terms like “rules of behavior”, “institutional

31 North 1990, 36. 32 “Political institutions constitute ex ante agreements about cooperation among politicians.” (North 1990, 50) 33 The establishment of "well specified and well-enforced property rights" account for the unprecedented growth of Western economies (North 1989, 1320). 34 North (1990, 48). 35 Regarding contracts: „…neither self-enforcement by parties nor trust can be completely successful.” (North 1990, 35) 36„...there are immense scale economies in policing and enforcing agreements by a polity that acts as a third party and uses coercion to enforce agreements.“ (North 1990, 58) 37 „...if the state has coercive force, then those who run the state will use that force in their own interest at the expense of the rest of the society.“ (North 1990, 59) 38 Public Choice Theory applies the neoclassical economic style of reasoning to the analysis of politics – as reviewed by Mueller (1979). For an empirical study of the politico-economic interdependence see Schneider, Pommerehne and Frey (1981). 39 North (1990, 111).


constraints” or “structure.” In addition, North (1990) distinguishes between “institutional arrangements” and “institutional environment,” the former being a subset of the latter, which are a set of fundamental political, social, and legal ground rules that govern economic and political activity (Davis and North 1970, 133). North stresses also the role of ideology.

Thus, we may say (strongly simplified):

• TCE analyses the “institutions of governance” given the institutional environment. Its object of research are agreed on arrangements essentially between two actors.40 Such institutions deal essentially with the transfer or administration of private goods and may themselves be considered to be private goods. They are the result of individual action.

• NIEH analyses the “institutional environment” inclusive ideology. Its object of research are the informal and formal institutional constraints that control the behavior of more than two actors. An institution in this sense deals with the provision or administration of public goods, in fact, it is itself a public good. 41 It is the result of explicit or implicit collective actions.

TCE abstracts from the interaction between economic and political decision making. It takes norms, customs, mores, tradition etc. as givens, the latter with the argument that “institutions at this level change very slowly – in order of centuries or millennia …” (Williamson 2000….). It may do so, because it deals with the transaction of private goods and concentrates on the limited task of showing that non-standard contracts need not result from monopolistic machinations.

NIEH, on the other hand, does not abstract from the interaction between economic and political decisions. It considers “the possibility of making economic decisions via the political process” (North 1971, 118). Its central object is the development of “a useful theory of institutional change.” (Davis and North 1970, 131) Ideologies are taken into account and understood as “comprehensive systems of cognitive and moral beliefs” that figure prominently in social life (North 1978, 972 ff.).

2.4 What Critics Said About the Williamsonian and Northian Approach

We are concentrating our discussion on some of the better known criticisms of Williamson’s transaction cost economics and North’s new institutional approach to economic history. Space does not permit us to go into the debate of “old” versus “new” institutional economics.42

We should begin by mentioning that the only “positive criticism,” that is the kind of criticism that tries to replace the attacked theory by another – better one – comes in both cases from mathematical economists. The rest limits itself to a criticism of assumptions.

2.4.1 Some Criticisms of TCE

Widely known criticisms come from scholars of mathematical economics, sociology and law.

40 Williamson (1993, 56) concedes: “Transaction cost economics mainly works out a dyadic set-up.” 41 Binger and Hoffman (1989, 68 f.). 42 For a more recent defence of old institutionalism see, e.g., Hodgson (1998). For an excellent comparison between the two views see Rutherford (2001, 185 – 190).


1. Mathematical economists such as Grossman and Hart (1986) have criticised the imprecision of TCE. They tried to develop, instead, a formal version of transaction cost economics. But their theory of incomplete contracts, as it became known, does not really deal with the central problem of TCE: ex post opportunism. Grossman and Hart explain rationally only who should acquire a (private) property right, in their case who should become the owner of the residual decision right of a contractual relation between a supplying and a buying firm (Hart 1995, 5 ff.). The solution of their theory of incomplete contract theory is again, legally, a complete contract. Thus, in Grossman and Harts model, the owners of the residual decision right face no problems in proving their ownership before a court and therefore rely on legal compulsion. It puts aside Williamson’s problem of what happens after contract conclusion. Irrespective of this, Gosssman and Hart’s approach opened up a new and attractive area of contract theory - the theory of incomplete contracts. Leading representatives of this approach are, in Germany, G. Nöldecke and Klaus Schmidt (1995), both from the Bonn school (see Schweizer 1999). Closer in spirit to the TCE may be the paper by Bajari and Tadelis (1999).

2. Granovetter’s (1995a, 63 ff.) sociological critique is centred upon Williamson’s assumptions of his “markets and hierarchies” analysis (Williamson 1975). Granovetter argues that Williamson’s appeal to authority relations “in order to tame opportunism” constitutes a rediscovery of Hobbesian analysis, an over-emphasising of hierarchical power (Granovetter 1995a, 65). Williamson disregarded the “embeddedness” of the individual in a net of personal relationships. In the creation of trust, social structures or networks are of significance. They discourage malicious behaviour (Granovetter 1995b, 200). Williamson “vastly overestimates the efficacy of hierarchical power … within his organizations.” (Granovetter 1995a, 68). However, Granovetter's criticism of TCE is besides the point because Williamson deals on purpose only with bipolar relationships that are not subject to social control – the case of the fundamental transformation. Williamson's claim that opportunism is prevalent is widely reflected by the facts. Examples are provided, not least, by the problems of corporate governance that are attracting growing attention recently in the United States and Germany (vide the Enron, WorldCom, and Berliner Bank affairs).

3. Posner (1993), a well known representative of the Economic Analysis of Law of the Chicago School, attracted much attention by his paper on “The New Institutional Economics meets Law and Economics.” He offers a very individual interpretation of the assumptions of TCE in sharply rejecting Williamson’s (1985a, 189 f.) criticism of the Chicago School's doctrine, and emphasises that the law and economics work at Chicago would as well be occupied “…with problems of uncertainty, bilateral monopoly, and opportunism and with how legal and economic institutions try to solve them.” (Posner 1993, 81). All that Williamson's “opportunism” would mean is advantage taking under conditions of a temporary monopoly, or through informational advantages in a situation of asymmetric information (1993, 80). That is not quite correct either. Williamson's point is that the bilateral monopoly situation exists not ad ovo but is the unavoidable side effect of the conclusion of an exchange contract between two individuals that requires specific investments. Finally, Williamson does not only criticise the assumptions of Chicago style (i.e., neoclassical) microeconomics, he suggests also to replace the attacked theory by another theory that is better equipped to explain non-standard exchange contracts like vertical integration that influenced antitrust


policy considerably. Of course, Williamson's TCE is not based on a formal model. However, that is a price to be paid (so far) if one leaves the sphere of perfect individual rationality and perfect foresight - as do all representatives of the NIE in the sense of this paper.43

2.4.2 Some Criticisms of NIEH

For whatever reason, Douglass North received less critical attention by well known people than Oliver Williamson. Two criticisms are worth mentioning:

1. Aoki (2001, 5), a mathematical economist, criticizes that North's theory of economic history is based on a visible-hand approach to institutions. He would apply a “rule-of- the-game view of institutions.” To quote North (1990, 3 f.):

Institutions are the rules of the game in a society, or, more formally, are the humanly devised constraints that shape human interaction…In the jargon of the economists, institutions define and limit the set of choices of individuals.

Rule-making would be susceptible to conscious design by legislators, political entrepreneurs, or mechanism design economists (Aoki 2001, 9). Aoki argues that an invisible-hand approach to institutions would be better suited to explain the “…diversity of institutional arrangements as well as the nature of the process of institutional change”. As a game theorist he favors a game-theoretic equilibrium approach that is characterized by the concept of Nash-equilibrium. Accordingly, Aoki defines an institution as

a self-sustaining system of shared beliefs about a salient way in which the game is repeatedly played. (2001, 10, italics in the original)

But the Nash equilibrium is a static concept. It explains the logic of self-enforcing social orders (the persistence of institutions) but not their change.44 For North (1990, 54), the ability of societies to develop "effective, low-cost enforcement of contracts is the most important source" of economic development. Institutional change comes about through the visible hand of “entrepreneurs in political and economic organizations” who realize that they could do better by changing the institutional framework. We interrupt here to resume the equilibrium of game view in the following chapter.

2. Another branch of criticisms is related to the age old controversy of economists or social scientists between individualism and socialism (or holism). Schumpeter tried to defuse the debate by suggesting to distinguish sharply between "political" and "methodological individualism (Schumpeter 1908, 90). The latter was thought to be used, within narrow limits, for the description of certain economic processes (1908, 94), however not in organization theory or sociology (1908, 95). To day, the term is used for a much wider purpose than Schumpeter had in mind. In any case, it became an axiom of the NIE and is represented in North's new institutional economic history. This is seriously criticized by economists like

43 On Williamson's reply to Posner see (1993c) 44 Greif and Laitin (2004) have shown a way out: The hypothesis of a self-undermining Nash equilibrium of repeatedly played games.


Fine and Milonakis45 as being North's "most sacred analytical principle" (Fine and Milonakis 2003, 561). They rightly ask, how the concept of methodological individualism would square with North's assumption of ideology (a social phenomenon) as the explanatory factor in his theory of institutional change. 46 His treatment of institutional change and stability would be exogenously determined because North does not provide a theory of ideology (see Rutherford 1994, 46). This argument relates to the problem of infinite regression which is contained in both, the visible and the invisible hand approach to institutions. It is an unavoidable, ever debatable issue of any theory.

3. Prospects of the NIE There is much to be speculated about concerning the future of the NIE. I abstain here from that temptation.47 Instead, I will comment briefly on three activities which are under way but, not yet, part of the NIE in the above described sense. These activities are:

1. the equilibrium-of-game view of institutions,

2. the new institutionalism in sociology,

3. the new institutionalism in political science.

Further research activities could be mentioned such as the evolving field of behavioral economics (e.g., Kahneman 2003) and, together with it, the efforts in experimental game theory (on early German experimental work see Tietz 1990, of the largely American work see Roth 1995). The latter two fields, however, are for the institutional economist only of interest as long as they deal with the scientific explanation of the formation of institutions – say, in the sense of North’s concept of the “cognitive science/institutional approach to history”.

45 See Fine and Milonakis (2003), Milonakis and Fine (2005). 46 For a brief review and assessment of the criticisms of North's NIEH see Zouboulakis (2005). 47 As opposed to chapter 10 in Furubotn and Richter (2005).


3.1 The Equilibrium-of-Game View of Institutions

We observe a growing literature on the application of game theory on institutional economic issues. They deal formally with what we called the “invisible-hand approach” to economic analysis. Lewis (1969) and Schotter (1981) are among the first representatives of this line of thought, later, i.a., the above mentioned work of Greif (1998) and Aoki (2001). Central to this equilibrium-of-game-view of institutions is the concept of the Nash equilibrium of a game - a state of a game, in which no actor has an incentive to deviate from his present plan of action as long as other actors do not do so. Expectations of actors about the behavior of others play an important role here.

The concept of the Nash equilibrium is interesting for two reasons: It explains the logic of a self-enforcing social phenomenon (answers the question: Who enforces the enforcer?) and it shows that “social agreements” are not eo ipso a state of harmony that is worth searching for. Rather, a Nash equilibrium can be a catastrophically bad equilibrium for all the participants. Still, even though all participants realize this, no one would have an incentive to deviate from his present plan of action as long as no others do so.

However, the equilibrium-of-game view of institutions deviates from the NIE as defined above, because in game theory, all possible strategic interactions have to be described beforehand (information in this sense is perfect) and individuals act perfectly rationally. Transaction or information costs play no essential role.48 These requirements are inconsistent with the basic assumptions of transaction costs, uncertainty and bounded rationality of the NIE. Thus, from a neoinstitutionalist viewpoint in the above defined sense, the institution-as-equilibrium-of-game view could, at most, be employed as an informal way of thinking, not as a formal model. Nevertheless, since loose talk can lead to dangerously wrong conclusions, it might be preferable to apply formal game theory in addition to informal game theoretic interpretations of social phenomena, as illustrated, e.g., by the “analytic narrative” approach described by Bates et al. (1998, 10ff.). Avner Greif, an economic historian, is among the leading representatives of this approach.49 He argues that game theory provides a natural theoretical framework to examine self-enforcing institutions and to view an institution as a coordination equilibrium. Game theoretic historical analysis

…. requires context-specific strategic modeling and an inductive historical analysis. (Greif 1997, 85, emphasis added)

As mentioned above, Aoki (2001) argues in a similar vein. Institutions would be explainable as a salient Nash equilibrium of the way by which an underlying game is repeatedly played. But since nobody can escape from the problem of infinite regression, one cannot start to explain institutions from an institution-free world. Going back to North's path dependency argument, Aoki suggests

…to seek to direct the infinite regression toward structures inherited from the past…(Aoki 2001, 15)

48 They may be interpreted into games of incomplete information or, more general, into the properties of the “underlying game” of a recursively played game. 49 His “historical and comparative institutional analysis” is excellently reviewed in Greif (1998a).


But the Nash-equilibrium, being a static concept, does not explain how it comes about or how the invisible hand “works”. On a trial basis this is done by dynamic approaches like evolutionary game theory50 or the theory of (individual) learning in games.51 They are used to formally illustrate how a spontaneous order might evolve and, thus, provide a mathematical background to the considerations in the tradition of Hume, Menger, Hayek.

In real life we find hardly any institutions of purely "invisible-hand" origin. Menger (1883) himself agreed that the (usual) "pragmatic" interpretation of institutions is just as indispensable as his "organic" view (1983, 148). It therefore seems advisable for practitioners like managers, law makers, business or policy analysts to use a suitable mix of both approaches - the visible and the invisible hand approach. Take the problem of predicting the effects of a new law, a "made" order. As for its probable effects two types of questions may be asked, a simpler and a more complicated one. The simpler question concerns the direct or "visible hand" effects and the enforcement requirements of a new rule (e.g., the direct effect of a ban on interest on loans). The more complicated question is: What are the "invisible hand" effects? (In our example: what evasive financial arrangements are imaginable?). Since no law is perfectly tight, there is always some room for strategic (opportunistic) maneuvers of the constituents. The general question then is: What set of informal rules might grow spontaneously into the gaps of a legal framework, and how long will the spontaneous growth process continue? Is it likely that some stable endpoint will be reached that represents an institutional arrangement? Can the end point be viewed as a self enforcing equilibrium? Or will the law undermine itself and collapse? For an example of the latter case see Fururbotn and Richter (2005, 29 f.).

If both, the invisible hand and the visible hand approach, are reasonably applied uni sono, it seems advisable to count both approaches among the methods defined by the term NIE.

3.2 The New Institutionalism in Sociology

With the development of NIE, economists deeply infiltrated sociologists’ territory and sociologists, understandably, rose in arms. They lined up to a counter attack under the banner of New Economic Sociology (NES). It was started in the 1980s at Harvard by former students of Harrison White, among them Robert Eccles (1981), Mark Granovetter (1985), Michael Schwartz and, as a student of Granovetter, Mitchel Abolafia (1984). Independently of the Harvard group, several other sociologists joined battle, among them, Susan Shapiro (1984), Viviana Zelizer (1983). Their objective was to attack economists “by elaborating the sociological viewpoint as forcefully as possible.” (Granovetter and Swedberg 1992, 7)52

The number of studies in economic sociology exploded during the following years as illustrated by the review article of Baron and Hannan (1994), the Handbook of Economic Sociology edited by Smelser and Swedberg (1994a, 2005), the Symposium on Sociology and Economics in the Journal of Economic Perspectives (Gibbons 2005), the bibliography of the recently established “Economic Sociology Section” of the American Sociological

50 cf. Mailath (1998). 51 cf. Fudenberg and Levine (1999). 52 For a comparison of NES and NIE see Richter (2001).


Association.53 Sociologists rediscovered their old object of research, “institutions”, and developed their own brand of new institutionalism as described and discussed in Powell and DiMaggio (1991) or Brinton and Nee (1998) - which is not necessarily very helpful for our purposes. We rather prefer to ask the more general question:

What can neo-institutional economists learn from the New Economic Sociology? We believe, three things.

1st, the scientific background of sociological concepts (partly reinvented by neoinstitutionalists) that are central to the NIE – among them the concept of institutions itself, of organizations, order, implicit agreements, relational contracts, convention, ideology, social capital, trust, individual preferences.

2nd, the possible uses of sociological concepts which might be able to complement the analytical concepts of the NIE – among them the idea of social networks, embeddedness, social exchange, business groups, culture, emotional relationships, power.

3rd, how to subdue the occupational disease of economists to drastically simplify all objects of their research and, instead, to look and see more closely - or even get dirty hands.

One example for each of the points may suffice.

Ad 1st: Take the concept of relational contracts. It was introduced into the NIE by Goldberg (1976) and Williamson (1976), based on of the contributions of Macaulay (1963), a sociologist of law, and Macneil (1974), a scholar of contract law. It is a special case of Max Weber’s concept of “social relationship” which Weber describes at length in his Economy and Society (Weber 1968, 40 ff.). Williamson uses the concept for long-term agreements between parties that take into account the fact of incomplete foresight. They establish contractual provisions, in order to accommodate unforeseen contingencies. Unavoidably, such contracts are incomplete. The contractual parties agree, either explicitly or implicitly, about the procedure (the constitution) that will be employed to deal with problems that may arise. In other words, legal enforcement is supplemented, or substituted for, by private ordering (cf. Furubotn and Richter 2005, 566).

Ad 2nd: Cast a quick glance at social networks. They are defined as a set of actors, attributes of actors, and relations between actors. Network relations raise issues, foreign to pure dyadic relations, such as the “centrality” or “prestige” of actors, their “social position”, their “social role.” (Wasserman and Faust 1994) The concept of social network puts a new light on competition theory: Competition can be interpreted as competition of actors for social positioning (Burt 1992a). Positioning of sellers or buyers in a network of market relationships is a matter of strategic significance. A new actor, entering in an already existing network, e.g., an existing market or firm, faces the challenge of positioning himself among the already existing actors and to build links with them. Links between actors are relationships over time such as the formal or informal authority relationships in a firm, standing contracts, streams of transactions in markets, social relationships. They may be tight or loose, “depending on the quantity (number) or quality (intensity), and type (closeness to the core activity of the parties

53 ”Economic Sociology Section in Formation”, Mission Statement (21.12.2000), see http://uci.edu/econsoc/mission.html


involved) of interaction between members.” (Thorelli 1986, 38). “Social structure” is characterized by the strengths of these links. An important role in the debate among sociologists of the NIE plays the concept of “embeddedness”, as used by Granovetter (1985). He argues that “economic action takes place within the networks of social relations that make up the social structure” (detailed reviewed in Granovetter 2005).

They may be self enforcing or third party enforced such as network hierarchies, like vertically controlled business groups (Hamilton and Feenstra 1995, 643 ff.) Building links with other actors requires sunk investments in social relationships or “social capital” (Burt 1992b, 58).

Ad 3rd: An example for "look and see" or "get your hands dirty" is provided by Melville Dalton who arranged to be employed at The Milo Fractionating Center without top management knowing that he was, to conduct a study on "personnel problems." He reports on his results in Milo (Dalton 1959). For an excerpt of his report see Granovetter and Swedberg (1992, 315 - 344). Dalton’s research provides a concrete example for our presumption that formal rules leave big enough gaps for the working of the invisible hand, i.e., for informal rules to grow spontaneously into. In the present example, the formal order is a written down organization chart, which was supplemented by an informal chart which grew into it. His study indicates how " … this informal structure, though deviant from what is expected, actually makes it possible for the plant's work to get done." (Granovetter and Swedberg 1992, 315). However, it is important to see that "in terms of profits and dividends paid, Milo was definitively successful and presumably well managed." (Dalton 1959, 190n - quoted from loc. cit.)


3.3 The New Institutionalism in Political Science.

Political science – as political economy – makes only sense under conditions of “imperfections” of the classical model, i.e., in a model with positive transaction costs and bounded rationality. Therefore, it’s subject is also suitable for the analytic style of the NIE. In fact, as in sociology, the new institutional economics movement has been applied, implicitly at least, in various fields of political science in recent years. The areas affected include the theory of the state (Levi 1988, 2002), government organization (Shepsle and Weingast 1987), public administration (Weingast 1984, Moe 1990), international organization (Keohane 1984), the American Congress (Weingast and Marshall 1988), the theory of international organizations (Keohane 1984), the emergence and change of (political) institutional arrangements (Knight and Sened 1995), federalism (Weingast 1995).54 This new institutionalism embraces many approaches, among them what Thelen and Steinmo (1992, 7) or Hall and Taylor (1996, 943) call the „rational choice institutionalism“, a line of thought which approaches the NIE in the original sense of this paper like the above mentioned work of Keohane, Weingast or Moe. It would include also context specific applications of game theory like in the work of Levi (1988), Bates (1998) or Mayerson (2004).

Another institutionalism in political science is “historical institutionalism” (Thelen and Steinmo 1992, 7; or Hall and Taylor 1996, 937 ff.). According to Thelen and Steinmo, the core difference between the two views lies in the question of preference formation, “whether treated as exogenous (rational choice) or endogenous (historical institutionalism).”55 However, the latter is also assumed by sociologists like Granovetter (2002, 7). At any rate, in the world of the NIE with transaction costs, imperfect information and bounded rationality, many different forces can influence what an individual knows about options and how he forms his preferences. Preference functions are necessarily vague constructs (Furubotn and Richter 2005, 545).

What can economists learn from political scientists? To stop looking at the legal ground rules of society as a datum of economics. Rather, to integrate the making, administering and enforcing of the rules into the economists’ set of research objects. To start viewing the polity and economy as one narrowly linked system (nationally and internationally). To recognize the possibility of making economic decisions via the political process.56

One example may suffice: The two ways of economic exchange. First, exchange the “naive” way: Traders negotiate with each other according to the rules of the market which they take as givens. Second, exchange the “sophisticated” way: Traders negotiate at front with each other, round the back with the government. They are trying to have the market rules changed their way, e.g., at the expense of some unorganized third group. In the first case, the rules of the market are an exogenous, in the second an endogenous variable. We get two different types of 54 Overview: Miller (1997). 55 See Thelen and Steinmo (1992, 9). 56 A point stressed by North (1971, 118): “The economist not only accepted tastes, technology, and population as given, but also he accepted equally the current basic ground rules within which both market and non-market decisions were made. For that matter, the theory did not recognize the possibility of making economic decisions via the political process.”


market equilibria. The first is a classical economic market equilibrium. The parties agree on the price at which demand is equal supply - given the rules of the market. The second is an interventionist market equilibrium in which two markets – the economic and political market – are equilibrated: On the economic market (e.g. the labor market) a price is agreed upon which equals legally restricted demand to legally restricted supply – the unsatisfied parties (e.g., the unemployed and consumers) are bribed or forced to accept. On the political market an intervention is agreed upon which organized interest groups and those in power find acceptable. The second case might reflect the situation on the (West-) German labor market since the first oil crisis 1974 until, say, reunification.

Noteworthy in this context is a remark by Olson (1984): Instead of asking, “why is there unemployment?“ he writes, one should ask “who benefits from unemployment?” At all events, the above interpretation has recourse to particular interest groups (trade unions as the representatives of the owners of jobs and employers’ associations as representatives of owners of capital and managers) in the pursuit of their special interests. From this viewpoint, unemployment can be a interpreted as a Nash equilibrium. In such a state, no actor of the political parties, the trade unions, the employers’ associations, the media, the labor courts would have an incentive to deviate from his present plan of action as long as other actors do not do so, even if they all realized to be in a bad equilibrium. As for the Chancellor, he could not seriously put his foot down. He is part of the game himself.

Instead of using a game equilibrium approach to tackle the above problem, one might as well use a transaction cost approach as suggested by Dixit (1996) in form of his “transaction-cost policy framework”, a combination of the Williamsonian and Northian concepts of the NIE.

4. Conclusion To summarize: It would be more appropriate to use the term "economics of institutions" instead of "institutional economics". In any case, the term "NIE" defines various kinds of economic explanations of institutions. According to our findings, it comprises property rights analysis, transaction cost economics, contract theory and the new institutional approach to history. All these theories belong to the "visible hand approach to institutional economics", which describes, in the terminology of Hayek, "constructed" orders. Next to Ronald Coase, who first realized the institutional consequences of transaction costs, are Oliver Williamson and Douglass North as the leading representatives of the NIE. Both stress the importance of transaction costs, uncertainty, imperfect rationality, methodological individualism. Otherwise their approaches differ considerably regarding their methods and objects of research.

Williamson concentrates on the limited task to show that nonstandard sales contracts need not result from monopolistic machinations. He turns his attention to the, so far by economists ignored, behavior of the parties after contract conclusion, i.e., to the process of execution, control and enforcement of contracts. The underlying problems result from contract specific investments, Knightian uncertainty, and the therefore unavoidable incompleteness of contracts. To minimize ex post opportunism of the partners to the contract, both parties are complementing or even supplementing potential legal enforcements by private orderings.


While Williamson deals with microeconomic problems and abstracts from political decision making, North, an economic historian, is concerned mainly with macro economic issues. His central object is the development of a useful theory of institutional change. He aims at a general theory of the interaction between the polity and the economy. In fact, his approach is basically an application of the new theory of political economics to economic history. North broadens the assumption of imperfect rationality by the concept of ideology and results of modern cognitive science.

However, the interest in an explanation of institutions is not limited to the NIE. Game theorists became interested in the illustration of the workings of the "invisible hand" mechanism and the logic of "self enforcement", i.e., in a revival of research in the invisible hand approach to the economics of institutions along the line of Hume - Menger - Hayek. The equilibrium-of-game view of institutions was developed. However, in real life we find hardly any institutions of a purely "invisible-hand" origin. "Constructed" orders (e.g., new laws) play an important role. Because of unavoidably incomplete information they leave gaps into which informal rules grow spontaneously. This has to be taken into consideration if one wants to predict the effects of new formal orders, e.g., new laws. It seems worthwhile for practitioners working in this area to learn some game-theoretic style thinking.

Together with economics, sociology and political science experienced a revival of interest in the theory of institutions. It is interesting for economic or legal analysts to learn the sociological background of such everyday concepts as institutions or organizations, of social relations, social capital, ideology – as well as by economists less applied concepts such as social network analysis, social exchange, national culture – and simply to learn how to "look and see".

Political scientists demonstrate that the polity and economy are a narrowly linked system – both, nationally and internationally. This perspective is still widely disregarded by economists in spite of the work of representatives of the new political economy like Buchanan, Olson or the work of North. Economists’ lost their innocence once they turned away from the principles of the classical liberal state57 in favor of some, however colored, welfare state.

Surprisingly, the application of the NIE remained so far rather limited: on the micro-level to issues of industrial organization, on the macro-level to economic history and development economics. Its potentialities are by far not exhausted. Extended by game-theoretic thinking the Williamsonian and Northian new institutional economic methodology can be applied to virtually all problems of economic life – be it on the national and or the international level. I am particularly thinking of the present German macro-economic situation and the helpless attempts of economists to advise politicians, interest groups and voters on the basis of good old static or dynamic macro models (cf. Institut der deutschen Wirtschaft 2005).

57 The classical liberal state is supposed to abstain from all attention to the personal wealth of its citizens and to go “not a step further than necessary to secure its citizens against themselves and foreign enemies; for no other final purpose should the State restrict their freedom” (Humboldt (1792/1967, 52).


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