The New Institutional Economics

PaperNIEH24.
doc 11/15/05
1
Revised 9 November, 2005.
An earlier version appeared in: The European Business Organization Law Review (EBOR),
6:2, 161 200; 2005.

The New Institutional Economics
- Its Start, Its Meaning , Its Prospects
1
-
by
Rudolf Richter
*

Abstract:
This article first describes the history of the use of the term "new institutional economics" (NIE) from
the time it was introduced by Oliver Williamson. It shows how the term has evolved from a generic to
a standard term on the basis of NIE conference issues and collective volumes which appeared between
1984 and 1997. In 1997 the International Society for New Institutional Economics was founded.
Ronald Coase, Douglass North and Oliver Williamson were the driving forces of this development. In
the second part of this article, the meaning of the NIE is outlined following the basic concepts of
Williamson and North. The ideas of these two protagonists are compared with each other and their
better known criticisms are described and assessed. The final part of the article deals with possibilities
of broadening and deepening the objectives and analytic style of the NIE. The article concludes with
the observation that the potentialities of the NIE are by far not exhausted.
Key words: transaction cost economics, new institutional economics of history,
criticism of the new institutional economics, equilibrium of game view of
institutions, new institutionalism of sociology, new institutionalism of political
science.
.
This article deals with the early stages, meaning, and prospects of a field known under the
name of New Institutional Economics - a generic term introduced by Oliver Williamson
(1975, 1). It soon became a standard (or banner) under which a diverse group of economists
assembled, who shared one common intellectual ground: institutions matter, the relationship
between institutional structure and economic behavior requires attention, the determinants of
institutions can be analyzed with the aid of economic theory.

1
Revised version of a paper written at the Hoover Institution, Stanford University, Fall 2003 and first presented
at the Center of New Institutional Social Science, Washington University St. Louis, MO, USA, 4 December
2003 and later at the School of Management of the Saint-Petersburg State University, St. Petersburg, Russia 19
October 2005. Financial support of the Fritz Thyssen Foundation is gratefully acknowledged. I thank John
Drobak (Washington University), Jan Kmenta (University of Michigan) and Eirik G. Furubotn (Texas A&M),
Valery Katkalo and Natalia Drozdova (Saint-Petersburg State University) for valuable comments. I also thank
Rainer Kulms (Editor-in-Chief of EBOR) for his thoughtful suggestions. Any remaining mistakes are the sole
responsibility of the author.
*
Professor of Economics (em.), Universitt des Saarlandes, Rechts- und Wirtschaftswissenschaftliche Fakultt,
P.O. Box 151150, D-66041 Saarbrcken, Germany, e-mail: r.richter@mx.uni-saarland.de
PaperNIEH24.doc 11/15/05
2

1. The Evolution of the Field of the New Institutional Economics
Introductory Remarks: That institutions matter for economic performance is an old and
inherently plausible intellectual position. However, during the first half of the 20th century, as
the mathematical development of neoclassical theory has progressed and economic models
have become increasingly abstract, institutional phenomena have received less and less
attention. Thus, in what may be regarded as mainstream theory through the 1980s
(exemplified by welfare economics and the general equilibrium models of Arrow-Debreu),
institutions play virtually no role at all. In other words, it does not matter whether goods and
services are exchanged by the use of money or otherwise (Samuelson 1968) or how
production is organized - by the price mechanism across markets, or within a hierarchically
organized firm (Coase 1937) etc. Not surprisingly, these extreme views were soon opposed by
various strands of a renewed kind of economic institutionalism. Among its outstanding
contributors are Coase (1937, 1960), Alchian (1961), Buchanan and Tullock (1962), Olson
(1965), Williamson (1971, 1975), North and Thomas (1973) - to name but a few of the
pacemakers. Linked with these names are theories such as property rights analysis, the
economic analysis of the law, public choice theory, constitutional economics, the theory of
collective action, transaction cost economics, the principal-agent approach, the theory of
relational contracts, and comparative economic systems. Common to all these approaches is
that they, unlike neoclassical economics, do not assume the institutional framework as given
but make it into the object of research and also seek to consider the implications of any given
institutional arrangements for economic behavior. They do not ask What would self-
interested rational actors do?, but How could rational actors be constrained (or constrain
themselves) not to pursue their self-interest? (G. Miller 1997, 1196). The term New
Institutional Economics is used as a generic term by different authors for different
combinations of the above mentioned and other fields. In this section, we shall briefly survey
the history of the kaleidoscopic use of the term New Institutional Economics (NIE) to
illustrate the evolution of a new and, as we are convinced, widely applicable bundle of
methods of economic research.

1.2. The NIE, its First Understanding: Oliver Williamson, creator of the term New
Institutional Economics, understands the term rather broadly. He subsumes under the NIE
Aspects of mainline microtheory, economic history, the economics of property rights, comparative systems,
labor economics, and industrial organization.
The common threads tying these studies together were:
(1) that received microtheory operates at too high a level of abstraction to permit many
important microeconomic phenomena to be addressed in an uncontrived way; and
(2) that the study of transaction . is a core matter and deserves renewed attention.
2

2
Among the studies that deal, directly or indirectly, with the NIE Williamson mentions (1975, 1, n.1): Alchian
and Demsetz (1972, 1973), Arrow (1969, 1974), Davis and North (1971), Doeringer and Piore(1971), Kornai
(1971), Nelson and Winter (1973), Ward (1971) and his own contributions Williamson (1971, 1973).
3
A few pages later Williamson (1975, 7) describes the principal differences between the earlier literature and
his approach as follows:
(1) I am much more concerned than are prior treatments with tracing out the ramifications of
bounded rationality;
(2) I expressly introduce the notion of opportunism and am interested in the ways that
opportunistic behavior is influenced by economic organization; and (3) I emphasize that it is not
uncertainty or small numbers, individually and together, that occasion market failure but it is rather the
joining of these factors with bounded rationality on the one hand and opportunism on the other that gives
rise to exchange difficulties.
Williamson concentrates in his work on what he later calls transaction cost economics (TCE),
which he says is part of new institutional economics (Williamson 1985b, 16).
The term NIE seems to have remained largely dormant during the following five or so years.
However, Leonard Silk mentioned the word in the New York Times of September 24, 1980 as
a possible new direction that will gradually draw economists away from their tired repetition
of stale and sterile arguments.
3
I myself discovered it around the same time on page one of
Williamsons 1975 book. Shortly before I had become editor of the time-honored Zeitschrift
fr gesamte Staatswissenschaft (founded in 1844), at that time still a German language journal
on general economics.
4
I wanted to internationalize the Zeitschrift and looked for a suitable
specialty, a niche, coming close to its original field, the entire science of the state.
5
Public
Choice and Law and Economics were already well covered by journals, thus the New
Institutional Economics in the sense of Oliver Williamson appeared to be a promising choice.
Eirik G. Furubotn was prepared to help me, and, without thinking twice, we started together a
series of international seminars on the NIE with the aim to help the old Zeitschrift on its feet.
That was in 1983. The series became known as Wallerfangen Conference and is held
annually with different organizers and at changing places, up till now. Papers and
discussions are published in the Journal of Institutional and Theoretical Economics (JITE)
since 1984.
6

1.3 A Brief Interlude: Two Strands of Thought
Among the various approaches to institutional economics, two strands of thought are of
interest for an assessment of the NIE. They are (by use of gentle force):
1. A line of thought from, say, David Hume (1739/40) to Carl Menger (1883), F.A. Hayek
(1948, 1967), R. R. Nelson and S. G. Winter (1982), M. Kirzner (1973), D. Lewis (1969), A.
Schotter (1981), R. Axelrod (1984), K. Binmore (1994, 1998), A. Greif (1998), M. Aoki
(2001). This line is characterized by self-adjusting processes. Transaction costs play no
explanatory role. We call it the "invisible-hand approach to institutional economics".

3
See Langlois (1986, 1).
4
Among them, after all, the 1965 paper by Reinhard Selten for which he later (in 1994) received the Nobel
Prize.
5
On the German science of the state see Lindenfeld (1997).
6
An overview of the names of the organizers, topics, contents and participants of the so far held 21 NIE
seminars can be found in the internet under http://www.mpp-rdg.mpg.de/oekinst.html

4
2. Another line of thought leads roughly from Frank Knight (1922) and John R. Commons
(1934) to Chester Barnard (1938), F. A. Hayek (1945), Ronald Coase (1937, 1960), J.M.
Buchanan and G. Tullock (1962), M. Olson (1965), A. Chandler (1962, 1977), Herbert Simon
(1957, 1987), A.A. Alchian (1961), K. J. Arrow (1969), O. E. Williamson (1975, 1985), L.
Davis and D.C. North (1971), and D.C. North (1981, 1990), J. Knight (1992). In this
approach, transaction costs (or information costs) are essential as an explanatory element. For
want of a better term, we dub this line the "visible-hand approach to institutional economics".
Note: By any means, the two lines of thought are not to be taken as an indication of the
historical roots of the NIE. That is a rather complicated issue which cannot be dealt with here.
As for the history of the NIE itself we limit ourselves to one single question, viz., how the
term new institutional economics evolved to an unifying standard.
1.4 The Development of the Term NIE to a Unifying Standard
As mentioned above, the term new institutional economics became a more widely known
term around 1980, i.e., five years after it had been coined by Oliver Williamson (1975, 1). It
took another three or four years until economists used it in topics or titles of their
publications. In EconLit, the term NIE does not appears before 1984, but then increasingly in
titles of journal articles, books, papers in collective volumes or conference issues.
7
One
simple way to feel the pulse of our profession is to read editorial prefaces. Editors are
supposedly the brokers (or switchmen) of our profession. So, why not apply their judgments
as a measuring instrument for the development of the use of the term NIE. Following this
strategy, I am going to offer a brief report and evaluation of the editors comments to six
successively published collective volumes, starting with above mentioned first publication in
which the term NIE appeared, edited by Furubotn and Richter (1984), and continuing with
the collective volumes edited by Langlois (1986), Nabli and Nugent (1989), Harris, Hunter
and Lewis (1995), Drobak and Nye (1997), and Clague (1997).
1.4.1 Which Institutional Economic Fields do Belong to the NIE?
A first, somewhat simple question to ask is: Which special fields do editors of the listed
collective volumes consider to be part of the NIE? The answer is:

1 property rights approach,
2. transaction cost approach,
3. evolutionary economics,
4. constitutional choice,
5. collective action theory,
6. public choice theory,
7. economic contract theory,
8. new institutional approach to economic history,
9. modern Austrian economics.
Table 1 shows which fields are ascribed by whom to be parts of the NIE.

7
I found 395 records until end of 2002, starting 1984 with four papers which appeared in the conference issue of
the first International Seminar on the New Institutional Economics of 1983 (Furubotn and Richter 1984).
5

Furubotn/
Richter
(1984)
Langloi
s
(1986)
Nabli /
Nugen
t
(1989)
Harriss
etc.
(1995)
Drobak/
Nye
(1997)
Clagu
e
(1997)
Transact.
Costs Ecs.
X X X X* X
Property
Rights
X X X X* X
Evolut.
Econ.
X** X
Public Choice
Political Ecs
X X
Contract Th. X X
NIE History X X
Modern
Austrian
X
Constitutional
Choice
X
Collective
Action
X X
Table 1 Fields assigned by editors of collective volumes on the NIE.
(* transaction costs and property rights mentioned implicitly by emphasizing Coase [1937, 1960] and North
[1993]; ** Furubotn and Richter dropped this field in their subsequent eleven collective volumes
8
).
Certainly, our six collective volumes and their editors are no representative sample. Still, it
may not be all wrong to guess that table 1 reflects the prevailing view of our profession,
which fields, and with what weight, should be considered part of the NIE. Property rights and
transaction cost economics are quite certainly among them. In fact, they were voted for by
the editors of all six volumes. A distinct minority of editors comments (2 out of 6) name
contract theory, collective action, public choice, evolutionary economics, and the new
institutional economics approach to history as part of the NIE. The fields of modern Austrian
economics and constitutional choice fall far behind with only one vote for each. The great
weight given to the property rights and transaction cost economics speaks for our earlier
presumption that the end piece of the visible-hand approach to institutional economics is
regarded as belonging to the methods of the new institutional economics.

1.4.2 What is the Intellectual Bond of the Fields of the NIE?
A more demanding questions to ask is: What is the common pattern of reasoning used or
what is the intellectual bond of economists who belong to the practitioners of the NIE? Again
we are following the judgment of the editors of the six collective volumes under
consideration. Proceeding in chronological order, well report briefly on how they justify their
understanding of the NIE:

8
See: http://www.uni-saarland.de/fak1/fr12/albert/mitarbeiter/richter/institut/waller.htm

6
Furubotn and Richter (1984) argue that the foundation stones of the NIE would consist of the
traditional ones of neoclassical theory, viz., methodological individualism and self interest
principle. But while in neoclassical economics the influence of the institutional framework
was disregarded completely or specified only in perfunctory a way, the NIE would seek to
demonstrate that institutions matter. Beyond this, institutions themselves would be regarded
as legitimate objects of economic analysis. In other words, the unifying elements of the NIE
would be its basic methodology and its analytical objects. It would not matter that a number
of different approaches are employed in attempting to integrate institutional considerations
into economic theory. The authors stress that the study of transactions themselves and of
transaction costs is crucial and that another important shift in thinking relates to the way in
which property rights structures are perceived. The participation of Armen Alchian, Ronald
Coase, Douglass North and Oliver Williamson underline these judgments.
Langlois (1986) argues that the NIE consists of a number of identifiable strands. Principal
among these are, in the first place, evolutionary theory and the modern Austrian school
9
as
influenced by F. A. Hayek. Historically, Carl Menger would have
... perhaps more claim to be the patron saint of the new institutional economics than any of the original
institutionalists [like John R. Commons who is quoted by Williamson]. (loc. cit. 5)
Finally, Oliver Williamson, Ronald Coase and Herbert Simon are mentioned (in this order).
The Austrian and evolutionary prioritization by Langlois is underlined by conference
participants such as Brian J. Loasby, Andrew Schotter, Richard R. Nelson, Gerald P.
ODriscoll, Jr.

Nabli and Nugent (1989) edited a collective volume on the application of the NIE to
Development Economics. While there is as yet no consensus on what is included in the NIE,
Nabli and Nugent find that two broad and general approaches would be salient, "namely
transaction and information costs, on the one hand, and the theory of collective action on the
other" (loc.cit. 10).
The transaction cost approach is targeted, in the first place, at private goods. It contains the
property rights economics, transaction cost economics proper, and the more mathematical
oriented agency (or contract) theory.
10

The theory of collective action, is targeted at public goods of both, physical character such as
pollution or highways, and of an abstract character such as a " higher wage rate, a higher
price, , a regulation, a lower tax rate or a policy rule." (loc. cit. 14).
The two general approaches would be complementary. As long as transaction costs are not be
prohibitively high, external effects of individual actions could be compensated by contractual
arrangements between individual parties. Otherwise, collective action would obtain (loc. cit.

9
In fact, a considerable part of this introductory essay is devoted to the defense of the Austrian view of
competition as a process(loc. cit., pp. 7 15).
10
As for the latter the authors speak of themes concerned with incomplete information and asymmetric
information in particular. (p. 12)
7
18). Contributors to this volume include the editors themselves and Samar K. Dutta, Timur
Kuran, Bruce H. Herrick.

Harriss, Hunter and Lewis (1995) edited another conference issue on development
economics
11
. Proof of the importance of the NIE would be the award of the Nobel Prize for
Economics first to Ronald Coase in 1991 and to Douglass North in 1993. The NIE would be
able to explain non-market forms of organization as rational consequences of market failures.
It would, thus, challenge the dominant role ascribed to the market by the orthodoxies of the
last ten years or so (loc. cit., 1). North, who participated at the conference, emphasized that
the NIE retains the neoclassical assumptions of individual choice subject to constraints. The
constraints, however, would include also institutions. Transaction costs would play an
important role as well as ideas and ideologies. The latter would be a critical factor in the
performance of economies, as the source of the diverse performance of economies, and the
explanation for inefficient markets. (North 1995, 19). Keynote speakers at this conference
were Douglass C. North, Robert H. Bates and John Toye.

Drobak and Nye (1997) edited a collection of papers that were presented at a celebration of
the award of the 1993 Nobel Prize in Economics to Douglass North. The editors say, the NIE
would be less a distinct school ..than a particular set of shared concerns grounded in
existing economic theories and doctrines (loc. cit xv). New institutional economic historians,
like North, would begin with an appreciation of neoclassical price theory as a powerful tool
for predicting many economic outcomes in the real world. But the neoclassical assumption of
perfect individual rationality would have to be watered down or even replaced by other
assumptions about human behavior.
12
Central fields belonging to the NIE would be
transaction cost and property rights economics, political economy and public choice,
quantitative economic history, cognition, ideology, and the role of path dependency. Speakers
at this conference were, i.a., Douglass C. North, Robert William Fogel, Avner Greif, Gary
Libecap, Barry R. Weingast, Paul A. David.

Clague (1997) edited also a collection of papers on the application of the NIE to development
issues. He describes the NIE as an expanded economics. It would relax some of the strong
assumptions of traditional economics with respect to the motivation of, and the information
available to, individual decision makers, and it would widen the scope of economics to
include political phenomena and the evolution of institutions. The NIE would have called
attention to the vital role of government administrative capacity in shaping the institutional
environment of business. It might help to explain why bureaucracies perform well or badly
and how the inefficient and corrupt ones could be reformed. Among the conference
contributors were, i.a., Mancur Olson, Philip Keefer, Elinor Ostrom, and Margaret Levi.

11
Held at the London School of Economics and Political Science in September 1993.
12
North suggests to use what is known from other disciplines such as cognitive science or learning theory (loc.
cit. xix).
8
Summing up: All editors of our sample seem to agree that the NIE is not characterized or
defined by a selection of fields but by the intellectual bond of its basic methodology. A clear
majority favors contributions that belong to the "visible-hand approach to institutional
economics". Only a small minority (one out of 6 in our sample) prefers components of its
counterpart, the invisible hand approach (Langlois).
Those favoring the visible hand approach agree that the foundation stones of the NIE are the
same as the ones of neoclassical economics: methodological individualism and individual
rational choice given a set of constraints. However, due to transaction or information costs,
information is limited and, thus, institutions matter.
Like the old institutionalists,
13
the new institutionalists start from a criticism of current
economic theory for its too high level of abstraction (Williamson 1975, 1). But while the
old institutionalists clearly refuse the abstract assumptions of classical or neoclassical
economics, the new institutionalists tend to accept them, though, in a watered down form
because of transaction costs, Knightian uncertainty, bounded rationality etc., and from the
perspective that institutional arrangements tend to substitute, to some extent, for these
qualifications. In any case, all editors of our sample keep their distance from old institutional
economics - most of them expressis verbis,
14
There are clearly major differences between the
old and new institutional economics, nevertheless, as Rutherford (2001, 187) rightly points
out, some aspects of the new institutionalism do connect back to the old including a
tendency to spread beyond the standard neoclassical boundaries.
Finally, all editors of the six collective volumes under consideration seem to agree that the
composition of the fields of the NIE depends mainly on the particular object of research. In
this respect, our sample is somewhat one-sided. Most of the six volumes are concerned with
macro issues: Three deal with issues of development economics, one with new institutional
economic approach to history, another one with issues of evolutionary economics. Only one
issue includes also micro economic problems. Certainly, that is no representative mix of
applications, in particular since a great deal of new institutional economic studies are on
micro economic issues such as firms
15
, industrial organization
16
, antitrust
17
, contractual
relations
18
, market organization
19
etc.. Still, our sample gives some insight into how the
generic term new institutional economics became a standard (or banner) under which a
diverse group of economists assembled.

13
As represented by the German Historical School and American Institutionalism.
14
Furubotn and Richter (1984, 1), Langlois (1986, 2 - 5), Nabli and Nugent (1989, 10), Drobak and Nye (1997,
xv).
15
JITE (1986).
16
JITE (1985).
17
JITE (1990).
18
JITE (1987).
19
JITE (1994).
9

1.5 The Foundation of the International Society for New Institutional Economics
(ISNIE)
With the foundation of the International Society for New Institutional Economics (ISNIE) - its
first conference was held at Washington University, St. Louis, MO
20
in September 19 21,
1997 - the NIE came of age. The organizers advertised in the internet the conference to
scholars ..working on transaction costs, contracting, political rules of the game, the rules
of law, norms and culture, and who pursue these interests using standard scientific methods.
(Furubotn and Richter 1997, 780).
At the inaugural conference, North, Williamson and Coase in this order described the NIE
basically as above. Although the immediate objective of the NIE is to replace the abstract,
static models of neoclassical economics, Coase cautioned that a frontal attack on neoclassicis
m would be neither needed nor desirable. For appropriable theoretical development to be
achieved, it is sufficient to focus on factual matters. Somewhat later Coase (1999, 1 ff.) said,
ISNIE would have a mission, viz to replace the current analysis with something better, the
New Institutional Economics..The Influence of the New Institutional Economics will be
exerted in the various sub-disciplines [of economics]. Guerilla actions will take place, which
will result in the New Institutional Economics dominating first one and than other of these
sub-disciplines, as indeed is beginning to happen. But he adds We will not replace price
theory (supply and demand and all that) but will make it vastly more fruitful.
A selection of the papers presented at the second annual conference of ISNIE at Paris in
September 1998 has been published by Claude Mnard (2000), among them again
contributions by the old guard: Ronald Coase, Douglass North, Oliver Williamson, Harold
Demsetz, Yoram Barzel but also by Masahiko Aoki who supported the concept of the
institution-as-equilibrium-of-a-game concept. Coase and North stress again that the
representatives of the NIE dont want to replace neoclassical theory but are trying to use these
analytical tools to study the working of the economic system (Coase 2000, 4, or Coase
1999, 5 as quoted above). But that appears to contradict Norths concept of the cognitive
science/institutional approach to history or Williamsons casuistic technique to broach
bounded rationality. Why not admit that a change in paradigm is already under way?

20
See the brief report by Furubotn and Richter (1998).
10
1.6 Summary and Comments
Williamson (1975, 1) introduced the NIE as a generic term for a divers group of already
existing modern economic studies of institutions. The term was later mentioned here and there
but it took eight years until it was first used by conference organizers. After some 10 or 15
years it became a standard under which economists assembled who are interested in aspects of
the economics of institutions. As it turned out, the term NIE is generally used as a name of
what we called the visible-hand approach to institutional economics.
Table 1 shows the nine modern institutional economic fields which were mentioned as part of
the NIE in the above quoted literature. These theories were developed by different scholars
during the 1960s and early 1970s. Core fields of the NIE became:
Transaction cost economics (Coase, Williamson),
Property rights economics (Coase, Alchian),
Economic contract theory (formal: Spence, Mirrlees, Stiglitz, informal: Williamson,
Macneil) and
New institutional approach to history (North).
There are reasons to follow Nabli and Nugent (1989) and to count the theory of collective
action (Olson 1965) among the NIE. While property rights economics, and the formal part of
contract theory still assume perfect rationality this is not the case with transaction cost
economics and the new institutional approach to history of North.
Williamson (1975, 4) assumes men to be only boundedly rational, North (1995, 18 f.) writes
that a theory of institutions has to begin with a modification of the instrumental rationality
assumption, Coase (1984, 231) regards the assumption that man is a rational utility
maximizer to be both unnecessary and misleading. Thus, the assumption of perfect
rationality is being abandoned by leading neoinstitutionalists.
Two branches of the NIE developed after Coases (1937, 1960): The transaction cost
economics (TCE) of Oliver Williamson (1985) and the new institutional economics of history
(NIEH) in the sense of Douglass North (1986). Next to Coase, Williamson and North, became
the two leading representatives of the NIE. The difference between the Williamsonian and
the Northian approach is described by Ensminger (1992, 21 f.) as follows:
While Williamson (1981) takes the position that institutions are expressly designed to
reduce transaction costs and that, in competitive markets, those that fail to do so will not
survive. On the other hand, North (1981, ch. 3, 1990, 8, 52) argues vehemently against the
view: that institutions are created only to reduce transaction costs and increase economic
efficiency. The reason for inefficient institutions are inefficiencies of political markets,
democracy in polity is not to be equated with competitive markets in the economy.
(North 1990, 51).
21

21
As North (1986, 236) rightly remarks: Pareto efficiency simply dont make sense a great deal (in the
economics of institutions). For details see Furubotn and Richter (2005, 108 110).
11
However, both approaches hardly square with the constantly referred to neoclassical
economics and seem unwilling to make the break to a fundamentally new paradigm.
22
While
this is not achieved, one should at least be ready to apply different, problem related analytical
methods for different objects of economic research and define the science of economics by its
objects, instead of its method - as is done in other applied sciences. Economics is more
appropriate to compare to engineering or medicine instead of physics or biology (Varian
1993, 2 f.).
The Williamsonian approach to the NIE is mainly applied in microeconomic fields like the
theory of firm, of industrial organization, antitrust, the economics of organization. The
Northian approach is used to tackle macroeconomic issues as those of the history of national
economies, of development economics or transformation economics.

2. Meaning of the NIE
I shall restrict myself to the meaning of the Williamsonian and the Northian approach to the
NIE and shall proceed in this section as follows: First, I am giving a brief description of the
analytical core of Williamsons TCE and Norths NIEH. Second, I compare the two
approaches with each other. Third, I shall discuss briefly what some of their critics said.

2.1 The Analytical Core of Williamsons Transaction Cost Economics (TCE)
Oliver Williamson points out, i.a., that non-standard contracts may, but need not, result from
monopolistic practices. The reason is that transaction specific investments can play an
essential role after conclusion of contract. Williamson illustrates this by use of the concept of
fundamental transformation: After contract conclusion the parties find themselves locked into
a bilateral monopoly situation, whereas before they were free to choose with whom to trade.
Transaction specific investments of whatever kind (if only in form of time invested in search,
inspection, and bargaining) are the reason for this transformation. In addition, Williamson
takes into account the fact that we dont know what the future will bring. Under Knightian
uncertainty it is impossible to write a complete contract that details all possible future
contingencies even if transaction costs were zero.
23
Therefore, contracts contain
unavoidably loopholes and the lock-in of the parties may invite opportunistic behavior of the
other side because, due to information costs (a special kind of transaction costs), the parties
may be unable to verify their case to a third party (e.g., a court). Thus, court ordering may
have to be supplemented or even substituted by private ordering to effectively protect the
parties against opportunism of their trade partners. There exist various ways to organize the
governance structure of a contractual relationship. Their efficacy depends on particular
circumstance, inter alia, the size of specific investments and the frequency of transactions
between the parties. Transaction cost economics has been supported by numerous empirical
studies (overview: Shelanski and Klein 1995).

22
Selten (2001) and Gigerenzer (2001, in this sense, are the boldest and call for heuristics rather than
optimizations.
23
For lack of knowledge of what the future will bring, i.e., of all the stochastic variables.
12
Williamsons TCE is a theory of contracts under conditions of uncertainty and asymmetric
information, where legal enforcement and self enforcement complement each another. Both,
court ordering and private ordering characterize the governance structure (or organization)
of non-standard contractual relationships. Attentive actors agree before they come to terms on
a governance structure that they regard suitable. Market and hierarchy are two of the
imaginable ideal types of possible governance structures. Important to see is that the choice of
an efficient (better efficacious) governance structure results not from optimizing some
target function subject to a set of constraints. It may rather be understood as a form of
boundedly rational or suitable choice from a set of governance structures in the sense of
Seltens hypothesis of the casuistic structure of boundedly rational strategies (see Furubotn
and Richter 2005, 180).
24
Which governance structure the parties choose depends on the
particular situation. The problem for the parties then is to agree about both the right
diagnosis (of the situation) and the best cure (the governance structure). Williamsons
(1985, 79) table of efficient governance may be understood as an example of how to think,
not as an answer to the parties decision problem. - The idea is, to think less like a physicist -
more like a physician.

2.2 The Analytical Core of Norths New Institutional Economics of History (NIEH)
Douglass North aims at an economic explanation of the structure and performance of
economies through time.
25
He starts from the simple observation that human cooperation
requires rules of behavior, viz. institutional constraints, which, in the final analysis, define the
opportunity set of individuals.
26
In the world of costless transactions and perfect foresight the
nature of institutional constraints (as, e.g., full ownership or rent of land) does not matter. It is
without influence on the economic performance of the polity. That is no longer true for a
world with positive transaction costs and imperfect foresight. Here, the nature of the
institutional framework plays a major role in the performance of an economy.
27
It reduces the
uncertainty of human interaction and, thus, the costs of cooperation.
28
Persistent changes in
relative prices, due to lasting exogenous changes (such as changes in total population,
knowledge or ideology
29
), will lead actors to realize that they could be better off under
alternative institutional arrangements and result in institutional change. Yet, institutional
change is path dependent and shaped by the feedback between economic and political
markets. Due to the high (political and economic) transaction costs, inefficient institutions
may persist for long periods of time.
30

24
In this context, casuistic means that typical cases are identified and studied as, e.g., study is conducted in
case law or medicine.
25
North (1981, 3).
26
North (1990, 67). Clearly, the rights of disposal over certain real resources and knowledge are described by the
institutional framework (or governance structure).
27
North (1990, 69)
28
Institutions provide the structure for exchange that determines the cost of transacting and the cost of
transformation. (North 1990, 34) Under conditions of limited information and limited computational ability
[bounded rationality], constraints reduce the costs of human interaction as compared to a world of no
institutions. (loc. cit. 36) However, the share of US transaction costs of GNP grew from roughly a quarter in
1870 to over one-half in 1970 (Wallis and North, 1988, 120).
29
North (1981, 207 f.; 1990, 111).
30
North (1990, 92 ff.).
13
Institutional constraints comprise informal and formal rules of behavior.
31
Formal rules
consist of political rules (example: the constitution
32
), economic rules (examples: property
rights,
33
contract laws) and contractual agreements between actors (example: sales contract).
Political rules would lead to economic rules, "though the causality runs both ways."
34
The
enforcement of rules matters. Self enforcement would be ideal but is frequently not
promising.
35
In general, legal enforcement is more effective.
36
However, the coercive force
given to the state may be used by those in power to their own advantage.
37
In a simple model,
North (1981, 28) interprets the state as a ruler who maximizes his profit subject to basically
two constraints: the degree of political competition with rivals and with other states, and
transaction costs. For both reasons, the property-rights structure, which maximizes the social
product, may not maximize the ruler's (long-term) monopoly rents. North's judgment is rather
pessimistic. He says that to stabilize his power the ruler will agree to a property rights
structure that is favorable to those groups with close access to alternative rulers, regardless of
its effects upon efficiency. And because of the costs of determining and collecting taxes, a
less efficient property-rights structure may be more favorable to the revenue maximizing
ruler.
Norths concept of the NIEH aims at a general theory of the interaction between polity and
economy. It is, insofar, an application of the economic theory of politics to economic history.
However, in contrast to public choice theory and the theory of collective action,
38
North
assumes imperfect individual rationality and emphasizes the role of ideology. He rejects
rational choice and efficient market hypotheses.
39
Rather, he opines that because of
imperfect individual rationality
Mental models, institutions and ideologies all contribute to the process by which human beings interpret and
order environment. Mental models are, to some degree, unique to each individual. Ideologies and institutions are
created and provide more closely shared perceptions and ordering of the environment. (North and Denzau 1994,
21)

2.3 Comparing the Williamsonian and the Northian approach to the NIE
Both deal with the same object: institution. Williamson (1985) prefers to speak of
governance structure, North (1981, 1990) uses terms like rules of behavior, institutional

31
North 1990, 36.
32
Political institutions constitute ex ante agreements about cooperation among politicians. (North 1990, 50)
33
The establishment of "well specified and well-enforced property rights" account for the unprecedented growth
of Western economies (North 1989, 1320).
34
North (1990, 48).
35
Regarding contracts: neither self-enforcement by parties nor trust can be completely successful. (North
1990, 35)
36
...there are immense scale economies in policing and enforcing agreements by a polity that acts as a third
party and uses coercion to enforce agreements. (North 1990, 58)
37
...if the state has coercive force, then those who run the state will use that force in their own interest at the
expense of the rest of the society. (North 1990, 59)
38
Public Choice Theory applies the neoclassical economic style of reasoning to the analysis of politics as
reviewed by Mueller (1979). For an empirical study of the politico-economic interdependence see Schneider,
Pommerehne and Frey (1981).
39
North (1990, 111).
14
constraints or structure. In addition, North (1990) distinguishes between institutional
arrangements and institutional environment, the former being a subset of the latter, which
are a set of fundamental political, social, and legal ground rules that govern economic and
political activity (Davis and North 1970, 133). North stresses also the role of ideology.
Thus, we may say (strongly simplified):
TCE analyses the institutions of governance given the institutional environment. Its
object of research are agreed on arrangements essentially between two actors.
40
Such
institutions deal essentially with the transfer or administration of private goods and may
themselves be considered to be private goods. They are the result of individual action.
NIEH analyses the institutional environment inclusive ideology. Its object of research
are the informal and formal institutional constraints that control the behavior of more than two
actors. An institution in this sense deals with the provision or administration of public goods,
in fact, it is itself a public good.
41
It is the result of explicit or implicit collective actions.
TCE abstracts from the interaction between economic and political decision making. It takes
norms, customs, mores, tradition etc. as givens, the latter with the argument that institutions
at this level change very slowly in order of centuries or millennia (Williamson
2000.). It may do so, because it deals with the transaction of private goods and concentrates
on the limited task of showing that non-standard contracts need not result from monopolistic
machinations.
NIEH, on the other hand, does not abstract from the interaction between economic and
political decisions. It considers the possibility of making economic decisions via the political
process (North 1971, 118). Its central object is the development of a useful theory of
institutional change. (Davis and North 1970, 131) Ideologies are taken into account and
understood as comprehensive systems of cognitive and moral beliefs that figure
prominently in social life (North 1978, 972 ff.).

2.4 What Critics Said About the Williamsonian and Northian Approach
We are concentrating our discussion on some of the better known criticisms of Williamsons
transaction cost economics and Norths new institutional approach to economic history. Space
does not permit us to go into the debate of old versus new institutional economics.
42

We should begin by mentioning that the only positive criticism, that is the kind of criticism
that tries to replace the attacked theory by another better one comes in both cases from
mathematical economists. The rest limits itself to a criticism of assumptions.
2.4.1 Some Criticisms of TCE
Widely known criticisms come from scholars of mathematical economics, sociology and law.

40
Williamson (1993, 56) concedes: Transaction cost economics mainly works out a dyadic set-up.
41
Binger and Hoffman (1989, 68 f.).
42
For a more recent defence of old institutionalism see, e.g., Hodgson (1998). For an excellent comparison
between the two views see Rutherford (2001, 185 190).
15
1. Mathematical economists such as Grossman and Hart (1986) have criticised the
imprecision of TCE. They tried to develop, instead, a formal version of transaction cost
economics. But their theory of incomplete contracts, as it became known, does not really deal
with the central problem of TCE: ex post opportunism. Grossman and Hart explain rationally
only who should acquire a (private) property right, in their case who should become the owner
of the residual decision right of a contractual relation between a supplying and a buying firm
(Hart 1995, 5 ff.). The solution of their theory of incomplete contract theory is again, legally,
a complete contract. Thus, in Grossman and Harts model, the owners of the residual decision
right face no problems in proving their ownership before a court and therefore rely on legal
compulsion. It puts aside Williamsons problem of what happens after contract conclusion.
Irrespective of this, Gosssman and Harts approach opened up a new and attractive area of
contract theory - the theory of incomplete contracts. Leading representatives of this approach
are, in Germany, G. Nldecke and Klaus Schmidt (1995), both from the Bonn school (see
Schweizer 1999). Closer in spirit to the TCE may be the paper by Bajari and Tadelis (1999).
2. Granovetters (1995a, 63 ff.) sociological critique is centred upon Williamsons
assumptions of his markets and hierarchies analysis (Williamson 1975). Granovetter argues
that Williamsons appeal to authority relations in order to tame opportunism constitutes a
rediscovery of Hobbesian analysis, an over-emphasising of hierarchical power (Granovetter
1995a, 65). Williamson disregarded the embeddedness of the individual in a net of personal
relationships. In the creation of trust, social structures or networks are of significance. They
discourage malicious behaviour (Granovetter 1995b, 200). Williamson vastly overestimates
the efficacy of hierarchical power within his organizations. (Granovetter 1995a, 68).
However, Granovetter's criticism of TCE is besides the point because Williamson deals on
purpose only with bipolar relationships that are not subject to social control the case of the
fundamental transformation. Williamson's claim that opportunism is prevalent is widely
reflected by the facts. Examples are provided, not least, by the problems of corporate
governance that are attracting growing attention recently in the United States and Germany
(vide the Enron, WorldCom, and Berliner Bank affairs).
3. Posner (1993), a well known representative of the Economic Analysis of Law of the
Chicago School, attracted much attention by his paper on The New Institutional Economics
meets Law and Economics. He offers a very individual interpretation of the assumptions of
TCE in sharply rejecting Williamsons (1985a, 189 f.) criticism of the Chicago School's
doctrine, and emphasises that the law and economics work at Chicago would as well be
occupied with problems of uncertainty, bilateral monopoly, and opportunism and with
how legal and economic institutions try to solve them. (Posner 1993, 81). All that
Williamson's opportunism would mean is advantage taking under conditions of a temporary
monopoly, or through informational advantages in a situation of asymmetric information
(1993, 80). That is not quite correct either. Williamson's point is that the bilateral monopoly
situation exists not ad ovo but is the unavoidable side effect of the conclusion of an exchange
contract between two individuals that requires specific investments. Finally, Williamson does
not only criticise the assumptions of Chicago style (i.e., neoclassical) microeconomics, he
suggests also to replace the attacked theory by another theory that is better equipped to
explain non-standard exchange contracts like vertical integration that influenced antitrust
16
policy considerably. Of course, Williamson's TCE is not based on a formal model. However,
that is a price to be paid (so far) if one leaves the sphere of perfect individual rationality and
perfect foresight - as do all representatives of the NIE in the sense of this paper.
43

2.4.2 Some Criticisms of NIEH
For whatever reason, Douglass North received less critical attention by well known people
than Oliver Williamson. Two criticisms are worth mentioning:
1. Aoki (2001, 5), a mathematical economist, criticizes that North's theory of economic
history is based on a visible-hand approach to institutions. He would apply a rule-of- the-
game view of institutions. To quote North (1990, 3 f.):
Institutions are the rules of the game in a society, or, more formally, are the humanly devised
constraints that shape human interactionIn the jargon of the economists, institutions define and limit
the set of choices of individuals.
Rule-making would be susceptible to conscious design by legislators, political entrepreneurs,
or mechanism design economists (Aoki 2001, 9). Aoki argues that an invisible-hand approach
to institutions would be better suited to explain the diversity of institutional arrangements
as well as the nature of the process of institutional change. As a game theorist he favors a
game-theoretic equilibrium approach that is characterized by the concept of Nash-equilibrium.
Accordingly, Aoki defines an institution as
a self-sustaining system of shared beliefs about a salient way in which the game is repeatedly played.
(2001, 10, italics in the original)
But the Nash equilibrium is a static concept. It explains the logic of self-enforcing social
orders (the persistence of institutions) but not their change.
44
For North (1990, 54), the ability
of societies to develop "effective, low-cost enforcement of contracts is the most important
source" of economic development. Institutional change comes about through the visible hand
of entrepreneurs in political and economic organizations who realize that they could do
better by changing the institutional framework. We interrupt here to resume the equilibrium of
game view in the following chapter.
2. Another branch of criticisms is related to the age old controversy of economists or social
scientists between individualism and socialism (or holism). Schumpeter tried to defuse the
debate by suggesting to distinguish sharply between "political" and "methodological
individualism (Schumpeter 1908, 90). The latter was thought to be used, within narrow limits,
for the description of certain economic processes (1908, 94), however not in organization
theory or sociology (1908, 95). To day, the term is used for a much wider purpose than
Schumpeter had in mind. In any case, it became an axiom of the NIE and is represented in
North's new institutional economic history. This is seriously criticized by economists like

43
On Williamson's reply to Posner see (1993c)

44
Greif and Laitin (2004) have shown a way out: The hypothesis of a self-undermining Nash equilibrium of
repeatedly played games.
17
Fine and Milonakis
45
as being North's "most sacred analytical principle" (Fine and Milonakis
2003, 561). They rightly ask, how the concept of methodological individualism would square
with North's assumption of ideology (a social phenomenon) as the explanatory factor in his
theory of institutional change.
46
His treatment of institutional change and stability would be
exogenously determined because North does not provide a theory of ideology (see Rutherford
1994, 46). This argument relates to the problem of infinite regression which is contained in
both, the visible and the invisible hand approach to institutions. It is an unavoidable, ever
debatable issue of any theory.

3. Prospects of the NIE
There is much to be speculated about concerning the future of the NIE. I abstain here from
that temptation.
47
Instead, I will comment briefly on three activities which are under way but,
not yet, part of the NIE in the above described sense. These activities are:
1. the equilibrium-of-game view of institutions,
2. the new institutionalism in sociology,
3. the new institutionalism in political science.
Further research activities could be mentioned such as the evolving field of behavioral
economics (e.g., Kahneman 2003) and, together with it, the efforts in experimental game
theory (on early German experimental work see Tietz 1990, of the largely American work see
Roth 1995). The latter two fields, however, are for the institutional economist only of interest
as long as they deal with the scientific explanation of the formation of institutions say, in the
sense of Norths concept of the cognitive science/institutional approach to history.

45
See Fine and Milonakis (2003), Milonakis and Fine (2005).
46
For a brief review and assessment of the criticisms of North's NIEH see Zouboulakis (2005).
47
As opposed to chapter 10 in Furubotn and Richter (2005).
18
3.1 The Equilibrium-of-Game View of Institutions
We observe a growing literature on the application of game theory on institutional economic
issues. They deal formally with what we called the invisible-hand approach to economic
analysis. Lewis (1969) and Schotter (1981) are among the first representatives of this line of
thought, later, i.a., the above mentioned work of Greif (1998) and Aoki (2001). Central to this
equilibrium-of-game-view of institutions is the concept of the Nash equilibrium of a game - a
state of a game, in which no actor has an incentive to deviate from his present plan of action
as long as other actors do not do so. Expectations of actors about the behavior of others play
an important role here.
The concept of the Nash equilibrium is interesting for two reasons: It explains the logic of a
self-enforcing social phenomenon (answers the question: Who enforces the enforcer?) and it
shows that social agreements are not eo ipso a state of harmony that is worth searching for.
Rather, a Nash equilibrium can be a catastrophically bad equilibrium for all the participants.
Still, even though all participants realize this, no one would have an incentive to deviate from
his present plan of action as long as no others do so.
However, the equilibrium-of-game view of institutions deviates from the NIE as defined
above, because in game theory, all possible strategic interactions have to be described
beforehand (information in this sense is perfect) and individuals act perfectly rationally.
Transaction or information costs play no essential role.
48
These requirements are inconsistent
with the basic assumptions of transaction costs, uncertainty and bounded rationality of the
NIE. Thus, from a neoinstitutionalist viewpoint in the above defined sense, the institution-as-
equilibrium-of-game view could, at most, be employed as an informal way of thinking, not as
a formal model. Nevertheless, since loose talk can lead to dangerously wrong conclusions, it
might be preferable to apply formal game theory in addition to informal game theoretic
interpretations of social phenomena, as illustrated, e.g., by the analytic narrative approach
described by Bates et al. (1998, 10ff.). Avner Greif, an economic historian, is among the
leading representatives of this approach.
49
He argues that game theory provides a natural
theoretical framework to examine self-enforcing institutions and to view an institution as a
coordination equilibrium. Game theoretic historical analysis
. requires context-specific strategic modeling and an inductive historical analysis. (Greif 1997, 85, emphasis
added)
As mentioned above, Aoki (2001) argues in a similar vein. Institutions would be explainable
as a salient Nash equilibrium of the way by which an underlying game is repeatedly played.
But since nobody can escape from the problem of infinite regression, one cannot start to
explain institutions from an institution-free world. Going back to North's path dependency
argument, Aoki suggests
to seek to direct the infinite regression toward structures inherited from the past(Aoki 2001, 15)

48
They may be interpreted into games of incomplete information or, more general, into the properties of the
underlying game of a recursively played game.
49
His historical and comparative institutional analysis is excellently reviewed in Greif (1998a).
19
But the Nash-equilibrium, being a static concept, does not explain how it comes about or how
the invisible hand works. On a trial basis this is done by dynamic approaches like
evolutionary game theory
50
or the theory of (individual) learning in games.
51
They are used to
formally illustrate how a spontaneous order might evolve and, thus, provide a mathematical
background to the considerations in the tradition of Hume, Menger, Hayek.
In real life we find hardly any institutions of purely "invisible-hand" origin. Menger (1883)
himself agreed that the (usual) "pragmatic" interpretation of institutions is just as
indispensable as his "organic" view (1983, 148). It therefore seems advisable for practitioners
like managers, law makers, business or policy analysts to use a suitable mix of both
approaches - the visible and the invisible hand approach. Take the problem of predicting the
effects of a new law, a "made" order. As for its probable effects two types of questions may
be asked, a simpler and a more complicated one. The simpler question concerns the direct or
"visible hand" effects and the enforcement requirements of a new rule (e.g., the direct effect
of a ban on interest on loans). The more complicated question is: What are the "invisible
hand" effects? (In our example: what evasive financial arrangements are imaginable?). Since
no law is perfectly tight, there is always some room for strategic (opportunistic) maneuvers of
the constituents. The general question then is: What set of informal rules might grow
spontaneously into the gaps of a legal framework, and how long will the spontaneous growth
process continue? Is it likely that some stable endpoint will be reached that represents an
institutional arrangement? Can the end point be viewed as a self enforcing equilibrium? Or
will the law undermine itself and collapse? For an example of the latter case see Fururbotn
and Richter (2005, 29 f.).
If both, the invisible hand and the visible hand approach, are reasonably applied uni sono, it
seems advisable to count both approaches among the methods defined by the term NIE.

3.2 The New Institutionalism in Sociology
With the development of NIE, economists deeply infiltrated sociologists territory and
sociologists, understandably, rose in arms. They lined up to a counter attack under the banner
of New Economic Sociology (NES). It was started in the 1980s at Harvard by former students
of Harrison White, among them Robert Eccles (1981), Mark Granovetter (1985), Michael
Schwartz and, as a student of Granovetter, Mitchel Abolafia (1984). Independently of the
Harvard group, several other sociologists joined battle, among them, Susan Shapiro (1984),
Viviana Zelizer (1983). Their objective was to attack economists by elaborating the
sociological viewpoint as forcefully as possible. (Granovetter and Swedberg 1992, 7)
52

The number of studies in economic sociology exploded during the following years as
illustrated by the review article of Baron and Hannan (1994), the Handbook of Economic
Sociology edited by Smelser and Swedberg (1994a, 2005), the Symposium on Sociology and
Economics in the Journal of Economic Perspectives (Gibbons 2005), the bibliography of the
recently established Economic Sociology Section of the American Sociological

50
cf. Mailath (1998).
51
cf. Fudenberg and Levine (1999).
52
For a comparison of NES and NIE see Richter (2001).
20
Association.
53
Sociologists rediscovered their old object of research, institutions, and
developed their own brand of new institutionalism as described and discussed in Powell and
DiMaggio (1991) or Brinton and Nee (1998) - which is not necessarily very helpful for our
purposes. We rather prefer to ask the more general question:
What can neo-institutional economists learn from the New Economic Sociology? We believe,
three things.
1
st
, the scientific background of sociological concepts (partly reinvented by
neoinstitutionalists) that are central to the NIE among them the concept of institutions
itself, of organizations, order, implicit agreements, relational contracts, convention,
ideology, social capital, trust, individual preferences.
2
nd
, the possible uses of sociological concepts which might be able to complement the
analytical concepts of the NIE among them the idea of social networks, embeddedness,
social exchange, business groups, culture, emotional relationships, power.
3
rd
, how to subdue the occupational disease of economists to drastically simplify all objects of
their research and, instead, to look and see more closely - or even get dirty hands.
One example for each of the points may suffice.
Ad 1
st
: Take the concept of relational contracts. It was introduced into the NIE by Goldberg
(1976) and Williamson (1976), based on of the contributions of Macaulay (1963), a
sociologist of law, and Macneil (1974), a scholar of contract law. It is a special case of Max
Webers concept of social relationship which Weber describes at length in his Economy and
Society (Weber 1968, 40 ff.). Williamson uses the concept for long-term agreements between
parties that take into account the fact of incomplete foresight. They establish contractual
provisions, in order to accommodate unforeseen contingencies. Unavoidably, such contracts
are incomplete. The contractual parties agree, either explicitly or implicitly, about the
procedure (the constitution) that will be employed to deal with problems that may arise. In
other words, legal enforcement is supplemented, or substituted for, by private ordering (cf.
Furubotn and Richter 2005, 566).
Ad 2
nd
: Cast a quick glance at social networks. They are defined as a set of actors, attributes
of actors, and relations between actors. Network relations raise issues, foreign to pure dyadic
relations, such as the centrality or prestige of actors, their social position, their social
role. (Wasserman and Faust 1994) The concept of social network puts a new light on
competition theory: Competition can be interpreted as competition of actors for social
positioning (Burt 1992a). Positioning of sellers or buyers in a network of market relationships
is a matter of strategic significance. A new actor, entering in an already existing network, e.g.,
an existing market or firm, faces the challenge of positioning himself among the already
existing actors and to build links with them. Links between actors are relationships over time
such as the formal or informal authority relationships in a firm, standing contracts, streams of
transactions in markets, social relationships. They may be tight or loose, depending on the
quantity (number) or quality (intensity), and type (closeness to the core activity of the parties

53
Economic Sociology Section in Formation, Mission Statement (21.12.2000),
see http://uci.edu/econsoc/mission.html
21
involved) of interaction between members. (Thorelli 1986, 38). Social structure is
characterized by the strengths of these links. An important role in the debate among
sociologists of the NIE plays the concept of embeddedness, as used by Granovetter (1985).
He argues that economic action takes place within the networks of social relations that make
up the social structure (detailed reviewed in Granovetter 2005).
They may be self enforcing or third party enforced such as network hierarchies, like vertically
controlled business groups (Hamilton and Feenstra 1995, 643 ff.) Building links with other
actors requires sunk investments in social relationships or social capital (Burt 1992b, 58).
Ad 3
rd
: An example for "look and see" or "get your hands dirty" is provided by Melville
Dalton who arranged to be employed at The Milo Fractionating Center without top
management knowing that he was, to conduct a study on "personnel problems." He reports on
his results in Milo (Dalton 1959). For an excerpt of his report see Granovetter and Swedberg
(1992, 315 - 344). Daltons research provides a concrete example for our presumption that
formal rules leave big enough gaps for the working of the invisible hand, i.e., for informal
rules to grow spontaneously into. In the present example, the formal order is a written down
organization chart, which was supplemented by an informal chart which grew into it. His
study indicates how " this informal structure, though deviant from what is expected,
actually makes it possible for the plant's work to get done." (Granovetter and Swedberg 1992,
315). However, it is important to see that "in terms of profits and dividends paid, Milo was
definitively successful and presumably well managed." (Dalton 1959, 190n - quoted from loc.
cit.)
22

3.3 The New Institutionalism in Political Science.
Political science as political economy makes only sense under conditions of
imperfections of the classical model, i.e., in a model with positive transaction costs and
bounded rationality. Therefore, its subject is also suitable for the analytic style of the NIE. In
fact, as in sociology, the new institutional economics movement has been applied, implicitly
at least, in various fields of political science in recent years. The areas affected include the
theory of the state (Levi 1988, 2002), government organization (Shepsle and Weingast 1987),
public administration (Weingast 1984, Moe 1990), international organization (Keohane
1984), the American Congress (Weingast and Marshall 1988), the theory of international
organizations (Keohane 1984), the emergence and change of (political) institutional
arrangements (Knight and Sened 1995), federalism (Weingast 1995).
54
This new
institutionalism embraces many approaches, among them what Thelen and Steinmo (1992, 7)
or Hall and Taylor (1996, 943) call the rational choice institutionalism, a line of thought
which approaches the NIE in the original sense of this paper like the above mentioned work
of Keohane, Weingast or Moe. It would include also context specific applications of game
theory like in the work of Levi (1988), Bates (1998) or Mayerson (2004).
Another institutionalism in political science is historical institutionalism (Thelen and
Steinmo 1992, 7; or Hall and Taylor 1996, 937 ff.). According to Thelen and Steinmo, the
core difference between the two views lies in the question of preference formation, whether
treated as exogenous (rational choice) or endogenous (historical institutionalism).
55

However, the latter is also assumed by sociologists like Granovetter (2002, 7). At any rate, in
the world of the NIE with transaction costs, imperfect information and bounded rationality,
many different forces can influence what an individual knows about options and how he
forms his preferences. Preference functions are necessarily vague constructs (Furubotn and
Richter 2005, 545).
What can economists learn from political scientists? To stop looking at the legal ground rules
of society as a datum of economics. Rather, to integrate the making, administering and
enforcing of the rules into the economists set of research objects. To start viewing the polity
and economy as one narrowly linked system (nationally and internationally). To recognize the
possibility of making economic decisions via the political process.
56

One example may suffice: The two ways of economic exchange. First, exchange the naive
way: Traders negotiate with each other according to the rules of the market which they take as
givens. Second, exchange the sophisticated way: Traders negotiate at front with each other,
round the back with the government. They are trying to have the market rules changed their
way, e.g., at the expense of some unorganized third group. In the first case, the rules of the
market are an exogenous, in the second an endogenous variable. We get two different types of

54
Overview: Miller (1997).
55
See Thelen and Steinmo (1992, 9).
56
A point stressed by North (1971, 118): The economist not only accepted tastes, technology, and population
as given, but also he accepted equally the current basic ground rules within which both market and non-market
decisions were made. For that matter, the theory did not recognize the possibility of making economic decisions
via the political process.
23
market equilibria. The first is a classical economic market equilibrium. The parties agree on
the price at which demand is equal supply - given the rules of the market. The second is an
interventionist market equilibrium in which two markets the economic and political market
are equilibrated: On the economic market (e.g. the labor market) a price is agreed upon
which equals legally restricted demand to legally restricted supply the unsatisfied parties
(e.g., the unemployed and consumers) are bribed or forced to accept. On the political market
an intervention is agreed upon which organized interest groups and those in power find
acceptable. The second case might reflect the situation on the (West-) German labor market
since the first oil crisis 1974 until, say, reunification.
Noteworthy in this context is a remark by Olson (1984): Instead of asking, why is there
unemployment? he writes, one should ask who benefits from unemployment? At all
events, the above interpretation has recourse to particular interest groups (trade unions as the
representatives of the owners of jobs and employers associations as representatives of owners
of capital and managers) in the pursuit of their special interests. From this viewpoint,
unemployment can be a interpreted as a Nash equilibrium. In such a state, no actor of the
political parties, the trade unions, the employers associations, the media, the labor courts
would have an incentive to deviate from his present plan of action as long as other actors do
not do so, even if they all realized to be in a bad equilibrium. As for the Chancellor, he could
not seriously put his foot down. He is part of the game himself.
Instead of using a game equilibrium approach to tackle the above problem, one might as well
use a transaction cost approach as suggested by Dixit (1996) in form of his transaction-cost
policy framework, a combination of the Williamsonian and Northian concepts of the NIE.

4. Conclusion
To summarize: It would be more appropriate to use the term "economics of institutions"
instead of "institutional economics". In any case, the term "NIE" defines various kinds of
economic explanations of institutions. According to our findings, it comprises property rights
analysis, transaction cost economics, contract theory and the new institutional approach to
history. All these theories belong to the "visible hand approach to institutional economics",
which describes, in the terminology of Hayek, "constructed" orders. Next to Ronald Coase,
who first realized the institutional consequences of transaction costs, are Oliver Williamson
and Douglass North as the leading representatives of the NIE. Both stress the importance of
transaction costs, uncertainty, imperfect rationality, methodological individualism. Otherwise
their approaches differ considerably regarding their methods and objects of research.
Williamson concentrates on the limited task to show that nonstandard sales contracts need not
result from monopolistic machinations. He turns his attention to the, so far by economists
ignored, behavior of the parties after contract conclusion, i.e., to the process of execution,
control and enforcement of contracts. The underlying problems result from contract specific
investments, Knightian uncertainty, and the therefore unavoidable incompleteness of
contracts. To minimize ex post opportunism of the partners to the contract, both parties are
complementing or even supplementing potential legal enforcements by private orderings.
24
While Williamson deals with microeconomic problems and abstracts from political decision
making, North, an economic historian, is concerned mainly with macro economic issues. His
central object is the development of a useful theory of institutional change. He aims at a
general theory of the interaction between the polity and the economy. In fact, his approach is
basically an application of the new theory of political economics to economic history. North
broadens the assumption of imperfect rationality by the concept of ideology and results of
modern cognitive science.
However, the interest in an explanation of institutions is not limited to the NIE. Game
theorists became interested in the illustration of the workings of the "invisible hand"
mechanism and the logic of "self enforcement", i.e., in a revival of research in the invisible
hand approach to the economics of institutions along the line of Hume - Menger - Hayek. The
equilibrium-of-game view of institutions was developed. However, in real life we find hardly
any institutions of a purely "invisible-hand" origin. "Constructed" orders (e.g., new laws) play
an important role. Because of unavoidably incomplete information they leave gaps into which
informal rules grow spontaneously. This has to be taken into consideration if one wants to
predict the effects of new formal orders, e.g., new laws. It seems worthwhile for practitioners
working in this area to learn some game-theoretic style thinking.
Together with economics, sociology and political science experienced a revival of interest in
the theory of institutions. It is interesting for economic or legal analysts to learn the
sociological background of such everyday concepts as institutions or organizations, of social
relations, social capital, ideology as well as by economists less applied concepts such as
social network analysis, social exchange, national culture and simply to learn how to "look
and see".
Political scientists demonstrate that the polity and economy are a narrowly linked system
both, nationally and internationally. This perspective is still widely disregarded by economists
in spite of the work of representatives of the new political economy like Buchanan, Olson or
the work of North. Economists lost their innocence once they turned away from the
principles of the classical liberal state
57
in favor of some, however colored, welfare state.
Surprisingly, the application of the NIE remained so far rather limited: on the micro-level to
issues of industrial organization, on the macro-level to economic history and development
economics. Its potentialities are by far not exhausted. Extended by game-theoretic thinking
the Williamsonian and Northian new institutional economic methodology can be applied to
virtually all problems of economic life be it on the national and or the international level. I
am particularly thinking of the present German macro-economic situation and the helpless
attempts of economists to advise politicians, interest groups and voters on the basis of good
old static or dynamic macro models (cf. Institut der deutschen Wirtschaft 2005).

57
The classical liberal state is supposed to abstain from all attention to the personal wealth of its citizens and to
go not a step further than necessary to secure its citizens against themselves and foreign enemies; for no other
final purpose should the State restrict their freedom (Humboldt (1792/1967, 52).

25

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