Reviewed by Rizal, K.
Douglass C. North (1990) provides a good foundation for understanding institutional economics. In his seminal work he put forward some underlying arguments on which he develops his concept of institutions.
First, he identified theoretical problems in explaining human coordination and cooperation in neoclassical economic theory and other social sciences. This problem of coordination and cooperation can be addressed through iterated games through which participants may explore each other’s motivations (see also Ostrom 2005). Institutions emerge from prolonged iterated interactions that make one’s motivations predictable for others.
Second, acknowledging the limitation of rational choice theory of neoclassical economics, North (1990) revealed two human characteristics that are crucial to be incorporated in a theory explaining economic outcomes, which are human motivations and human abilities to process information (bounded rationality). Again, institutions (formal and informal) may constrain human behaviors, thus provide predictable motivations that shape choices and help individuals to decipher the complexity of the environment.
Third, institutions reduce uncertainty by providing structure for exchange, thus reducing the costs of transactions. He also stressed that institutions may provide stable structures but that these structures are not necessarily efficient. Differences in economic outcome therefore hinge on the efficiency of institutions in reducing transaction and transformation costs that exist in society within local, regional and national levels. For empirical evidence, he juxtaposes two cases of North and South America, of which the later has more efficient institution, leading to better economic performance.
Further, North acknowledged embeddedness of institutions into social and cultural situations that change incrementally even though formal institutions may change overnight as a result of political or judicial decisions (p. 6).
It is important to note that despite North’s tendency to tie institutions to the economic analysis of transaction costs, his line of argument is in fact built on bounded rationality of human behavior and embeddedness of institutions into social-cultural contexts which are in contradiction with the basic assumptions of neoclassical economics. Embeddedness itself is an important concept in economic sociology introduced by Granovetter (1985).
North, DC 1990, Institutions, Institutional Change and Economic Performance, Cambridge University Press, Cambridge.