Douglass C North’s new institutional economics and development is a classic introduction to the field of New Institutional Economics (NIE). NIE is a family of economic theories. In order to understand NIE, we must first consider what constitutes and economic theory.
There are certain characteristics of the core paradigms of economics research that establish it as a scientific discipline. Major theories in economics are enterprises in model building, guided by experience and data. These models are then subjected to critical validation both in terms of their explicitly stated underlying assumptions and their predictions. Like in any scientific discipline, the best economic theories are are refutable, and it is the failure to refute the theory using historical, cross-sectional and experimental data from the real world that build confidence in the theory. Again like in any science, best theories are ones that imply predictions considered useful in some way. In the case of economics, useful predictions are ones that help use guide policy in various fora like market design, corporate leadership, governance and international development. Departing from hard sciences, economic theories have another important component – an analysis of the various assumptions of the theory and the impact of the various possibilities in these core assumptions to the predictions of the theory. It is precisely this last aspect that allows multiple conflicting economic theories to coexist and vie for general acceptance over long periods of time. Both the real world being modeled, and the experimental validation tools available to economics are non-deterministic and all major economic theories are necessarily vast simplification of the systems they describe. This means that the underlying assumptions are often known to not hold universally in the real world, and it is important to both understand when the assumptions hold, to what degree, and how these assumptions affect the predictions of the theory.
With this background, it is possible to understand new institutional economics (NIE) as an attempt to extend neo-classical economic theory in a way that avoids the contradiction of the predictions of that theory with the persistent and widespread existence of institutions. Neo-classical economic theory predicts that institutions should not exist, and if they do, should not matter for final outcomes. But these predictions are demonstrably false. NIE introduces institutions front-and-center into the theory. By introducing institutions, it opens the door to a better treatment of the last aspect of theories stated above – institutions vary wildly across time and geography and these differences can be leveraged to describe the difference economic outcomes experienced by the peoples. At the same time, the theory does not simply state the various institutional structures as being given. Instead, it attempts to describe the wide variety of institutions via more basic assumptions, closely mirroring those of neo-classical economics.
There are various extensions of neo-classical economics referred to as NIE. It is important to clearly state the extensions proposed and analyze the differences in the institutions that follow from the modified assumptions. Various ideas from behavioural economics, transactional cost models and information cost models often contribute to theories in NIE. A great example of a clean NIE theory is Joseph E Stiglitz’s treatment of rural organization via introduction of information asymmetry in the market transactions. Stiglitz introduces no other assumptions than information asymmetry and describes the conclusions that follow for various observed aspects of rural organization in various countries (both rich and poor). He also compares his theory with alternative NIE explanations of the observed phenomena and provides a good template to critically examine various NIE theories.
I think the challenge for future NIE theorists consists in their adherence to the core principles of economic theorizing stated above. NIE extensions abound in competing assumptions that may describe the characteristics of various institutions to varying degrees. Theorists need to focus on developing a handful of clear consistent theories with good verifiable conclusions that are generally applicable and yet flexible.