Institution and economic life Week 10

The limitation of neoclassical economic theory

It assumes a direct connection between choice and outcome, it ignores institutions
It assumes actors have complete information, eliminate uncertainty
It overlooks imperfect processing of information by actors
It assumes that actors maximize utility and undermine the effects of cultural belief and ideology.
It assumes zero transaction cost

Transaction cost is the cost incurred in making an economic exchange, includes:
• Search information cost (cost of information)
• Bargaining cost (cost of negotiation)
• Enforcement and monitoring cost (cost of enforcement)

Production cost is the sum of transformation cost and transaction cost. Transaction cost arises from specific institutional arrangements.

Why transaction costs are so costly?

It is largely because the asymmetry of information among transacted parties. It is costly to get accurate information and determine and measure value. Sometimes, people have an interest in withholding information.

North’s Transaction cost approach suggests:

Economic theory must take into consideration of the transaction cost. There are many economic efforts and resources are devoted to measurement of attributes; warranties, guarantees, trademarks; sorting and grading. Much effort and resources involved in enforcing contract and in case of disputes arise, arbitration, mediation and litigation also increase transaction cost.

The same is also applied to relationship of the principal and agent; the employee and employer. To ensure the maximum effort from employee and agent, often, employer and principal need to monitor their performance, but the frequent measurement is very costly. There are always some degrees of trade off and uncertainties in these relationships. The greater uncertainty, the higher transaction cost.

In order to reduce the uncertainty, the new institutional economics model suggests that institutions act as a system of interrelated formal and informal elements governing social relationships within which actors pursue and fix the limits of legitimate interests. They facilitate, motivate and govern economic and social action.

Institutional constrain in regulating economic and social action acts in different levels:
• Network constrains the internal relationship between exchange parties
• Third party may also constrain the first party
• Government by law and police imposes political constraints
• Social norms and customs impose societal constraints.