1.1 Introduction, Background and Basics Flashcards Preview

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2. What are key assumptions of neoclassical economics and the model it creates? (slides; Furubotn et al. 2003)

Neoclassical Economics is a predictive/normative way to analyse the allocation of goods and services in exchange. It is a model of social behaviour to determine prices.


Market Attributes & Institutional Set-up:
Neo-classical Economics analyses the basics of economic efficiency under ideal-typical conditions of perfect
information and foresight. It emphasises the important role of relative prices in economic decision making and focused
on the material world (the production, consumption and exchange of tangible goods and services) for people
maximising their well being, defined according to stable preferences, constrained by resources and technology.


Anything that cannot be explained by nature and technology was ascribed to differences in preferences, that are
stable and exogenous. Thus the market in the neoclassical theory deals with:
• homogeneous goods
• spot market with no accessing limitations and dominating competitor
• full market transparency, nor information costs and instantaneous
• all players in the market comply, no externalities (fully specified property rights)
• firms are places of production and serve a production function (production in a black box with homogeneous
technologies). They operate in perfect (spot) input and output (factor) markets and their main goal is profit


The model assumes that actors have rational capacity (rational actors) and thus make parametric decisions under
certainty. Rationality is viewed as the terms of choices it produces. Perfect individual rationality implies that all decision
makers have consistent and stable preferences. A perfectly rational actor can foresee everything, evaluate and
optimally choose among available alternatives in the blink of an eye and with no costs. Actors:
• rank order outcomes
• have stable and transitive preferences e.g. they chose the highest ranked option without being influenced by emotions
or a mental process
• in case of uncertainty & risk they maximise the expected utility


3. What are differences in assumptions between neoclassical economics and new institutional economics and what are the implications of these differences with regards to the core questions of the respective theories? What are the respective core questions? (slides; Furubotn et al. 2003)

  1. Integration of institutions into model (exogenous/endogenous)
  2. Transaction costs (no/yes)
  3. Behavior of individuals (rational/boundedly rational)
  4. Preferences of individuals (stable/shifting depending on the outcome)
  5. Objectives (striving for Pareto efficiency in terms of profits/shifting: efficiency, distribution etc.)
  6. Decisions and actions (to maximize profits/satisficing)
  7. Information (complete/incomplete, therefore opportunism) 

Core questions NCE: optimal allocation of resources in a Pareto optimal way with perfect information; how actors make decisions under the condition of scarce resources, i.e. how consumers maximize their utility level, assuming constant preferences, and how producers maximize their profits 

Core questions NIE: 1. Effects of institutions on behavior, resource allocation, income distribution, incentives, transaction costs; 2. Choice and change of institutions – designed/spontaneous order, oriented towards efficiency, distribution, or transaction cost reduction (equilibrium outcome) (PPT) 

Implications of differences: The assumptions of NCE can be aggregated to the so called model of the "homo economicus". NIE, in contrast, does not assume perfect rationality but rather “bounded” rationality. Because NIE acknowledges that individuals do not possess perfect information, act emotionally, and have shifting preferences, transaction costs have to be incorporated into economic models. Collective action, that is, the interdependence of market actors, instead of individual action, and the search for a social optimum become the focus of analysis. In order to find a socially optimal resource allocation, transaction costs have to be minimized. This requires institutions. Hence, NIE studies how institutions arise, change, and how they affect behavior, resource allocation, income distribution, and transaction costs whereas NCE examines how individuals and firms make decisions, given constraints, to maximize their own utility/profit in the absence of institutions.


4. Discuss assumptions concerning full rationality – why does neoclassical economics presume full rationality? (slides; Furubotn et al. 2003; Simon 1986)

NCE assumes the existence of a perfect individual rationality: that means a rational behaviour on a very high order. With that assumption the decisions make process is always rational and make under certainty, no matter emotional/mental processes. Of course that is impossible in the reality. It presume full rationality meaning that the individual will always evaluate the optimal choice (without consider preferences, tastes, etc.)

It is important for neoclassical economists, because it expresses the economist's understanding of how agents are motivated and provides normative criteria, e.g. Pareto efficiency, that have no appeal unless agents are assumed to seek what is good for them. It provides economists with a certain consistency in choice.


5. What is the main critique concerning the rational choice approach? To what extent and under which conditions would you consider rational choice to represent choice behaviour as we find it empirically? (slides; Furubotn et al. 2003)

The rational choice approach is based on the assumption that an actor is able to predict each possible outcome of a set of decision alternatives based on full and cost-free availability of information and, hence, to make an optimal choice. Assuming rational actors is unrealistic because, first, individuals rarely possess perfect information and are able to process it. As a consequence, preferences are not stable. They may change as the outcome of a choice, i.e. new information, becomes clear, different preferences (socially constructed vs. individual) have to be managed, and actions might not fit preferences. Second, a reaction to someone else’s behavior often involves emotions that are considered irrational, such as envy or altruism.  Third, the outcome of a decision often depends not only on one actor, so decisions are made in ‘game- situations’. Actors are able to maximize only their subjective expected utility. 

However, if we consider a decision that requires few and simple information, does not have a large impact on others, involves unambiguous preferences (i.e. socially constructed and individual preferences are the same), and is the result of actions coherent with preferences, rational choice might in fact represent choice behavior. In addition, the outcome of a decision has to be in the near future and can therefore be realistically assessed (full information).  


6. What are the foundational assumptions of new institutional economics? (slides; Furubotn et al. 2003)

  1. Methodological individualism (people are different – have tastes, goals, ideas. Individual agents)
  2. The Maximand: Individuals seek their own interest within the limits allowed by organizational structure in which its operating.
  3. Individual Rationality: Decision makers are incomplete and subjective to change over time (imperfect rationality) -  Bounded Rationality – decision makers are not omniscient and have difficulties in processing information.
  4. Opportunistic behaviour: some individual are likely to be dishonest
  5. Economic Society: involve individuals and a set of rules or norms that assign sanctioned property rights to each member of society
  6. Governance structure: the property rights configuration existing in a economy is determined and guaranteed by a governance structure or order.
  7. Institutions: set of formal and informal rules and their enforcement arrangements with the purpose to guide individual behaviour in a particular direction or to reduces uncertainty - to overcome information costs and safeguard against opportunistic behavior
  8. Transaction costs exists and means that resources have significance


7. How are substantive and procedural rationality different? Define the two concepts according to Herbert Simon and use an example? (slides; Simon 1986)

Substantive rationality views rationality in terms of the choices it produces

•    The decision maker's computational powers are unlimited

•    No distinction between the real world and the decision maker's perception of it

•    We can predict the choices that will be made by a rational decision maker entirely from our knowledge of the real world and without the decision maker's perceptions or modes of calculation.

•    Always reaches the decision that is objectively, or substantively, best in terms of the given utility function

•    No empirical analysis on (1) the process on how values are formed, (2) how particular aspects of reality come to the actor's attention, (3) how a choice situation is formed and (4) how reasoning processes are applied.

Procedural rationality views rationality in terms of the processes it employs.

• Knowledge and computational power of the decision maker are severely limited

• Distinction between real world and the actor's perception and reasoning about it

• Construct a theory of the processes of a decision and the processes that generate the actor's subjective representation.

• Actors are procedurally reasonable in the light of the available knowledge and means of computation

• The goal is to understand processes that an actor employs in making decisions and observing these processes directly (while they are going on)

Example Executives: a manager will be hired on the basis of his past performance or productivity (substantive) or certain qualities that make them suitable for the position (procedural).

Example: Buying a Flood Insurance

Substantive rationality: a property owner would buy flood insurance if the expected reimbursable damage from the floods was greater than the premium he has to pay the insurance company.

Procedural rationality: assumes that most people buying flooding insurance are those that already experienced a flood or who have friends and family who experienced a flooding event. It entails that the property owner's attention to flood insurance was triggered by certain circumstances and that a process of deciding was involved.


8. What is opportunistic behaviour and how is that related to differences between neo-classical economics and new-institutional economics? (slides)

With opportunistic behaviour we assume that some individuals are likely to be dishonest. Opportunism is taking consciously selfish advantage of certain situations. What not happen with NCE because it assumes that all individuals are perfect, rational and evaluates always the optimal choice. In NIE we assume that some individuals will act with opportunism (seeking self-interest act by that lying, stealing, and cheating etc). And that is why Institutions are needed - to safeguard agents against opportunistic behaviour and to encourage agents to transact.


9. What are institutions according to NIE? Why are institutions important for the study of economics according to New Institutional Economists? (slides; Vatn 2005; Hodgson 2006)

Institutions are a set of formal and informal rules/codes/contracts/knowledge and their enforce arrangements to guide individual behaviour and reduces uncertainty and aim to solves a coordination problems. As there is no full information processing capacity available, transaction costs arise.  Institutions are necessary to reduce these costs and make transactions possible. They can be formal (de jure – legislated) and informal (de facto – cultural).


• Durable systems of established and embedded social rules that structure social interactions. (Hodgson)
• Institution is a special type of social structure that involves potentially modifiable and (evidently or imminently)
normative rules of interpretation and behaviour. (Searle)
→ assumes that institutions can exist only if people have particular and related beliefs and mental attitudes.
• Institutions can be defined as the sets of working rules and are the outcome of human interactions and aspirations.


10. How are rules, norms and strategies/conventions different? Use examples of each. (Vatn 2005; Hodgson 2006)

Rules: Combines a certain situation with an act that is required or forbidden and which is governed by third-part sanctioning. The main function is to solve situations with conflicting interests. E.g property law, water pollution etc (involves sanction!!!)

Norms: Combines a certain situation with a required act or solution that in order to support an underlying value. The main function of a norm is to simplify life in a complex world, create regularity, solves coordination problems, protect the identity of human values, encourage proper human relations e.g. through guilt or external sanction (it may replace rules). E.g greeting, birthday gifts… (more obligation to act in a certain way (with social sanctions) like birthday gifts)

Strategies/conventions: Combining a certain situation with certain act or solution. The main function of a convention is to simplify life in a complex world, create regularity, solves coordination problems, identity protecting of human values, proper human relations, guilt or external sanction (it may replace rules). E.g.: (both parties benefit) - language... which makes it easier to navigate in a complex world; dress code (when we know exactly what to do!!!)


11. Can we think of institutions at different levels of social aggregation? How many levels does Oliver Williamson distinguish and how are they different? Use examples. (Williamson 2000)

Yes. Oliver Williamson describes four levels of social analysis.

  1. The first level is Embeddedness and refers to the social theory. It changes very slowly and relates to informal institutions like our traditions, customs, norms and religion. This level is taken as given by NIE.
  2. The second level refers to the Institutional Environment. It changes trough decades or centuries and describes the formal rules of the game. The economics of property rights (polity, judiciary, bureaucracy) and positive political economy (to understand how the things work).
  3. The third level refers to the Governance. It change trough years or decades and describes the play of the game. Specifically contract (the governance of contractual relations becomes the focus of analysis.
  4. The forth level refers to the Resource allocation and employment, it is a continuous process  described by neoclassical economics and agency theory to deal with prices and quantities; incentive alignment etc.


For the NIE the second and third levels are important and subject of analysis.

Level 1 : Embeddedness ( religion, conventions, traditions...etc. )

Level 2:  Institutional environment

(formal laws of game,constitutions, acts, proprietary rights)

Level 3: Control, management ( contract, harmonization of management)

Level 4: Resource allocation and employment ( price and quantity)