A Microeconomic Analysis of Institutions

Ola Olsson

Working Papers in Economics no 25

Department of Economics
Göteborg University

Box 640, SE-405 30, Göteborg

[email protected]

Revised version
April, 1999

Abstract

This survey paper has three themes; a microeconomic analysis of institutions, an

institutional analysis of microeconomics, and a discussion on the scope for an “institutional
microeconomics” that takes insights from psychology and older institutional theory into
account. Institutions are defined as the long-run rules of the economy that have the
character of public goods and whose main function is the reduction of transaction costs.
The institutional requirements for the Walrasian equilibrium and for a cooperative solution
in a Prisoner’s Dilemma-like game, are thoroughly analyzed. The paper briefly surveys the
main results from the OIE and NIE-schools and discusses the possibilities of an
interdisciplinarily oriented institutional microeconomics.

Keywords: institutions, microeconomics, Walrasian equilibrium, game theory

JEL Classification:C72, D23, D70

* I am grateful for comments on earlier drafts from Arne Bigsten, Per-Olof Bjuggren,
Bruno Frey, Henrik Hammar, Douglas Hibbs, Börje Johansson, Charlie Karlsson, Douglass
North, Bo Sandelin, Michael Wallerstein and the participants at the seminar at Jönköping
International Business School.
 1. Introduction

In all actions that we pursue as economic agents, we are affected by institutions. When
we buy apples at the local market, when we try to decide what pair of trousers to buy, when
we consider whether it will be worthwhile to start a neighbourhood cooperation or not,
institutions structure the way we think and constrain our behaviour. They constitute the rules
of the game in game theory settings and the arena where individuals exchange goods and
services in their attempts to reach equilibrium. Apart from being behavioural constraints,
institutions also serve as a kind of knowledge in a world of imperfect information and
imperfectly rational individuals. They can take an almost infinite number of forms; laws,
university statutes, ethics, dinner table conventions, norms like egoism or hospitality, etc.
Some institutions are more economically relevant than others and some might even be
regarded as inefficient from an economist’s point of view. However, without the presence of
institutions, social interaction would be nearly impossible and there would be no reason why
self-interested individual utility maximizers would not be engaged in a constant war of all
against all in the struggle over limited resources.
The study of institutions is not a new area within economics. Already in the early
twentieth century, institutionalism provided a forceful alternative to orthodox microeconomic
theory. However, the institutionalist research programme has never become a part of
mainstream economics, and for many years, the insights provided by economists like
Thorstein Veblen were in disrepute and were shunned by the economics discipline. With the
rise of “New Institutional Economics” in the 1970s, institutions were once again put on the
research agenda. Among several prominent contributors, some names stand out; Oliver
Williamson (1975), inspired by Ronald Coase, with his contractual theory of the firm,
Douglass North (1990), analyzing economic history from an institutional perspective, Mancur
Olson (1965) on the emergence of collective action, Robert Axelrod (1986) on the evolution
of norms in dynamic game theory settings. But the analysis of the economic consequences of
institutions is still confined to a rather small group of economists. In central fields within
economics, like growth theory or general equilibrium theory, the existence and relevance of
institutions are hardly recognized at all, and when institutions are recognized, they are simply
assumed as given. There is further a serious conceptual confusion in the economic literature
regarding terms like “institutions”, “organizations”, and “markets”. It has been claimed that
these confusions act as a serious obstacle to a sensible research on the subject (Khalil, 1995;
Ménard, 1995).

1
 New areas of research within other disciplines also appear to have great relevance for our
thinking on institutions. Evidence from social psychology suggests that the utility functions of
individuals tend to be misspecified (Rabin, 1998). Preferences may indeed by endogenous to
the economic system (Bowles, 1998). In cognitive science, research on the working of the
mind has shown that the human brain does not operate like a “lightning calculator”, as
standard economic theory suggests. Our thinking rather tends to be highly pattern-based and
path-dependent, structured along so called neural networks. History and past experiences play
crucial roles in the development of these paths (Clark, 1997). Research in economics based
upon these findings has still been very limited, but the implications for our perception of
individual economic choice are probably very important, perhaps particularly so for our
thinking on institutions (North, 1998).
This paper has three purposes: (1) To analyze the microeconomic properties of
institutions. In so doing, I will make an attempt to define and disentangle fundamental
concepts like institutions and organizations so that a clear understanding of the nature of
institutions can be attained. (2) On the basis of (1), to discuss the institutional properties of
microeconomics, in particular two of the most commonly used model setups; the Walrasian
equilibrium and game theory. (3) To critically survey the literature on the institutional
challenge to neoclassical microeconomics and to discuss the scope for an ”institutional
microeconomics” that takes insights from cognitive science into account. Section two will
deal with the nature of institutions (purpose (1)), section three with institutions in Walrasian
equilibrium and game theory (purpose (2)), and section four with institutionalism and the
future research agenda (purpose (3)). Section five summarizes the main conclusions.

2. The Microeconomics of Institutions

For the purpose of our discussion, I will define institutions as the humanly devised rules
or constraints that shape human interaction. Institutions are the rules of the game which help
people to form expectations of what other people will do in the presence of uncertainty and
imperfect information. Because of this, institutions can be said to limit and define the choice
set of individuals (Lin and Nugent, 1995; North, 1990). Institutions necessarily involve
interaction of agents and are characterized by common conceptions, routines, habits, and
values (Hodgson, 1998).

2
 This very broad definition can be subdivided into formal and informal institutions.
Among the formal institutions, we find for instance laws, constitutions, contracts, and
property rights. These are the official rules of a society with a high degree of legitimacy. They
are backed by explicit punishment. Formal institutions are purposefully created by the state,
by private enterprises, or by other alliances or individuals in civil society and are often, but
not always, in close correspondence with the underlying structure of informal institutions.1
Among the informal institutions, we find for instance norms, ethics, customs, taboos, and
ideologies. These are the unofficial behavioural rules of a society, an integrated part of its
culture. Informal institutions are learned through socialization and are largely the inherited
view of the world from older generations. As such, informal institutions in turn structure the
way that the present generation looks upon and thinks about society. In a sense, informal
institutions are therefore a kind of knowledge. Boland (1979) claims that the only difference
between ”institutional knowledge” and ordinary knowledge is that the former takes longer to
change.
Whereas it is usually rather simple to trace the origin of formal institutions, the origins of
informal institutions is a much more complicated matter. Scholars in the neoclassically
oriented ”New Institutional Economics” (NIE) discipline would probably propose an
instrumental view; all institutions have been consciously created in order to reduce the
transaction costs of economic exchange and production. A very different but not uncommon
point of view is that institutions are the unplanned consequences of a process of evolution and
that institutions therefore can evolve spontaneously (Sugden, 1989). I will return to this
discussion later.
Obviously, the prominence of institutions varies a great deal. The political ideology of a
society certainly has a more far-reaching influence than its dinner table conventions. Khalil
(1995) has formalized this idea by categorizing institutions according to grades. If a family is
a Baptist, Khalil reasons that the grade of the institution Christianity is a deeper institution
than the grade of Protestantism, which, in turn, is deeper than the grade of Baptism.
A clear distinction must also be made between institutions and organizations. If
institutions are the rules of the game, organizations (as well as the individuals that the

1
Lindbeck (1995, 1997) provide interesting discussions on the interaction between economic incentives as
defined by formal rules, and the structure of informal norms. The main argument is that norms tend to be
“sticky” and that a change in the formal rules will only slowly alter the informal norms. Thus, for instance, the
norm that saving is a good thing can live on and make people save long after the formal rules structure has been
changed and made saving less profitable.

3
organization is made up of) are the players (North, 1990).2 A tribe, a trade union, a firm, or a
state, are examples of organizations in this sense. Obviously, institutions and organizations
are most often strongly interdependent. In some sense, it might be claimed that organizations
are the embodiment of underlying institutions. For instance, a congregation might be thought
of as an organization based upon the institution religious faith. However, this is not always
the case. There is ample evidence of organizations which have very little to do with the
underlying institutions. Khalil (1995) argues that the implications of a separation of the
concepts have not been fully understood by economists like North. The lack of clarity has
resulted in a conceptual confusion in the literature where writers do not see or acknowledge
the distinction and frequently refer to organizations as institutions.
A further complexity in the literature on institutions is that writers tend to use different
concepts for similar phenomena. One such example is the term ”social capital”. Social capital
is essentially equivalent to the set of informal institutions within a social unit. Coleman
(1990) views en entity of social capital as being characterized by two things; (i) some aspect
of social structure and (ii) certain actions that are facilitated for those who are within the
structure. Whereas physical capital is embodied in machines and human capital in people,
social capital is embodied in the relations among persons. An important feature of social
capital is therefore the prevalence of informal networks that improve the efficiency of society
by facilitating coordinated actions (Putnam, 1993). In a recent empirical paper on growth,
Hall and Jones (1999) refer to ”social infrastructure”, which is meant to capture formal and
informal aspects such as the rule of law, corruption, openness to trade, etc. Both social capital
and social infrastructure are essentially just variations of the institutions-theme.
Another group of writers focuses on one particular type of institutions; norms. A norm is
a purposively generated behavioural rule of the type: ”Do X”, or: ”Don’t do X”, or more
complicated rules like: ”If you do Y (or are in state of nature Y), do X”, or: ”If others do Y, do
X” (Elster, 1989). An important property of norms is that violations of a norm will result in
some kind of punishment, either by oneself (feelings of guilt), by one’s social environment
(ostracism), or by society (court sentences). Likewise, compliance to a norm might give
rewards. Those who hold a certain norm claim a right to apply positive or negative sanctions
(Coleman, 1990). With very strong norms, there might even be a tendency to punish those
who do not punish violators of norms. This phenomenon has been referred to as a metanorm

2
Williamson (1998) distinguishes between “institutional environment” (rules) and “institutions of governance”
(players). Lin and Nugent (1995) refer to “institutional arrangements” as the rules within a specific social unit

4
(Axelrod, 1986). Norms are distinguished from habits by the fact that the latter have no
punishment associated with their violation. A convention, in turn, is a habit that is shared by
many people which people follow mainly because they do not wish to deviate. When some
moral aspects are added to habits and conventions, i.e. when the individual feels that he/she
ought to take certain actions, then the habits or conventions have become norms. Norms,
habits and conventions are institutions in themselves but can also be regarded as the smallest
units in the construction of deeper and more complex institutions. However, by putting simple
norms of the kind referred to above in the same category as democracy or national
constitutions, one runs the risk of getting a definition of institutions that is too broad to be
useful.3
To some extent, institutions have the characteristics of public goods. The benefits of law
and order, for instance, can be enjoyed by anyone and by many people at the same time.
Institutions are therefore often nonrival. It is, however, easy to think of situations when
institutions can be at least partially excludable. A law or a contract might explicitly define for
whom the arrangement is concerned, excluding all others. A more proper view of such
institutions might therefore be to regard them as club goods.4 For instance, a state’s legal
system is a good that only the club members, i.e. the citizens of that state, are supposed to
enjoy. Even so, in most situations, it seems probable that the effects of an institution would
tend to “spill over” to people who are formally not club members. In our example, the rule of
law in one state might be a positive externality for citizens in neighbouring states.
As always with public goods, the possibility of free riding behaviour suggests that no
individual agent will be willing to supply the Pareto optimal amount of the good (Samuelson,
1954). When the institution in question has the magnitude of law and order of a nation, the
scale of operation is usually so great that only one particular type of agent can supply it; a
state. The state is perhaps the most important supplier of formal institutions and it has been
argued many times that it is the existence of natural public goods like defence and
administration of justice that is the main reason historically for the emergence of states. The
king or the state bears all the direct costs of the public good but expects taxes and/or services
in return. Likewise, private business companies, political parties, and various other
associations in society take the responsibility of establishing and enforcing formal institutions
on behalf of their subjects. In so doing, organizations supply a public good in its technical

whereas “institutional structure” is the totality of institutional arrangements including organizations and more
universal rules.
3
I am grateful to Michael Wallerstein for this last point.

5
sense, but apart from their own increased welfare, these organizations will expect some direct
or indirect favours in return, like loyalty, sympathy, gratitude, votes, or even material
benefits.
The situation is somewhat different for most of the informal institutions. Who is the
principal for a norm like honesty? The only reasonable answer is that there can not be a single
”supplier” of this type of behavioural rules. As I have mentioned before, informal institutions
might be hard to change. A ruler can prescribe and enforce almost any type of formal rules
but he can not immediately alter the way people think. No single agent has ever had such an
influence over the minds of his fellow human beings.5 But if this is so, how then are informal
institutions created? For the moment, I will confine myself to the observation that the costs of
establishing and enforcing informal institutions must, at least to some extent, be borne
individually by all those involved. For a norm to get established in a group, each individual
has to convince him-/herself of its righteousness to the degree that he/she is willing, not only
to comply, but also to punish possible defectors. This process of becoming convinced must
incur some costs, for instance in terms of time or effort. If there are no costs, the individual is
either already convinced or is totally incapable of critically assessing ideas. Once in place, the
pattern of behaviour that the informal institution prescribes is a public good which anyone can
benefit from.
What are the functions of institutions? Lin & Nugent (1995) claim that there are two
basic functions; economizing and redistribution. Economizing refers to the notion that
institutions reduce the transaction costs of exchanges between agents. This type of costs
include those of negotiation over a contract, of obtaining information about exchange
opportunities, of monitoring the contract, and the costs of enforcement when some party starts
to defect. Institutions reduce these costs in a number of ways. Law and order see to that trade
and production can take place without the agents having to engage in costly protection
activites. A system of monetary exchange decreases the costs of transportation since one
physical commodity not necessarily has to be exchanged for another physical commodity. A
common sense of morale ensures that people will not be stealing or robbing from each other
even in situations when they have the opportunity of doing so.

4
The theory of club goods was introduced by Buchanan (1965).
5
Not even the prophets of Christianity or Islam had such an influence. Even though Jesus Christ spent his whole
life trying to reform the informal institutions of the Jews, he had relatively little success during his lifetime. In
our age, a striking example of the impotence of government efforts to alter the informal institutions, is the quick
revival of typically Central European habits and norms even after forty years of communist regime.

6
 The transaction costs approach is usually considered to have sprung from Coase (1937)
who used it as an explanation for the emergence of firms, an idea that was later picked up by
Williamson (1975). In his famous paper on the ”Coase theorem”, Coase (1960) stated that in a
situation when an externality is present and when there are no transaction costs, it does not
matter how property rights are allocated; the agents will trade rights until the optimal solution
is reached. However, when transaction costs are present, this proposition does not apply.
Thus, in such situations, the allocation of rights matters a great deal. Especially the last point
seems to have been rather neglected in the huge literature that the Coase theorem has induced.
Wallis and North (1986) and North (1990) extends the transaction costs implications and
outline a theory of economic history based upon the idea that only those societies which
succeed in creating institutions that efficiently reduce transaction costs, will thrive in the long
run.
The other basic function, redistribution, has got more to do with an idea of fairness than
with efficiency. Although for instance property rights insure the individual the right (limited
or unlimited) to dispose of the property that he or she owns, the situation might arise when a
handful of property owners own almost all productive resources while the majority owns
nothing. In most societies, this is not regarded as a desirable situation. Ideology, solidarity and
charity to the poor, are examples of institutions which might cause resources to be
redistributed for the sake of attaining a higher level of equality.
At this stage, it should be pointed out that institutions are far from always efficient.
Institutions do not always decrease transaction costs but might actually, when they are
inefficient, increase transaction costs. Welfare state policies might for example create
disincentives towards working and saving (Lindbeck, 1995, 1997) or asymmetries in
information and power might encourage harmful rent seeking behaviour and corruption
(Krueger, 1974). I will return to this issue later.

3. The Institutions of Microeconomics

One of this essay’s main motivations is the observation that in the core of neoclassical
microeconomic theory, institutions are taken as given or are simply assumed away. As an
illustration of this negligence, I will make an institutional analysis of two of the most often
used scenarios in microeconomics; the Walrasian general equilibrium and the Prisoner’s
Dilemma in game theory.

7
 3.1 Walrasian General Equilibrium

Consider the usual representation of an Edgeworth box with two consumers and two
goods with convex, continuous indifference curves, convex budget sets, and initial
endowments of the two goods, as shown in Figure 1. If trade occurs when consumers are at
their initial endowments, it is possible to reach a Walrasian equilibrium at point E which has
the property of Pareto optimality (First Fundamental Welfare Theorem). It can also be shown
that from any competitive equilibrium, a Pareto optimal allocation can be reached by proper
lump sum redistribution of wealth (Second Fundamental Welfare Theorem).6

Good 2
Initial allocation
02
Walrasian
equilibrium

Consumer 1:s
E indifference curves

Budget line,
slope: -p1/p2

Good 1
01

Consumer 1:s
indifference curves

Figure 1: The Edgeworth box representation of a Walrasian equilibrium.

Needless to say, the implications of these two theorems are of paramount importance and
serve as the main powerful arguments for a laissez-faire economy. Indeed, the First
Fundamental Welfare Theorem is nothing but a formal representation of Adam Smith’s
”invisible hand”. With free trade and perfectly competitive markets, a vector of prices will be
found that clears all markets so that all excess demand and supply vanish. At this allocation, it
is impossible to make anyone better off without making someone else worse off, i.e. we have
reached the Pareto optimum. Furthermore, if a social planner should find that the initial
endowments were unfairly distributed so that, for instance, one of the agents had a much

8
greater budget set than the other, a redistribution of resources can be arranged so that another
Pareto optimal allocation can be reached.
In this world of free competition and optimal allocations, why would we need
institutions? The point of the example is that the general equilibrium model can work only if a
number of institutions, which are usually not mentioned, are in place. In the section below, I
will discuss some of the most important such institutions and argue that they are necessary
prerequisites for the Walrasian market solution:

(a) Self-interested agents with stable preferences seeking utility maximization. These
fundamental institutional assumptions of human behaviour are usually regarded as given by
”nature” and applicable to all social situations. This view has often been criticized, for
instance by Hodgson (1998). The egoistic utility maximizer is not a universal law in
Hodgson’s eyes but a special case among many different and equally plausible behavioural
assumptions. Sen (1977) remarks that the neoclassical view of the individual is difficult to
reconcile with the observation that individuals tend to act according to what he calls
”commitments” which are formed by a person’s values and sense of morale. In reality, people
do care about the well-being of other people. ”Economic man” must therefore me regarded as
something of a ”social moron” or a ”rational fool” (Sen, 1977). Bowles (1998) presents
evidence from experimental social psychology which shows that the institutional setup often
affects people’s preferences, thereby making preferences endogenous and inherently instable.
From an evolutionary perspective, Simon (1990) develops a model where altruistic behaviour
(socialization) stands just as great chances of surviving the natural selection process as
individualism. It has also been suggested that individuals are not maximizers but ”satisficers”
with ”bounded rationality” (Simon, 1982).

(b) Private property rights and free trade laws. The two prospective sellers in the
Edgeworth box must legally own their endowments of goods so that the goods are excludable.
Otherwise there would be no reason for trade; the strongest of the two consumers could just
take possession of the weaker agent’s whole endowment. Through economic history, efficient
private property rights have certainly not always been the case (North, 1981). Nor has free
trade. It would rather seem as if unfree trade has been the standard situation throughout
history. Even today, when free trade is the official ideology of more or less all governments in

6
See for instance Mas-Colell, Whinston, and Green, (1995), chapter 15.

9
the Western world, institutionalized barriers to free trade still persist in for instance the EU
market for agricultural commodities.

(c) A market. A market is indeed a whole set of institutions. It requires social norms for
peaceful trade and established information networks (Hodgson, 1998). For trade to occur,
there must exist some market place or market mechanism through which the prospective
traders can carry out the exchange. Markets usually do not evolve spontaneously but require
some kind of planning and coordination. History is full of examples of how the state often
consciously have founded cities, market places and fairs. Goodfriend and McDermott (1995)
pursuasively argue that a certain critical level of population density is required for agents to
abandon primitive production and enter into increased specialization and market exchange.

(d) Rules of exchange. First of all, the agents must have a means of communication in
common, i.e. they must speak the same language (Field, 1984). Further, the rules of exchange
must include rules of how to exchange information about the products which are to be traded.
The buyer must somehow be able to control that the seller’s goods are what they are claimed
to be. In this regard, various standards and generally agreed upon measures of height, weight,
density, etc, are usually necessary. Some mechanism through which (relative) prices are
determined, must also be in place. In the original model, this problem is solved by a
”Walrasian auctioneer”, who is of course an institution in him/herself. More realistically
perhaps is to acknowledge that the price determination process should be greatly facilitated by
established rules of negotiation procedures and by the use of a monetary system within which
all goods could be put in abstract value. A further requirement must be that the contracts that
eventually are settled are enforceable. If they are not, it would once again be optimal for the
self-interested agent without moral norms to steal back all the goods that he has sold.

(e) A neutral social planner with perfect information is necessary for the wealth
redistribution in the Second Welfare Theorem. Such a social planner is usually thought of in
the form of a state. It is hard to imagine any other agent in the economy who can calculate
optimal taxes or redistributions and then carry the changes through. However, states are
complex, purposefully created organizations built upon innumerable formal and informal
institutions. Their objectives are not necessarily in line with those of its majority of citizens,
as public choice theory has indicated. Nor can it be taken for granted that they have perfect

10
information. The pure version of the Second Welfare Theorem therefore seems to have little
relevance to the study of real economies.

But even in a situation when all the institutions above are in place, other institutions
might lead to market failures. Through history, various forms of price regulations have often
been used by governments and policy-makers. Price regulations in the Edgeworth general
equilibrium model means that the market clearing price might not be attainable (since the
budget line might not have the ”right” slope). This gives rise to excess demand for some
goods and excess supply of others. Trade quotas have almost the same effects. Markets will
not clear and whereas people will queue to get hold of certain commodities, other
commodities will lie in waste since no one wants to buy them. During such arrangements,
black markets may arise as well as unproductive rent-seeking activities aimed at ”getting past
queues”. With the prevalence of asymmetric information regarding the quality and quantity of
the goods, the trader with least information might prefer not to trade at all due to fear of
adverse selection. Asymmetric information might be institutionalized for instance when firms
are allowed to keep the recipes of their commodities secret or when employers are forbidden
by law to make certain tests on employees due to reasons of personal integrity.
Apart from the aspects above, many institutionalist writers would question the whole
idea of a static general equilibrium analysis. Such an analysis would miss the evolutionary
aspects of the economy and would only be like a snapshot of reality. Furthermore, at least the
older institutionalists would argue that the economy does not have the sort of automatic
adjustments of imbalances and self-correcting mechanisms that the neoclassical market theory
suggests. Instead, a more correct depiction of reality might be ”cumulative causation”
scenarios where imbalances cause even greater imbalances and development gets stuck in
vicious circles (Hodgson, 1989). I will return to this debate below.

3.2 Game Theory

In game theory language, the Walrasian general equilibrium can be considered as a

”cooperative game” (Field, 1984). Interagent communication is assumed to exist and in the
end, binding and enforceable contracts are produced. What I will now move on to is the non-
cooperative version of microeconomic analysis, effectively analyzed in a game theoretic
framework.

11
 As a frame of reference for the discussion below, consider an extension of the famous
”Prisoner’s Dilemma” example of a noncooperative, simultaneous-move game.7 There are
two self-interested players who both have a surplus of a commodity which they consider
trading in exchange for their neighbour’s surplus commodity. The alternative is to stay home
and live in autarky. However, should they decide to bring the commodity to the market for
peaceful trade, each of them face the risk of their neighbour betraying them, perhaps by
committing robbery or fraud. Should both players go to the marketplace in pursuit of
betraying their counterpart, some kind of trade war will erupt where both players will suffer
losses. There are thus three possible actions that each player can take; (a) abstain from trade,
(b) trade and betray your neighbour, (c) trade and cooperate. Should any of the players
decide to abstain from trade, both players will remain at status quo and get a payoff of 0
(utility units). This follows the logic that there has to be at least two traders to achieve a
market. Should both players choose to cooperate (betray), they will both receive a payoff of 1
(-1). Should, however, one player decide to betray while the other would choose to cooperate,
the betraying party will get 2 and the cooperating –2. The payoffs and the pure strategies of
this game are shown in Figure 2.

Player 2

a b c

a 0, 0 0, 0 0, 0

Player 1 b 0, 0 -1, -1 2, -2

c 0, 0 -2, 2 1, 1

Figure 2: ”Trade game” version of Prisoner’s Dilemma.

Note: Based upon Basu (1995). ”a” – abstain, ”b” – betray, ”c” – cooperate.

The ”socially” optimal solution to this problem – i.e. the solution that would maximize
the players’ joint payoff - is obviously ”trade and cooperate” (c,c). Each player will go home
from the trading with a payoff of 1 and will be strictly better off than without trade. One
might even say that this is the only strategy that can cause economy-wide growth. However,

7
The example is based on Basu (1995). I will assume that the basic elements of game theory is well known to

12
due to the possibility of betrayal, cooperation can never be a dominant strategy in this game.
It turns out that the Nash equilibrium payoff actually is (0,0), i.e. at least one player will
always abstain from trade. Hence, no market economy will arise and there will be no utility
growth. Rational, self-interested players thus necessarily end up at a solution that is clearly
not optimal.
If it, for some reason, is impossible to abstain, so that the (0,0) payoff squares are not
considered, we have the classical Prisoner’s Dilemma situation, so frequently cited that it has
almost become a cliché. In this case, each player’s (strictly) dominant strategy will be to
betray (b,b)and the Nash equilibrium will end up at (-1,-1). There will be a trade war and both
players will be net losers.
So where do institutions enter this story? They do it in two ways. First, as we said earlier,
institutions are often defined as the rules of the game. We have already briefly gone through
these rules. Unlike the Walrasian equilibrium example above, we are now in a non-
cooperative framework where communication is impossible. Just like in the Walrasian world,
we have self-interested, rational players who maximize their own utility and who have perfect
knowledge of their counterparts’ goods. We also have a generally agreed upon market place
and laws that allow free trade. However, we do not have perfectly enforceable property rights
since it is possible to rob unsuspecting fellow merchants. Nor do we have a continuing
process of adjustment. The example above is a simultaneous, one-shot game.
The second way that institutions enter the game is that institutions determine the
strategies available and their respective payoffs. Deceitful behaviour in the trade game
assumes a norm that says that it is acceptable to betray someone as long as you yourself stand
to gain. In the same manner, cooperative behaviour is also based upon a norm. Institutions
thus define the choice set of the players. The payoffs are also affected by institutions. Given
that certain strategies exist and are played, a neutral social planner might try to punish certain
strategies which he/she considers harmful for society. For instance, taxes, fines, penalites, etc
could change the payoff matrix in Figure 2 considerably.
With these remarks in mind, let us go back to the Nash equilibrium solutions of the trade
game (a,a) and the pure prisoner’s dilemma without the possibility of abstaining (b,b). In
Alexander James Field’s words, in a setting with self-interested players, it really seems as if
there exists no explanation to why the world does not degenerate into ”a Hobbesian war of all
against all” (Field, 1984, p 685). People either go to war with each other or live in isolation.

the readers. For concepts and details, see Mas-Colell, Whinston, and Green (1995), chapter 8.

13
Yet, in our everyday world, one frequently observes stable social existence. How can this
paradox be explained?
As the discussion above probably has indicated, institutions can help the players to
overcome this problem. The logic of collective action is treated in Mancur Olson’s (1965)
path-breaking work on interest group formation. Without loss of generality, it is also possible
to dicuss the formation of institutions using Olson’s basic framework. In all situations
regarding collective action, the central question is why anyone would work for the
establishment of an institution when an institution has the character of a public good which
free riders can utilize? The basic setup in this analysis is the non-cooperative game situation
outlined in Figure 2. What Olson wants to find are the required elements for making both
players play cooperate. Olson and his followers conclude that, in general, collective action is
more likely (i) the smaller the number of players, (ii) the more homogenous the origin of the
players, (iii) the longer the players have been associated with one another before their first
game, (iv) the closer the social and physical proximity between them, and (v) the greater the
sensitivity of the players to the losses incurred by betrayal (Lin and Nugent, 1995). In other
words, the success of collective action and of forming new institutions depend on already
existing institutions. As a limiting case when social institutions are very strong, the betray-
strategy will be gone from the choice set of both players. There are then be only two strategies
left; abstain or cooperate. As becomes evident from Figure 2, this transformation of the game
implies that cooperate becomes the (weakly) dominant strategy for both players, which in
turn implies a unique Nash equilibrium at the socially optimal solution (c,c). Such a solution
does not seem implausible. It is also a promising one; in the long run, trustful cooperation is
the only norm that can create prosperity.
Another strategy that might achieve the optimal solution is to allow the game to be
played repeatedly. This means that the game is no longer a one-shot affair but a so called
supergame. Taylor (1976) assumes that nature can be described as an infinitely repeated
Prisoner’s Dilemma situation. Even though there are no social institutions to begin with, since
the game is played an infinite number of times, the players will eventually ”learn” to play
(c,c) which they realize is the only strategy that avoids a war situation. This outcome is only
possible with an infinite time horizon. If there is a terminal date, it will always be optimal to
betray in the last round. Likewise, in the second last round, it will also be optimal to betray,
and so on. By backward induction, we must conclude that the betray-strategy by all players
constitute what game theorists would call a subgame perfect Nash equilibrium (Mas-Colell,
Whinston and Green, 1995). Thus, it is not enough just to have a repeated game; it must be

14
infinitely repeated. Can the real world be considered an infinitely repeated game? If one
assumes that each generation loyally continues the strategies by their predecessors and if each
generation is unselfish enough to attach some utility to the payoffs of future generations, then
perhaps the world can be considered to be an infinitely repeated game. However, that is not
self-evident.
A problem with the idea of ”social optimality” is that unlike the Walrasian equilibrium,
the ”socially optimal” solution in our games is not Pareto optimal (Field, 1984). A quick look
in Figure 2 shows that the move from (b,c) to (c,c) increases the sum of the players’ payoffs
from 0 to 2. But the move fails the criterion for Pareto improvement which says that a change
is Pareto efficent if it makes someone better off without making anyone else worse off. The
move from (b,c) to (c,c) causes Player 1:s payoff to decline from 2 to 1. Hence, the move to
(c,c) can not be a Pareto improvement.
In the game theory literature on institutions, it is often evolutionary games that are played
and discussed. This type of analysis has its roots in evolutionary models in the natural
sciences in which species play games against nature.8 Here, I will only make a very brief
outline of the main ideas. An evolutionary game looks much like an ordinary game except
that the players are not players in the usual sense but phenotypes, born to play a certain fixed
strategy. All other people of the same phenotype also play the same fixed strategy. Further,
the payoffs of an evolutionary game are not von Neumann-Morgenstern utlility levels but the
players’ fitness. Hence, if one phenotype always tends to receive lower fitness in the repeated
evolutionary game, then that phenotype will gradually die out from the population.
Eventually, only those individuals with the right phenotype will be left. If a new phenotype
now appears, called a mutant, it will have to play games against the old phenotype. The
invasion of mutants will be very small to begin with and will vanish if the old phenotype turns
out to be more fit in the long run than the mutant. In that case we say that the old phenotype is
immune to the invasion from the mutant. If a certain phenotype turns out to be immune
against all invasions of mutants, then the strategy that this surviving phenotype plays is an
evolutionary stable strategy. This strategy is therefore also a Nash equilibrium.
Institutions enter the evolutionary game in the sense that the phenotypes can be thought
of as norms for human behaviour. A norm is evolutionary stable if it has been proven to be
immune against all other competing norms. Thus, the set of norms or institutions that a
society has at a particular time is that which has survived evolutionary competition. These

8
For a more thorough discussion of evolutionary games, see Maynard Smith (1982) or Basu (1995).

15
institutions have served their ”minimal function” of making their users survive (Basu, 1995).
However, this is not to say that they necessarily are optimal for the phenotypes’ fitness.
According to Basu (1995), a mutant in a nation is much like a migrant with a set of
institutions constraining his/her behaviour. History is full of examples of how small fractions
of people move from one culture to another and play games against the prevailing phenotype.
The English in India in the eighteenth and nineteenth centuries and Indians in England today
are examples of successful settlements of such migrants. The Greek colonies around the
Mediterranean in ancient times is another such success story, as well as most Jewish groups in
the Western world. Many other mutants have proven less successful in their new
environments and their institutions have been dissolved. Even militarily strong migrants, like
the Mongols in thirteenth century China or the Germanic barbarians in ancient Rome, have
been losers in the evolutionary game and have assimilated the institutions and culture of their
defeated enemies.
When a small group of mutants is immediately successful against a whole population of a
prevailing phenotype, Basu (1995) claims that the invaders exploit what he refers to as a
normative loophole in the old phenotype’s set of institutions. For instance, in a society where
9
”Jante’s law” is a dominant norm among people, a mutant who has a norm towards
maximizing his personal exposure in all kinds of situations, would be enormously successful.
Basu thinks that the Spaniards’ relatively easy conquest of the American civilizations in the
sixteenth and seventeenth centuries and the British conquest of India during the eighteenth,
can in part be explained by the hypothesis that the invaders successfully exploited normative
loopholes in the institutions of the old populations.

4. The Scope For An Institutional Microeconomics

An alternative to the neoclassical microeconomic paradigm is provided by the

heterogeneous collection of ideas which are sometimes brought together under the broad
heading institutionalism. In this section, I will give a brief overview of the two related modes
of thought Old Institutional Economics (OIE) and New Institutional Economics (NIE) and
their critique of and challenge to neoclassical microeconomic theory.

9
The expression stems from a famous novel by Sandemose (1933).

16
 4.1 Institutional Economics

To put it simply, institutional economics recognizes the notion that the Walrasian market
equilibrium and the game theoretic framework that we analyzed in the previous section,
necessarily require a number of institutions which can and should not just be taken as given.
Although probably all institutionalist writers would agree to this statement, the brief analysis
below will show that there is disagreement between the old and the new traditions on many
other aspects.
OIE had its roots in the German and English historical schools and produced prominent
writers like Veblen, Mitchell, Commons, and Myrdal.10 The old institutionalists saw
themselves as an alternative not only to the neoclassical way of thinking but also to the
Marxist school. Many of the writers were inspired by evolutionism which had then started to
influence the social sciences. During the interwar years in the first half of the twentieth
century, their influence was at its peak and institutionalism was by some considered to be
more “mainstream” than neoclassicism. Institutionalist ideas also played a major role in the
formation of the New Deal package.
One of the most striking differences between OIE on the one hand and NIE and
neoclassical microeconomics on the other, is their views on the individual agent in the
economy. OIE writers are highly critical of the neoclassical assumption of a self-sufficient,
egoistic, economic man who is also “a lightning calculator of pleasures and pains” (Veblen,
1919). Hodgson (1998, p 176) writes:

“...despite the temporal adjective, the “new” institutionalism is built upon some antiquitated
assumptions concerning the human agent, derived from the individualism of the Enlightenment. In
this 300-year tradition, a key idea is the notion that the individual can, in a sense, be “taken for
granted”. Accordingly, the individual is taken as the elemental building block in economic theory.”

Like Karl Marx and Max Weber, the old institutionalists claim that the individual is a
product of his social environment and that “economic man” is not necessarily a universal
phenomenon. Rather, economic man is an institution that has emerged from specific historical
and social settings.

10
This section bears heavily on more extensive overviews such as Foster (1991), Samuels (1995) and Hodgson
(1998).

17
 Neither should markets be taken as given. Old institutionalists argue that the market is
indeed just a metaphor for a set of institutions which operate within a broader institutional
framework. The Walrasian market is therefore only a special case, although an important one.
This view should be contrasted with the quite different point of departure of many of the NIE-
writers, summarized in a famous statement by Williamson (1975, p 20): “...in the beginning,
there were markets”. Markets are not the only important objects of analysis. It is the whole
organizational and institutional structure in an economy that allocates resources and
distributes income. The force governing economic outcomes is rather the system of power
relations than the market price mechanism (Foster, 1991).
Whereas NIE and neoclassical microeconomics are mainly static in nature,
institutionalism highlights the dynamic nature of economies and socities. In the OIE tradition,
history plays a fundamental role. Through careful analysis of case studies, it is possible to
reach a good understanding of economic processes. In so doing, OIE researchers are often
interdisciplinary with methods borrowed from sociology, biology, or psychology. The
important thing is that theory has realism. The old institutionalists are critical of the
neoclassical tendency to formalize social relationships in abstract mathematical models from
which hypotheses are formed and tested econometrically. This type of analysis, OIE writers
claim, misses fundamental aspects of the economy.
The main goal of OIE is to find appropriate policy prescriptions that will improve the
functioning of society. OIE therefore has an activist approach to the research agenda. “Social
control” is a keyword for many old institutionalists and the economic role of government is
often stressed. This aspect is of course something that institutionalism had in common with
contemporary Keynesianism but certainly not with neoclassicism.
OIE gradually lost in importance after the Second World War. It has often been claimed
by neoclassical writers that institutionalism failed because it did not manage to present a
coherent and well specified theory of the economy. An equally important explanation,
however, was probably that neoclassical theory improved its theoretical apparatus during the
time and, in some cases, attained a synthesis with Keynesian economics in the post-war era
(Rutherford, 1997).
The revival of institutionalism is mainly considered to have taken place during the 1970s,
although some of its central works appeared earlier. Among many important inspirators,
Ronald Coase (1937, 1960) is probably the most influential contributor with his emphasis on
the implications of transaction costs. Coase’s early paper on the nature of the firm inspired
Williamson’s (1975) theory of the firm as a collection of contractual agreements; a very

18
different view from the prevailing neoclassical notion of the firm as primarily a technological
solution. Williamson (1985) claim that there are in fact three earlier traditions with which NIE
is usefully compared: (1) the neoclassical conception of the firm as a production function, (2)
the Arrow-Debreu extension of general equilibrium to deal with uncertainty, (3) the applied
price theory orientation favoured by post-war Chicago economists. By emphasizing the
prevalence of institutions, NIE reaches new conclusions and implications from these basic
theories. Hence, NIE uses neoclassical concepts and methodology to a much greater extent
than OIE. The way that NIE differs from neoclassicism can be said to be that NIE makes a
shift of focus away from “within rules choices” to choices with rules or institutions as
constraints (Buchanan, 1991). To complete the analogy, OIE differs from neoclassicism and
NIE in that it regards institutions both as constraints to individual behaviour and as
influencing individuals’ preferences and objectives (Hodgson, 1993).
NIE is now a vibrant field which has attracted scholars from various backgrounds. A
complete survey of the literature is certainly beyond the scope of this essay.11 Lin and Nugent
(1995) divide NIE into those subdisciplines studying (implicitly or explicitly) the demand for
institutions and those studying the supply. Those studying the demand for institutions usually
take as their point of departure the notion that economic exchanges and interactions give rise
to transaction costs. We saw in section 3 what types of costs this refers to; costs of obtaining
information, of negotiation, of monitoring that contracts are fulfilled, of punishing defectors,
etc. Coase (1937) and Williamson (1975) see these costs as the primary reason for the
establishments of firms. Transaction costs are also the basis for Douglass North’s (1990) more
macro oriented discussion on institutions and economic performance. Institutions’ primary
purpose is to reduce transaction costs and thereby enhance economic performance. The “Law
and Economics” subdiscipline of NIE studies the behaviour of rational agents in a setting
where rules of law impose prices on various non-market decisions (Posner, 1987). A related
area is the economics of property rights and contracts (Alchian, 1965).
Risk is another factor that might positively affect the demand for institutions. The Arrow-
Debreu equilibrium theory of contingent goods lends itself conveniently to analyzing the
development of risk sharing contracts and insurance institutions in the presence of
uncertainty. An often used example is that of a landlord and a tiller where the landlord is the
principal and the tiller the agent and where the quantity and quality of harvests depends on
the weather, which might be good or bad.12

11
Eggertsson (1990), Lin and Nugent (1995), and Foss (1995) provide extensive surveys on the NIE literature.
12
See for instance Otsuka, Chuma and Hayami (1992).

19
 The study of the supply side of institutions is concerned with the issue of how institutions
are formed. A key concept within this discipline is the previously discussed collective action
(Olson, 1965). The collective action approach also offers a convincing explanation to why
small lobby groups often can be so effective in their pursuits. The main reason is that the
other citizens in society might be “rationally ignorant” about the matters that the interest
groups work for, which in turn might lead to the “exploitation of the great by the small”.
When rent-seeking interest group behaviour becomes an accepted institution in society, there
is a risk that too much resources are devoted to unproductive activities, which might imply
lower growth (Olson, 1982).
Sugden (1989), inspired by Austrians like Hayek, argues that at least informal institutions
can arise without conscious human design through what he refers to as “spontaneous order”.
The idea that people can stand outside society and rationally appraise its institutions is, in
fact, nothing but an illusion. Instead, the institutions of a free society are the unplanned
consequences of a process of evolution. The development of institutions should thus be seen
as a part of an evolutionary development where the capacity of replication and survival are
more crucial than economic efficiency.

4.2 Towards an Institutional Microeconomics?

The success of NIE might be summarized as; (i) the creation of a coherent theory of how
contracts and collective action can be seen as the logical outcome of rational individuals’
utility maximization in a world of uncertainty, (ii) an analysis of how these institutional
constraints alter the pattern of individual choices as predicted by othodox microeconomic
theory.
Like all schools in economics, NIE has received its fair share of criticism. Hodgson
(1993, 1998) writes that although the NIE tradition has introduced an important dimension
into economic theory - namely that of institutions as constraints to individual behaviour -
NIE still follows the route of “methodological individualism” by taking individuals as given.
Atomistic individuals, along with their behavioural characteristics, are seen as the elemental
building blocks in theories of social or economic systems, but the NIE has so far failed to
explain the evolution of the rational individual utility maximizer him/herself. Nor has NIE
been able to show how institutions, once in place, affect individual preferences and
characteristics.

20
 Is this a satisfactory state of the art? Perhaps the study of how individual behaviour and
preferences evolve, is not an issue for economists? Hodgson (1993) and Frey (1993) argue
that economic theory should attempt to explain how institutions like self-interest, rationality
and preferences evolve and how they, in turn, affect markets and prices. Stopping short of
such fundamental aspects does not make economists credible in their analyses of society.
Indeed, Hodgson (1998) suggests that it should be possible to develop an “institutional
microeconomics” that takes these aspects into account.
How then should such an institutional microeconomics proceed? One such path seems to
be to learn from experimental social psychology. Rabin (1998) presents evidence from
various experiments that convincingly refutes some of the basic axioms of in our modelling of
individual utility functions. For instance, individuals often seem to be more concerned with
changes in outcomes, relative to some reference level, than with absolute levels of outcomes.
It is further shown that people indeed have difficulties in evaluating their own preferences and
that one can not disregard norms like fairness as an important part of human behaviour. In a
similar vein, Bowles (1998) shows that the economic arrangements in a society, in particular
the market situation, tend to influence the evolutions of tastes, values, and personalities,
thereby making preferences endogenous.
Research on the working of the brain has also confirmed the widespread suspicion that
the human mind does not act as a perfectly logical calculator which takes every relevant fact
into account. Rather, human thinking appear to follow so called neural networks.13 These
structure our reasoning and in many ways determine how we think. The development of
neural networks depends on our learning, through formal education and socialization, and on
our past experiences. What we are taught by our fellow human beings is in turn a product of
the experiences of older generations. Our thinking is thus highly path-dependent in the
meaning that our past, and other people’s past, influence how we think today. Our perception
of the world is also very much pattern-based; given that we recognize a certain pattern in our
everyday life, our mind almost instinctively tells us how to act. If we do not recognize any
familiar pattern in a situation that we encounter, we act in accordance with the pattern that the
situation is most similar to.
It has been suggested that these insights from cognitive science also should be applicable
to the theory of how institutions evolve (North, 1998). Indeed, institutions are in their essence
simply mind constructs or patterns which are formed by our thinking. In Clark’s (1997) terms,

13
The part on neural networks relies heavily on Clark (1997).

21
they are the “scaffolds” of choice situations. The development of institutions is therefore also
highly path-dependent and to a great extent a function of our history. This would explain the
great divergence in institutional structure that can be observed between societies which have
been isolated for a considerable time, for instance the previously mentioned difference in
institutions between the Spaniards and the Indians in the sixteenth century.
In summary, a synthesis of cognitive science and microeconomic theory would probably
have great implications for our view on institutions and the economy in general. It might even
have the potential of laying the grounds for an institutional microeconomics that considerably
would improve the realism of models on individual human behaviour.

5. Conclusions

In this essay, I have tried to outline a careful description of the nature of institutions. I
have defined institutions as the rules of human behaviour which act as constraints in
economic situations and define our choice sets. Institutions can be formal or informal and of
varying prominence. A clear distinction must be made between institutions, which are the
rules of the game, and organizations, which are the players. Norms, conventions, and social
capital are basically just different words for institutions. Institutions often have the character
of public goods, or, more specifically, club goods.
Although seldom explicitly mentioned, institutions enter microeconomics in a number of
ways. For the Walrasian general equilibrium solution, some of the required institutions are (i)
self-interested, utility maximizing individuals, (ii) private property rights and free trade laws,
(iii) a market, (iv) rules of exchange, and (v) a neutral social planner. In game theory settings,
basic rules regarding cooperation, order of playing, and utility maximization are in fact
institutions, as well as the set of strategies available and the payoffs of different outcomes.
Institutions can also be the solution to a move from socially non-optimal outcomes, like
abstaining from trade or betrayal, to the optimal solutions like trade and cooperate.
Evolutionary game terminology provides some valuable insights to how phenotypes with a
socially optimal norm during certain times can become immune to mutants with non-optimal
norms, thereby creating periods of prosperity.
The institutionalist challenge to neoclassical economics has an old (OIE) and a new
tradition (NIE). The OIE criticized the neoclassical assumption of rational utility maximizers
and self-equilibrating market mechanisms. History and dynamic aspects of the economy were

22
seen as more important than the neoclassical static analysis. OIE saw the pure market solution
as a special case which was not always a valid description of reality. The NIE tradition is
more influenced by neoclassical theory and sees institutions mainly as behavioural constraints
in utility maximizing situations. The discipline has gained many followers in recent years and
has come up with new insights to the theory of the firm, to economic history, to the study of
goverment and voting behaviour, and to the theory of collective action. However, NIE has
still failed to present a comprehensive analysis of the formation of informal institutions like
norms and beliefs which often are necessary prerequisites for formal institutions. Nor has NIE
been able to show how institutions, once in place, affect individual preferences and
objectives. The road ahead for institutional theory appears to be a synthesis between
microeconomics and cognitive science, i.e. an institutional microeconomics, which recognizes
the path-dependence and evolutionary aspects of human thinking.

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