The New Institutional Economics and Development

In this essay I intend to briefly summarize the essential characteristics of the new institutional economics, to describe how it differs from neo-classical theory, and then to apply its analytical framework (as I see it) to problems of development. I The new institutional economics is an attempt to incorporate a theory of institutions into economics.1 However in contrast to the many earlier attempts to overturn or replace neo-classical theory, the new institutional economics builds on, modifies, and extends neoclassical theory to permit it to come to grips and deal with an entire range of issues heretofore beyond its ken. What it retains and builds on is the fundamental assumption of scarcity and hence competition--the basis of the choice theoretic approach that underlies micro-economics. What it abandons is instrumental rationality--the assumption of neoclassical economics that has made it an institution-free theory. Herbert Simon has accurately summarized the implications of this neo-classical assumption, as follows: If we accept values as given and constant, if we postulate an objective description of the world as it really is, and if we assume that the decisionmaker's computational powers are unlimited then two important consequences follow. First we do not need to distinguish between the real world and the decisionmaker's perception of it: he or she perceives the world as it really is. Second we can predict the choices that will be made by a rational decisionmaker entirely from our knowledge of the real world and without a knowledge of the decisionmaker's perceptions or modes of calculation (we do, of course, have to know his or her utility function). (Simon, 1986, p. s 210) In a world of instrumental rationality institutions are unnecessary; ideas and ideologies don't matter; and efficient markets--both economic and political--characterize economies. In fact, we have incomplete information and limited mental capacity by which to process information. Human beings, in consequence, impose constraints on human interaction in order to structure exchange. There is no implication that the consequent institutions are efficient. In such a world ideas and ideologies play a major role in choices and transaction costs result in imperfect markets. The place to begin a theory of institutions, therefore, is with a modification of the instrumental rationality assumption. We are still a long way from completely understanding how the mind processes information, but cognitive science has made impressive strides in recent years. Individuals possess mental models to interpret the world around them. These are in part culturally derived--that is produced by the intergenerational transfer of knowledge, values, and norms which vary radically among different ethnic groups and societies. In