What’s new about New Institutional Economics (NIE)? In their editorial introduction to Handbook of New Institutional Economics, Claude Menard and Mary Shirley explain that NIE abandons certain assumptions of neoclassical economics, specifically the assumptions that actors possess “perfect information and unbounded rationality and that transactions are costless and instantaneous.”
Rather, “NIE assumes instead that individuals have incomplete information and limited mental capacity and because of this they face uncertainty about unforeseen events and outcomes and incur transaction costs to acquire information” (1). Institutions, formal and informal, arise in an effort to reduce risks and transaction costs.
Neoclassicism is not set aside entirely: “While new institutionalists reject the neoclassical assumption of perfect information and instrumental rationality, they accept orthodox assumptions of scarcity and competition” (2).
According to the authors, this opens up new possibilities for economic theory. Summarizing an essay by Douglass North, they write that “one of NIE’s main inputs to economics has been to remove the fiction of the frictionless market by adding institutions, but . . . NIE has the potential to perform an equally, or more powerful service: changing neoclassical economics from a static to a dynamic theory.” That is, it’s not enough to know “the basic rules of the game or even customs, norms and habits”; it’s also necessary to “understand what people believe and how they arrive at those beliefs—how people learn” (3).
NIE also suggests new ways to understand the economic role of political institutions: “political institutions can play an important role in reducing transaction costs by improving the security of property rights and enforcement of contracts.” States are not necessarily a threat to economic life, since the legal institutions “support market economies by enforcing contractual obligations and protecting private property from state predation” (7). Needless to say, not all states do this; many are “an important threat to the security of property rights and a prime violator of contracts” (4).
Summarizing another essay from the collection, they notes that NIE explores ways to steer past the paradox of state power: “NIE [drops] the traditional economic assumption of government as benevolent and the opposite assumption of government as Leviathan, focusing instead on how different institutional arrangements affect the incentives and performance of government. In particular NIE considers a fundamental dilemma: investment increases when property rights are protected, but a state strong enough to protect property rights is also strong enough to expropriate them” (5).
Stressing the limits of knowledge and the reality of change, NIE insists that no one can know the “reality” of the political and economic system, but that we do form elaborate beliefs about the way the system works. Dominant beliefs determine political and economic performance, and this institutional and epistemological matrix “imposes severe constraints on the choice set of entrepreneurs” (25).
Change is constant but incremental because it is “path dependent,” dependent on choices already made and on beliefs formed and embodied in institutional patterns. Rules, norms, conventions, and beliefs form a “scaffolding” that constrains choices at any moment. Choices are constrained not only because of technology and resources but because the scaffolding of beliefs and norms and institutional conventions (26). Growth economics has highlighted certain features of development, but NIE argues that this literature misses “the incentive structure” or “matrix” that constrains how investments are made and thus how development takes place (28).