Neoinstitutionalists Neoinstitutionalism

Neoinstitutionalists, Neoinstitutionalism

Neoclassical economics left out institutions or, to be more precise, posited the institutions it needed in order to make the available mathematical techniques work. Initially this led to the use of static analysis, then to the use of comparative static analysis, then to differentiable calculus, and later, to set theory, measure theory, and optimal control theory. An interesting aspect of neoclassical eco­nomics was that, in part, technique had driven the questions it had addressed and the answers it found.

The science of economics is far less likely to explicitly include institutions, for the simple reason that the analysis of institutions is messy and the search in science is for elegant underlying relationships that fit into existing techniques. Avoiding the explicit analysis of institutions, however, does not free the science of economics from them: neoclassical economics included a variety of implicit assumptions about institutions in its underlying structural model. For example, consider "the firm"—the production unit of neoclassical economics. It was composed of many individuals and was enormously complicated, but neoclassical theory reduced its goals to a single goal—profit maximization—without explain­ing how that goal can be consistent with the utility maximization of individuals within the firm. For example, will managers and other employees engage in activities that benefit them at the expense of profits? The same applies to markets: neoclassical economics assumed the existence of particular types of markets with specific mathematical characteristics; it did not explain how such markets came about, how they might change, whether their existence might influence individu­als' behaviors and preferences, or whether those markets are close approxima­tions of what we see in the real world. Thus, it had a very narrow focus.

Such narrowing of focus and theoretical simplifications ruled out many of the questions posed by critics of economics; thus, heterodox economists who have been consistent critics of society have also focused more heavily on explicit analyses of institutions than did neoclassical economists.

Some neoclassical economists believe that the messiness of institutions must be addressed, and they propose to do it within a neoclassical framework. These "neoinstitutionalists" include more institutional detail in their theoretical models than was usual for neoclassical economists, but they retain the conventional individual maximization procedures of the neoclassical model. Transaction costs play a central role in their analysis. Ronald Coase's article on the theory of the firm (1937) is a seminal article for these neoinstitutionalists. It argues that firms develop because the transaction costs of the market are too high for interfirm transactions.

Neoinstitutionalism is sometimes also called rent-seeking analysis or neoclas­sical political economy. Its proponents contend that rational individuals try to improve their well-being not only within a given institutional structure but also by changing that structure. Economic analysis, they contend, must include a consideration of the forces determining that institutional structure. An equilib­rium institutional structure is one in which it is not worthwhile for individuals to expend further effort to change the institutions. Only on the basis of an equilibrium institutional framework, they say, can one produce relevant analysis. These neoinstitutionalists argue that a competitive institutional structure is unstable, because some individuals have a strong incentive to change the institu­tional structure to benefit themselves, and this incentive is not offset by incentives to support a competitive structure. Perfect competition loses out in the compe­tition of institutional structures. Accordingly, neoclassical economics is irrele­vant, not because of its maximizing assumption but because its assumed institutional structure is not an equilibrium institutional structure. The maximi­zation assumption has not been carried far enough. These ideas, unlike those of the few remaining followers of the original institutionalists, have provoked mild interest within the profession. Oliver Williamson's studies of the firm are in what we call the "neoinstitutionalist" mold.

Neoinstitutionalists have been gaining popularity within the profession. In the 1990s they started a "New Institutionalist" organization, complete with its own journal and an aggressive research agenda. This group includes many well-known economists and in many ways is a part of modern mainstream economics rather than a heterodox group.