ARBA MINCH UNIVERSITY

POST GRADUATE SCHOOL

ECONOMICS DEPARTMENT

DEVELOPMENT ECONOMICS PHD PROGRAM

THE METHODOLOGICAL THEORY OF MARKET PRODUCTION

AND INSTITUTIONAL ECONOMICS

Seminar I Theory Review

By: Asnakech Alemu

ID/NO 109/2011

Address [email protected]

Phone No +251946258037

Adviser: Mebratu Alemu (PhD)

February, 2020

Arba Minch,Ethiopia
Table of Contents
ACCRONOMY...............................................................................................................................................ii
Abstract......................................................................................................................................................iii
CHAPTER ONE..............................................................................................................................................1
1 Introduction..........................................................................................................................................1
1.1 Background..................................................................................................................................1
1.2 Rational for the Review.....................................................................................................................2
1.3 Objectives of the Review...................................................................................................................4
1.3.1 General objectives......................................................................................................................4
1.3.2 Specific objectives.......................................................................................................................4
CHAPTER TWO.............................................................................................................................................5
2 LITRARTURE REVIEW.............................................................................................................................5
2.1 Definition of Institution.................................................................................................................5
2.2 Economics and institution.................................................................................................................5
2.2.1 Compering of OIE and neoclassical economist...........................................................................5
2.2.2 Emerging of NIE..........................................................................................................................7
2.2.3 The economic institutions and transaction costs. Theorem G. Cowes........................................9
2.2.4 The economic production performance and institution...........................................................14
CHAPTER THREE........................................................................................................................................16
3 METHODOLOGIES...............................................................................................................................16
CHAPTER FOUR..........................................................................................................................................18
4 DISCUSSIONS......................................................................................................................................18
4.1 Theory of production...................................................................................................................18
4.1.2 The Production Function...........................................................................................................18
4.1.3 The Short-Run and the Long-Run.............................................................................................19
4.2 Theories of Institutional Economics and market production...........................................................21
CHAPTER FIVE............................................................................................................................................25
5 Conclusions.........................................................................................................................................25
Reference..................................................................................................................................................27

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ACCRONOMY
GDP Growth domestic product

NIE New institutional economics

OIE Old institutional economics

ii
Abstract
The economic structures (production system) are the fundamental cause of economic
performance. Economic structures determine the rate of structural learning, affect institutional
performance, influence the distribution of income and establish the direction of political
transitions. To show this the mainstream version and the heterodox strand of Institutionalism
indeed share some analytical conclusions. One clear cut example is the work by  Acemoglu and
Robinson (2008) and by Acemoglu (2010) argues that “economic institutions that only protect
the rights of a rich elite or the privileged will not achieve such equality of opportunity and will
often create other distortions, potentially retarding economic growth.” (Acemoglu, 2010).
Further, according to the author the economic or political elite will only invest in public goods
such as education if they expect to reap the benefits in the future. In that context, because there
are conflicting preferences over institutions and policies, the distribution of political power in
society plays an important role in determining which institutions and policies are chosen, also
explaining why some non-growth enhancing institutions cannot be reformed (Acemoglu, 2010).

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 CHAPTER ONE
1 Introduction
1.1 Background

Economics is part of social science, which is rooted in positive moral philosophy. Over the years
it became increasingly independent of developments in other sciences, including moral
philosophy. When we compare the different schools of economic thought with each other
mercantilists, classical economists and neoclassical economists, for instance, we observe an
increasing ‘isolation’ of so-called economic factors from noneconomic factors. In the
mercantilist view the economy was an instrument in the hands of the state. In classical political
economy a positive analysis was made of the functioning of a Western capitalist economy in its
different stages of development. Institutions such as capitalism, classes, charity institutions and
legal rules (property rights, poor laws and compulsory education) were recognized as principal
factors that influence economic performance.
If we compare Smith with Ricardo there is an important difference already in the role of
institutions in the analysis of a capitalist economy. While the economics of Smith is a mix of
institutional analysis and economic logic, Ricardo has become well known economist because of
his rigorous economic analysis. Nowadays most economists know Smith from his analysis of the
role of specialization in the creation of wealth and his famous ‘invisible hand’, a metaphor that
expresses his optimism about the functioning of free markets with respect to allocation. The
institutional part of Smith has disappeared from modern economics textbooks though. Ricardo
still plays a role in some modern radical economics circles, because of his straight economic
analyses of the production process and of his laws of distribution of income over different
classes.
In the end of the 19th century an increasing number of economists were impressed by the
methods of research of the natural sciences. Here the strategy was focused on the discovery of
natural laws. By isolating one force the effects of it, and of changes in the strength of this force

1
can be tested. Applied to social science economists such as Mill, Jevons and Menger (1875)
advocated the isolation of the economic force from other forces.
In a process that took place over a period of several decades they developed the so-called
neoclassical research strategy. An economic world was constructed that was characterized by the
Omni-present problem of scarcity and inhabited by economic-rational man. The actors were
assumed to be rational and socially independent in their drive to maximize their utilities under
the constraints of the resources available. The logic of this world can be analyzed, leading to the
formulation of a series of economic laws, which were supposed to have a universal and eternal
character. In this way economists hoped to model the economic aspect of human behavior. The
psychic aspect was disregarded by the adoption of the assumption of perfect rationality, which
means that actors take decisions on the basis of carefully constructed knowledge rather than on
emotion or tradition. The social aspect was ignored by the adoption of the assumption of social
independence of the actors. In other words, relations between people are of an economic nature
only. Humans do not recognize each other as humans and are therefore not inclined to attach
(moral) rights and duties to each other that are linked to the mere fact of being human.
The analysis of the economic world is a perfect reflection of the phenomenon of scarcity. In this
interpretation the term ‘economic’ does not refer to a sort of observable behaviour. In real life
human behaviour has more aspects than the economic one, also in the economy. Empirically
observable behaviour results from the operation of different forces, and it is the task of other
social sciences to model the other forces.
Some neoclassical economists were skeptic about the possibilities of application of the economic
analysis to the real world, since other forces do also play a significant role in reality. But other
neoclassical economists assumed that a capitalist economy, characterized by free and
competitive markets, was an area of real life society that is dominated by the economic force. If
actors, for instance firms, would allow other forces to play a role as well, these actors would not
survive in the competitive struggle. Therefore, economic analysis was extensively used to
explain the functioning of the private sector of our economy.

1.2 Rational for the Review

Institutional economics denotes a variety of traditions in economics that are concerned with the
social institutions linked to the production, distribution and consumption of goods (Hodgson

2
2001) as well as the corresponding social relations. As such it has a very broad scope of inquiry
and has close ties with other disciplines, like economic sociology and economic history, but also
with psychology, political science, anthropology, business and management studies, and biology,
physical science, and nowadays also cognitive, neuro and brain sciences. Since institutional
economics is a very diverse church, a crisp classification of “the” perspective of institutional
economics is impossible. Most institutional economists understand the economy as a system of
(formal and informal) social organization related to the production, distribution and consumption
of goods, or, in a traditional institutionalist wording: for the provision of the means of socio-
economic life and its reproduction. Rather than presupposing certain universal features rooted in
human nature, the crucial insight is that the concrete characteristics of societies and forms of
economic organization considerably vary across space and time. Pursuing this view of the
economy, institutional economists attempt to understand the concrete socio-historical factors that
shape the functioning of the economy.

One key feature for understanding the social and historical nature of economic organization is to
identify social institutions. In their broadest sense institutions can be defined as “the regular,
patterned behaviour of people in a society and the ideas and values associated with these
regularities” (Neale 1994, 402).

The loose definition of institutions allows for the analysis of factors as varied as behavioral
consumption and production patterns on the one hand and belief systems, on the other. The latter
include, for example, religious beliefs or other “enabling myths,” under which Veblen
understands a set of beliefs such as racism, sexism or social Darwinism that enable certain
(normatively bad) forms of economic organization to persist. Furthermore, patterns of state
regulation or technology application as well as the complex arrangement of such factors in the
socio-economy are investigated. Given this openness, all sorts of economic phenomena can serve
as objects of investigation, which enables institutional economists to pose a wide range of
different questions. The knowledge of the changing nature of institutions implies also that many
scholars develop a critical attitude towards the necessary existence of the status quo, since this
might easily change. Institutional scholars attempt to understand how certain economic
phenomena emerge and develop over time or the relative stability of certain behavioral
regularities (e.g. in consumption, leisure or mobility) or state arrangements. Comparative

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scholars set out to understand differences or similarities between entities and their institutional
arrangements (Elsner 1987), for example, the GDP differential between (so-called) developed
and developing economies or organizational convergence between companies in different
locations, and the different multi-dimensionalities of economic development in general.

Institutional economists, thus, also reject the use of deductively derived assumptions and models
and instead often produce very detailed and contextualized accounts that attempt to do justice to
the specificity of the situation.

Different strands of institutionalist economics were amongst the leading economic traditions
from the late 19th century until the Second World War with Germany and the United States
being the strongholds of institutionalist theorizing. Afterwards institutionalist analysis was
relegated to the margins as more formalistic and abstract “universal” theories became dominant
in economics (Milonakis and Fine 2009, Hodgson 2001, 57–59). In the 1970s and 1980s,
renewed interest in economic institutions was sparked by the contributions of the mainstream
(marginalist) New Institutionalist Economics (NIE) and its comparison with OIE (Elsner 1986).
Researchers in the NIE field have especially focused on themes such as transaction costs and
game theoretic interactions amongst individuals and organizations within a constant or
comparative-static (rather than evolutionary) institutional environment. However, more macro-
oriented institutional topics like the emergence and development of capitalism have also been the
subject of NIE (e.g. North 1990).NIE is primarily based on the neoclassical conception of
rational (short-run maximizing) economic behaviour (for a critical assessment of NIE, Samuels
1995 and Groenewegen et al. 2010).

1.3 Objectives of the Review

1.3.1 General objectives
To review the methodological theory of market production and institutional economics

1.3.2 Specific objectives

 To review the historical theory of market production and old institutional economics
 To review the theory of new institutional economics and market production
 To review the theory of institutional economics and production performance (growth)

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  To draw lesson from methodological theories of market production and institutional
economics.

CHAPTER TWO
2 LITRARTURE REVIEW
2.1 Definition of Institution
Institution is defined as a rule that governs human behavior and an institutional framework is a
more or less coherent set of rules that shape and restrict human behavior (Neale 1994).
In this definition two terms are relevant, namely rule and behaviour. Important categories of
rules in the institutional literature are habits, routines, customs and legal rules. Habits are more or
less conscious regularities in behaviour that must make life more convenient.
Routines are more urgent regularities. Families and production households can adopt routines in
order to make the raising of children or a particular production process more effective. Customs
are rules of behaviour that include a moral connotation. People expect from each other to behave
according to particular customs. Legal rules are set by a government in an attempt to regulate
human behaviour. An institutional framework is a set of interrelated rules or institutions that
aims at the framing of behaviour in a particular situation. It contains a certain degree of
coherence; if not then the framework is not effective in reaching its goals. Important examples of
institutional frameworks in the economy are the system of collective bargaining with respect to
labour conditions, the social security system and the monetary system.
Thus institutions also refer to rules that shape and restrict human thinking and human feeling.
Our ideas, frames and world-views and the values and norms that are derived from these views
are institutionalized in our minds. Of course there are close relationships between the institutions
that shape the human mind and the institutions that shape external human behaviour.

2.2 Economics and institution

2.2.1 Compering of OIE and neoclassical economist
If we compare neoclassical economics with original institutional economics we observe a
number of important differences in methodology. From an ontological point of view neoclassical
5
economics is about an isolated economic world, where important factors are ignored just for the
sake of modelling the typical economic force. Original institutional economics, however, is
about real life economy and society, and tries to abstract only from factors that are less essential
for a good understanding of the evolution of economies and societies from one stage to the next.
From an epistemological point of view neoclassical economics must be characterised as
deductive. On the basis of introspection (observation of one’s own thoughts and emotions) a few
axioms are formulated. These axioms form the basis of an analysis from which important laws
are deducted. If it is assumed that the economic force is relatively strong in particular practical
situations, empirical testing of the deducted statements makes sense. Original institutional
economics, however, is of an inductive nature. On the basis of empirical data trends are
observed. By means of a general picture of the evolution of economy and society and the
different stages that are distinguished future developments are predicted.
Because of the diversity of human life prediction is a precarious business, especially with respect
to long-term developments. But on the basis of reliable statistical information it is possible to
select factors that are crucial to future developments and governmental policies might improve
conditions so as to stimulate progressive forces.
From a methodological point of view neoclassical economics has a clear micro orientation. The
character of an individual actor is assumed to be the stable element – like atoms in physics. His
behaviour changes under the influence of changes in circumstances only. Groups of actors or
societies at large must be interpreted as aggregates of individuals. So social science must start to
explain individual behaviour. The individual actor is assumed to have stable preferences and a
given set of scarce resources. By deliberately weighing costs and benefits of all possible options
he finally decides which action is maximising his utilities. Every action results from this decision
making process.
The economy as a whole result from the aggregation of all the individual decisions.In
preferences under the influence of their learning processes. But they stick to the fact that
individuals take decisions, not groups or societies. Original Institutional Economics, however,
has a clear macro orientation. Societies are part of the process of evolution of the universe and of
the emerging global society. Not any society can escape from this process and must accept its
particular stage of development, including the institutional structure that belongs to it. Now the
economic and societal performance is determined by the existing institutional frameworks. The

6
prevailing institutions even shape the human motivations that form the basis of the micro
approach. this world behavioural change results from changes in the amount of scarce resources
and from changes in the technique of production and consumption. When neoclassical
economists make their analyses more sophisticated they recognise that actors can use each other
as important sources of information and that some people or statistics about group behaviour
may have a strong effect on the behaviour of an individual actor. So people learn from each other
and from their own experiences. They change their preferences under the influence of their
learning processes. But they stick to the fact that individuals take decisions, not groups or
societies. Original Institutional Economics, however, has a clear macro orientation. Societies are
part of the process of evolution of the universe and of the emerging global society. Not any
society can escape from this process and must accept its particular stage of development,
including the institutional structure that belongs to it. Now the economic and societal
performance is determined by the existing institutional frameworks. The prevailing institutions
even shape the human motivations that form the basis of the micro approach.

2.2.2 Emerging of NIE

During the Thirties and Forties the role of the government had grown significantly. This must
have stimulated the institutional awareness of neoclassical economists. When neoclassical
analysis is applied to real life economies it must be recognised that a particular institutional
structure is implicitly assumed. Institution-free economies do not exist. A government is
assumed to be responsible for the protection of private and public property rights. Moreover,
even a perfect market economy cannot produce public goods efficiently. Related to the public
goods problem there is the problem of externalities. The intervention by a third party – i.e. the
government - is a necessary condition for a Pareto efficient solution.
These developments triggered neoclassical economists to become increasingly interested in an
analysis of the government sector (Public Choice), of organizations (Organization Economics)
and institutions in general (New Institutional Economics: NIE). On the basis of axioms that
constitute the economic world – utility maximization under the constraint of scarce resources,
rationality and social independence – they tried to argue why institutions can be efficient means
to achieve a maximum of efficiency. So in this approach institutions are meant to be
economic-efficiency-enhancing rules. They save information costs and coordinate decisions in

7
prisoners’ dilemma and assurance game like situations. Some institutions contribute to the
efficiency of the economy as a whole, while others make the economy more rigid and stagnating.
In a competitive economy inefficient rules will not survive. Especially democratic societies
appear to be vulnerable for pressure on the government from private interest groups, which
might deteriorate the general efficiency of society as a whole. Via voting-with-feet people may
escape from these sorts of inefficiencies.
Methodologically the NIE is similar to neoclassical economics. So, ontologically reality is
framed according to the axioms that constitute the economic world, epistemologically it is
deductive, and methodologically it is micro-orientated: institutions result from economizing
behaviour of individuals. The following examples illustrate the typical NIE explanation of
institutions.
• Many consumers have developed habits by buying always the same brand of butter because this
saves information and decision making costs. Once a particular brand satisfies well, they think
that marginal costs of searching for better alternatives are higher than its marginal benefits. So
when buying butter, they always stick to the same brand.
Physicians have developed routines to diagnose a particular disease so as to save costs. When
they send a patient to a particular medical specialist, he follows a protocol when combating the
disease. Groups of experts have developed such protocols in the course of time and an individual
specialist can save time by simply applying these protocols.
• In football stadiums a custom has been developed that says that it is not polite to stand up in
order to better watch the game. Experience shows that, without this custom, there is a prisoner’s
dilemma. This dilemma results in a crowd that stands upright all the time. So it is efficient for all
rational and socially independent spectators to accept the custom to sit down.
• Many economic actors prefer to have a legal rule that forbids robbery and homicide. They have
an interest in the promotion of ideas such as ‘respect for the other’ and ‘respect for the property
of other actors’. Only those who think to have a talent for violent activities would vote against
the adoption of such rules.
Practice shows that these people are a small minority. Legal rules that forbid these activities
diminish feelings of anxiety and create room for many people to take different sorts of initiatives.
For them these rules enhance efficiency significantly.

8
Now the number of economists that participate in the NIE-research programme is growing.
History repeats itself. Over a period of about a hundred years a much higher number of
economists worked in the neoclassical research programme compared with the OIE-programme.
Nowadays the same is true for the NIE-program.

2.2.3 The economic institutions and transaction costs. Theorem G. Cowes

The representatives of institutionalism to the fore two major issues: economic power and control
over the economy. their solution is carried out by applying the concept of institutions. In market
institutions create the incentive structure of society (social, political or economic). They are both
formal laws (constitutions, laws, property rights) and informal rules (traditions, customs, codes
of conduct).

In a civilized society, institutions shape the people to ensure order and eliminate uncertainty in
the exchange. Such institutions, together with standard restrictions adopted in the economy
determine a set of alternatives and, therefore, costs of production and circulation and,
accordingly, the profitability and the probability of involvement in economic activities. John.
Knight believes that institutions — set of rules that structure social relationships in a special way,
the knowledge of which must have all members of a particular society.

In market economies, formal institutions are often created to serve the interests of those who
control it institutional changes. There is a conflict of interest. The pursuit of self-interest alone
causes negative effects in others. This should be a warning in the formation of a modern
institutional environment of economic behaviour in Ukraine.

Institutions can be seen as social capital that is undergoing changes due to impairment and new
investment. The formal change of the law can occur quickly, but coercion and informal rules
change slowly. For example, Ukraine fits the economic institutions of capitalism, which
correspond to its market model. Informal rules, norms, customs does not create power, they often
develop spontaneously.

9
In the period of transformational change institutions slowly adapt to environmental changes.
Therefore, institutions that were previously effective become ineffective and remain so for a long
time.

It is necessary to distinguish institutions from organizations. Institutions are a set of rules and
laws that determine the action and interaction of individuals.Organization corporate stakeholders
who may be subject to institutional constraints. Organizations have internal structure,
institutional frameworks, which define the interaction of the individuals composing it. Some
collective enterprises can act as institutions, and organizations. For example: firm, government
bureaucracy, Bank, Church, or school.

Like institutions, there are formal and informal organizations. There are economic, political and
social organizations with boundaries and structures, defined by a network of contracts. These
organizations produce products, starting with goods, political laws and ending with the
satisfaction of spiritual needs. The choice of individuals to act independently or to join
organizations linked with costs: the active person trying to organizations that minimize costs to
include transaction.

In the short term, the active person can't influence the institutions and take them in the usual
way. In the long run the organizations link with the institutions is performed as follows: 1) by
participants of various organizations to achieve their goals within the existing set of institutions;
2) through institutional changes in the current and future shape of institutions is determined in
the present which investments for your organization is more profitable to implement, and affect
the future. Institutions and institutional changes affect the long term direction of all forms of
investment in knowledge.

The concept of transaction costs gives a deeper understanding of the relationship between
institutions and production efficiency. As already noted, these costs are not related to production
as such, but derived his costs.

The model of personalized exchange serves multiple transactions of the same nature with one
another, where the participants are known attributes, characteristics and qualities of each other.
Measured transaction costs in a society with a dense network of social interactions is very low.

10
Sell, violation of these obligations, unscrupulousness be very weak or completely absent, as it is
unprofitable. Standards of conduct in such a situation dramatically captured in written laws.
Formal contracts are not signed there is no contract law. However, at low transaction costs in
such circumstances, production costs are high because specialization and division of labor is
limited by the scope of the market defined by personalized exchange.

The world specialized relationships is the opposite of personalized exchange. In the well-being
of the individual participants depends on a complex structure characterized by individual
specialization and therefore exchange when, having temporal and spatial length. In the model
non-personalized exchange it is assumed that the properties of goods and services, or the
behavior of agents have important differences, the exchange is of a temporary duration, and the
repeated recurrence of transactions is missing. In this form of trade transaction costs can be high
because there is a problem with the site characterization of the exchange, and enforcing the terms
of exchange. As a result, it is possible for deception, violations of agreements, lack of integrity
and other negative phenomena, since it requires considerable gain.

To reduce such negative action may have a complicated institutional structures that would
impede participants and thus minimise the loss from the above actions. In modern civilized
societies, has formed a system of contract law, mutual obligations, guarantees, trademarks,
complex systems monitoring, and effective mechanisms for the introduction of laws in a life. For
such services transactions requires enormous resources (although per the deal, these costs are
small), but the productivity associated with the gains from trade greatly increased. Therefore, the
Western market economy had the opportunity of rapid development.

In the process of deepening of specialization and division of labor there are new institutional
structures that allow economic agents to make decisions regarding their behavior, which is based
on relationships with other people is complicated both from the point of view of individual
knowledge and from the perspective of temporal contrast. The development of a complex
network of social relationships would be impossible if new institutional structures did not reduce
the uncertainty that is the consequence of this situation. Under such circumstances, becomes
essential institutional reliability, because its essence lies in the fact that despite the constant

11
expansion of the network of interdependence caused by the growth of specialization, e belief in
the results that inevitably becomes more distant from the boundaries of individual knowledge.

Implementation of institutional requirements to implement the factor productivity increase

associated with the model of impersonal exchange, presupposes the existence of efficient
markets for products and factors of production and a reliable medium of exchange. Enforcement
of property rights allows the people who are in extremely difficult situation of interdependence,
to feel confident in the process of making deals with those with whom they personally do not
know and do not support a relationship of mutual exchange on long-term basis. Mean: 1) the
emergence of the third party exchange, namely the state, which specifies the rights and enforce
contracts; 2) the emergence of certain norms that ethically restrict the conduct of the parties that
interact. Therefore, the exchange is possible in a situation where high costs of measurement,
even with the protection of legality, which takes a third party to create the appropriate conditions
for exchange.

The process of formation of impersonal rules and contracts is a sign of the formation of the state
and with it unequal distribution of forces of coercion. There is an opportunity for those who has
greater powers of coercion, to interpret the laws in their own interests, without regard to their
impact on performance. In practice, this suggests that are accepted and executed only those laws
that serve the interests of vladyyy, and not those that reduce aggregate transaction costs.

For any political systems is characterized by the tendency to produce inefficient property rights
which result in stagnation or decline. This situation is due to at least two reasons: 1) incomes
received by officials can be more inefficient if the structure of property rights, which is
controlled by less and creates more opportunities for taxation, compared with an effective
structure that requires a lot of costs control and tax collection; 2) the officials, as a rule, unable to
establish effective property rights, however, this may offend some citizens and thereby to
endanger the rights of others. In this case, the interests of efficiency are sacrificed in the interests
of self-preservation, which offers a different method of action, because efficient rules can
undermine the interests of powerful political groups.

12
In the economy, high transaction costs often associated with weak institutions (weak public
enforcement in enforcing the laws). However, they can also be associated with strong institutions
that leave agents with few rights. The result of the institutional framework of society determines
the cost of controlling assets, which affect the efficiency of resource use and the desire of
individuals to buy assets and invest in them.

Note that transaction costs are influenced by some other factors, such as technology assessment
and monitoring, the physical characteristics of the assets and the nature of the exchange. With all
other conditions being equal, transaction costs are relatively high if participate in the exchange of
assets with complex characteristics (commercial Bank, factory, etc.);the exchange involves a
time factor (as in the case when the owner of a coal mine enters into a long agreement with the
railway for the transportation of coal to the place of sale);exchange takes place between
individuals who do not have any business relations, and are not repeated here (e.g., street vendor
and tourist);

assets depreciate in a way that it is difficult to determine, but the actual exchange does not have a
permanent nature (for example, if individual pieces of equipment are leased to and expensive to
ascertain whether a failure of equipment a consequence of the initial mechanical error, natural
and physical wear, or defective equipment); assets are of a special nature and depend on specific
usage (the case of the pipeline, which nato china the company pays rent to transport their
products, or plant which has been producing spare parts for resumenes manufacturer).

G. Coase in "the Problem of social cost" (1960) showed that the neoclassical model that is the
Foundation of most Orthodox economic theories of the mainstream, is only true under extremely
strict preconditions of zero transaction costs. For zero transaction costs is necessary to consider
the impact of institutions. As noted by D. North, in the neoclassical model of institutions is not,
therefore, economic growth is no problem: his pace is only the birth rate and rate of deposits.

However, in the real economy, the institutions and organizations function. To understand this, is
to figure out why they were chosen for a role in limiting transaction costs. In theory, the
transaction costs of trying to explain why some transaction costs be on the market, while others
have a place within hierarchy and organizations.

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2.2.4 The economic production performance and institution

Khan (2010) contends that institutional performance differs across time and space because of
differences in political and economic structures. He explains that developed countries have a
larger ratio of private sector production to GDP as compared to underdeveloped countries. This
structural difference affects the costs and effectiveness of institutional enforcement. In developed
countries with advanced production structures (composed of economic activities with increasing
returns), allocative institutions are readily enforced since the proceeds from these economic
activities are sufficiently high to cover the costs of enforcement. But in poor countries with little
production capabilities and a plethora of commodities with diminishing returns, the gains from
private contracting are hardly sufficient to cover the costs of enforcing property rights. This
fundamental insight illustrates the dominance of economic structures over institutions.

At a general level, as the production of economic activities with increasing returns grow relative
to diminishing returns the gains from private contracting exceed the costs of enforcing allocative
institutions. Thus, in countries with advanced or increasing returns production structures,
institutions of exchange perform as expected. But in the absence of these conditions, institutions
of exchange are inadequately enforced. Consider the implications for poor countries. In
diminishing returns production structures, the gains from private contracting are not sustainable.
A great share of economic transactions is undertaken through extra-market institutions for one
principal reason—the monetary gains from diminishing returns activities are not sufficient to
cover the costs of enforcing formal institutions or private contracts. Extra-market institutions
range from black-markets, gifts to political patronage and these can explain the prominence of
corruption and poor enforcement of the rule of law observed in many less developed countries.
Unlike rich countries, there is no collective or political interest in protecting and developing the
private sector in poor countries. This lack of political interest explains the frequency of populist
policies and continuous rule violating behaviour. The relatively small private sector necessitates
a narrow tax base and a low employment premium. Inevitably, the state becomes the largest
source of employment and, by extension, represents a formidable political force. In this context,
“good” institutions are unlikely to be effective and the evidence indeed supports this. Countries
across Africa, Asia and LAC with diminishing returns production structures are well known for
being highly corrupt with weak institutions and enforcement of the rule of law (Khan 2000,

14
2006, 2009). North et al. (2007) argue on the contrary and explain that the form of political
organization rather than economic structure determines how institutions perform. In their view,
importing “inclusive” institutions on limited access orders (societies where political and
economic access to key resources are limited to an elite group) do not transform society since the
way elite factions are organized is at odds with these institutions.

In our view, the different forms of political organizations (limited access orders or open access
orders) are the outcomes of different economic structures. In rich countries with increasing
returns production structures, politics is structured around private sector interests and “good”
institutions are easily enforced. “Good” institutions are consistent with private sector interest
since “good will” and reputation affect the profit line of the firm. Private enterprises are unlikely
to maintain market share and influence if they are tainted with corruption scandals. In contrast,
politics is structured around non-private sector interests in poor countries (Khan 2010), where
“good will” and reputation are of less significance to the firm. This explains why consumer
protection codes, fire and other safety regulations, etc., are superficially applied in countries with
diminishing returns economic structures.

This is hardly an argument to defend poor governance or corrupt business practice, but from a
policy standpoint, it is imperative that we fully understand the structural reasons why institutions
perform differently across geographies. Given this insight, the claim that institutions determine
the rate of economic growth becomes trivial. Institutions can perform differently due to different
economic structures. Any variation in economic growth can only be explained by the factor that
causes variation in institutional performance—this factor is economic structure.

15
 CHAPTER THREE
3 METHODOLOGIES

Methodologically speaking, institutionalists do mostly reject the deductive-nomological

perspective. Institutionalist economists attempt to understand the complexities associated with
concrete time-space-bound phenomena.

If one were to use the deductive–inductive dichotomy – not as an adequate description of how
science is done but as a heuristic allowing for comparability– the institutionalist approach due to
its relative emphasis on empirical work can be considered to be closer to the inductive camp.
Nonetheless there are also many instances of institutionalist scholarship, which could be more
aptly placed in a middle category between deduction and induction. An example would be the
abductive approach suggested by pragmatist philosopher Charles S. Peirce and the German
historicist Arthur Spiethoff regarding the elaboration of new types from empirical data (Thieme
2015, 147 in Heise ed. 2015). Still, it can be stated that institutionalists reject grand deductive
theorizing and long chains of reasoning. Instead, they aim, as said, for mid-range theory, where
qualitative boundaries are specified with regard to which actions are deemed possible inside an
institution or a structure (Dugger 1979, 905).

What this means in practice is that Institutionalists start their analysis by identifying one or a
small group of institutions which they consider particularly relevant for the event they want to
explain, and from there they build their explanatory edifice. This method is by some called
“concessive holism” (see O´Hara, 2000). Contrary to conventional institutionalism, which
always puts the rational-egoistic individual, maximizing behavior and the protection of property
rights at the center of the explanation.

Regarding the choice of concrete methods, scholars often rely on case studies and questionnaires
(Dugger 1979, 906–907). These methods can be said to be privileged in certain forms of
empirical research, where the aim is to analyze a specific phenomenon with a high degree of
detail. Yet far from confining methods to a rigid set associated with the perspective, the object of
research determines the methods and strategies that scholars draw upon and can include both
qualitative and quantitative research methods. Qualitative interviews, field observation,

16
participative research and archival research, exist alongside econometrics, game-theoretic
modeling, and quasi-experimental methods (see also Hodgson 2015, 2). Furthermore, whereas
scholars work with a variety of different methods, they also draw heavily upon secondary
literature, which is integrated with findings from primary research. This does not mean that
anything goes. Methods such as laboratory experiments and highly abstract formal-deductive
modelling are generally uncommon. Nevertheless, institutionalist scholars working close to
complexity science have incorporated mathematical and game-theoretic models, social network
analysis, agent-based modeling and computational simulations (cf. Elsner et al 2015).

Another important method of institutionalist theorizing is the identification of types by virtue of

which institutional arrangements (a state or a firm), periods (e.g. Classical Antiquity or
Feudalism) or geographically specific forms of organization (e.g. German or Japanese
Capitalism) can be categorized in a way that conveys meaning and information (Hodgson 2015,
2). Examples of such types are the stages of developments of states (e.g. industrialized economy,
emerging economy, newly industrialized economy, least developed country) and the position of
an economy on the state–market continuum from planned and regulated economy to “neoliberal”
de-regulated (free) market economy.

It is important to notice in this context that categories will always be impure and fuzzy. For
instance, characteristics of forms of feudal slave labour are still present in modern capitalism and
some kind of “black markets” have coexisted in the planned and regulated economies of the
state-socialist countries (Hodgson 2001, 333–334). Furthermore, while the categories or types
are attempts at distillations of some essential properties of the analyzed phenomena, they do so at
the epistemological level, which faces the problem of being fallible. Also, changes on the
ontological level might make old typologies obsolete (cf. Sayer 1994, 162–165). On the other
hand, the ongoing development of theories of these different types makes it possible to engage in
theory building regarding possible transitions from one dominant type to another in a historically
and spatially confined setting.

17
 CHAPTER FOUR
4 DISCUSSIONS
4.1 Theory of production
A firm’s objective is profit maximization. If, in the short run, its total output remains fixed (due
to capacity constraints) and if it is a price-taker (i.e., cannot fix the price or change price on its
own as in a purely competitive market) its total revenue will also remain fixed. Therefore, the
only way to maximize profit is to minimize cost. Thus profit maximization and cost
minimization are the two sides of the same coin.

Moreover, supply depends on cost of production. The decision to supply an extra unit depends
on the marginal cost of producing that unit. Perhaps the most important determinant of the firm’s
price- output decision in any market is its cost of production.

The firm’s cost, in its turn, depends on two main factors:

(1) the technical relation between inputs and output (i.e., how outputs vary as inputs vary), and

(2) factors price’s (i.e., the price of labour or the wage, the price of capital or the interest rate,
etc.). In this article we will discuss a new concept, called production function. In this context we
will clear a distinction between the short-run and the long- run as also between the return to a
factor and the return to scale.

The business firm is a technical unit in which inputs are converted into output for sale to
consumers, other business firms and various government departments. In the theory of
production we are concerned with the nature of the conversion process, i.e., how inputs are
converted into output. The key concept in the theory of production is the production function.

4.1.2 The Production Function

The production function shows the relation between input changes and output changes. It also
shows the maximum amount of output that can be obtained by the firm from a fixed quantity of
resources.

18
The production function is expressed as:

Q = f (K, L, etc.)

Where Q is output (which is the dependent variable) and K and L are capital and labour inputs,
respectively. We can think of other inputs as well, such as land. For the sake of convenience we
assume here that the firm employs only two factors of production— labour and capital. The
firm’s output is treated as a flow, i.e., so many units per period of time. The volume of output of
the firm’s product, per period of time, depends on the quantities of these factors that are used by
the firm.

Let us now suppose that the firm wishes to increase its volume (rate) of output. This can be
achieved by increasing the inputs of one or both factors of production. However, it is very easy
to vary the quantity of labour in the production process. It can be done very quickly (in a week or
a month). On the other hand, a fairly long period of time is required to vary the quantity of other
factors, for example, change the quantity (or usage) of capital, e.g. to install a new machine.

The speed with which different kinds of factors can be varied largely depends on the time period
under consideration. Here we assume that the firm is making decisions within two time periods
— the short-run and the long-run.

4.1.3 The Short-Run and the Long-Run

The distinction between the short-run and the long-run is based on the difference between fixed
and variable factors. A factor of production is treated as a fixed factor if it cannot easily be
varied over the time period under consideration. On the other hand, a variable factor is one which
can be varied over the time period under consideration.

4.1.3.1 The Short-Run:

The short-run refers to the period of time over which one (or more) factor(s) of production is
(are) fixed.

19
In the real world, land and capital (such as plant and equipment) are usually treated as fixed
factors. Here we are considering a simple production process with only two factors. We treat
capital as the fixed factor and labour as the variable factor.

Thus, output becomes a function of (i.e., output depends on the usage of) the variable factor
labour working on a fixed quantity of capital. In other words, if the firm wishes to vary its
production in the short-run, it can do so only by changing the quantity of labour. With a fixed
quantity of capital, this necessitates changing the proportions in which labour and capital are
combined in the production process.

4.1.3.2 The Long-Run

On the other hand the long- run is defined as the period over which all factors of production can
be varied, within the confines of existing technology. In the long-run all factors are variable.
Moreover the long-run also permits factor substitution. More capital and less labour or more
labour and less capital can be used to produce a fixed amount of output.

“The long-run is the period that is relevant when a firm is either planning to go into business or
to expand, or contract, its entire scale of operation. The firm can then choose those quantities of
all factors of production that seem most suitable. In particular, it can opt for a new factory of any
technologically feasible size. However, once the planning decision has been carried out— the
plant built, machines purchased and installed, and so on—the firm acquires fixed factors and it is
operating in the short run.”

4.1.3.3 The Boundary between the Two

The boundary between the short-run and the long- run is not defined by reference to any calendar
a year, or a month or a quarter. It varies from industry to industry and from time to time within
the same industry. In most plantation industries the long-run is 15-20 years. For example, rubber
trees require a very long time to grow. On the other hand, in a barber’s shop it may be just a
week.

A barber may require only a few days to make all types of changes in his small shop. In fact, the
boundary between the two runs is defined only in terms of the fixity of one factor of production.

20
The length of the short-run is influenced by two sets of considerations technological (such as
how quickly equipment can be manufactured or installed) and economic (such as the price the
firm is willing to pay for equipment).

We may now turn to a consideration of how output varies in response to input changes in the
short run as also in the long run. It may be noted, at the outset, that short-run output changes
reflect changes in the proportions in which factors are combined.

On the other hand, long-run changes in output reflect changes in the entire scale of operation. In
other words, in short-run we study the returns to a variable factor (such as labour) and in the
long-run we study the return to scale.

4.2 Theories of Institutional Economics and market production

In recent years two strands of non-Walrasian economic literature have developed well articulated
endogenous theories of institutions, and they are both getting to be prominent in the new
microeconomics of development. One is the transaction cost school, flowing out of the famous
paper by Coase (196(l), followed by the writings of Alchian, Demsetz, Williamson, North and
others; the other school is associated with the theory of imperfect information as in the work of
Akerlof, Stiglitz, Spence and others. Although there is some family resemblance between the
two strands, there are important differences in their points of emphasis. But they both deny the
validity of some of the principal results of mainstream economics. For example, one of the main
pillars of Walrasian neoclassical economics - the separability of equity and efficiency - breaks
down when transaction costs and imperfect information are important; the terms and conditions
of contracts in various transactions, which directly affect the efficiency of resource allocation,
now crucially depend on ownership structures and property relations. Development economics,
which deals with cases where market failure and incomplete markets (often the result of the
substantive presence of transaction costs and information problems) are predominant, clearly
provides hospitable territory for such institutional analysis.
According to the transaction costs school, institutions that evolve to lower these costs are the key
to the performance of economies. These costs include those of information, negotiation,
monitoring, coordination and enforcement of contracts. When transaction costs are absent, the
initial assignment of property rights does not matter from the point of view of efficiency, because

21
rights can be voluntarily adjusted and exchanged to promote increased production. But when
transaction costs are substantial, as is usually the case, the allocation of property rights is critical.
In the historical growth process there is a tradeoff between economies of scale and specialization
on the one hand and transaction costs on the other. In a small, closed, face-to-face peasant
community, for example, transaction costs are low, but the production costs are high, because
specialization and division of labor are severely limited by the extent of market defined by the
personalized exchange process of the small community. In a large-scale complex economy, as
the network of interdependence widens the impersonal exchange process gives considerable
scope for all kinds of opportunistic behavior (cheating, shirking, moral hazard) and the costs of
transacting can be high. In Western societies over time, complex institutional structures have
been devised (elaborately defined and effectively enforced property rights, formal contracts and
guarantees, corporate hierarchy, vertical integration, limited liability, bankruptcy laws and so on)
to constrain the participants, to reduce the uncertainty of social interaction, in general to prevent
the transactions from being too costly and thus to allow the productivity gains of larger scale and
improved technology to be realized.
North and Thomas (1973) have explained economic growth of Western Europe between the 10 th
and the 18th centuries primarily in terms of innovations in the institutional rules that governed
property rights. In this view, as in Marxist history, property relations which were socially useful
at one time become “fetters” on the further development of the forces of production, and an
appropriate redefinition of property rights becomes necessary. New property rights emerge that
allow an increase in gains from trade by economizing on transaction costs (including gains from
new production or exchange which were unprofitable under earlier high transaction costs and the
consequent “market failure”). North and many other neoclassical institutional economists believe
that the basic source of institutional change is fundamental and persistent changes in relative
prices, which lead one or both parties in a transaction to perceive that they could be better off
under alternative contractual and institutional arrangements. Historically, population change is
judged to have been the single most important source of relative price changes, though
technological change (including that in military technology) and changes in the costs of
information are also deemed as major sources.
The imperfect-information theory of institutions is closely related to that of transaction costs,
since information costs constitute an important part of transaction costs. But the former theory is

22
usually cast in a more rigorous framework clearly spelling out assumptions and equilibrium
solution concepts, drawing out more fully the implications of strategic behavior under
asymmetric information and sharply differentiating the impact of different types of information
problems. Imperfect-information theory yields somewhat more concrete and specific predictions
about the design of contracts, with more attention to the details of terms and conditions of
varying contractual arrangements under varying circumstances, than the usual presentations of
transaction cost theory. Exceptions in the latter are provided by Williamson’s theory of
transaction specific assets and his theory of incomplete contracts as further developed by Hart
and Holmstrom (1987).
The latter focus on adaptive sequential decision making rather than the comprehensive
contingent claims contracts of the imperfect-information literature. The imperfect information
theorists give more emphasis to ex ante mechanism design in contracts and less to maladaptation
costs incurred when transactions drift out of alignment ex post in a world of bounded rationality
where contracts are necessarily incomplete (i.e., cannot possibly take into account all
contingencies). In particular, once relation-specific investments (i.e., where the investments the
parties make have a much greater use inside the relationship than outside) are made, there is
scope for post-contractual opportunistic behavior. Institutional devices to reduce this consist
usually of long-term contractual relations or integration of firms (converting an arms-length
transaction into an internal one and defining property rights as the default option in incomplete
contracts). Long-term implicit contracts and personalized, less-than-armslength transactions are,
of course, quite common in developing countries, although Williamson’s immediate concern is
with the corporate structure and practices in industrially advanced countries.
The imperfect-information theory has been fruitfully used in modeling many key agrarian
institutions which are seen to emerge as substitutes for missing credit, insurance and futures
markets in an environment of pervasive risks, information asymmetry and moral hazard.’ It
started with the literature ‘on sharecropping, then on interlocking of transactions in labor, credit
and land lease, on labor tying, on credit rationing and so on. Radical economists have often cited
some of these production relations as institutional obstacles to development in a poor agrarian
economy, overlooking the microeconomic rationale of the formation of these institutions. Under
a set of informational constraints and missing markets, a given agrarian institution (say,
sharecropping or interlocking of contracts) may be serving a real economic function. Its simple

23
abolition, as is often demanded on a radical platform, without taking care of the factors that gave
rise to the institution in the first place, may not necessarily improve the conditions of the
intended beneficiaries of the abolition program. There may be some important political lessons
here from what can be called the economics of second-best reformism.

24
 CHAPTER FIVE
5 Conclusions
The mainstream version and the heterodox strand of Institutionalism indeed share some
analytical conclusions. One clear cut example is the work by  Acemoglu and Robinson (2008)
and by Acemoglu (2010) argues that “economic institutions that only protect the rights of a rich
elite or the privileged will not achieve such equality of opportunity and will often create other
distortions, potentially retarding economic growth.” (Acemoglu 2010). Further, according to the
author the economic or political elite will only invest in public goods such as education if they
expect to reap the benefits in the future. In that context, because there are conflicting preferences
over institutions and policies, the distribution of political power in society plays an important
role in determining which institutions and policies are chosen, also explaining why some non-
growth enhancing institutions cannot be reformed (Acemoglu, 2010, p. 822). This is a line of
reasoning that easily could be supported by the more heterodox strand of Institutionalism
discussed here. There is, however, a difference in suggested policy recommendations. Whereas
Acemoglu and his colleagues go on to suggest that, in general, liberalizing reforms inspired by
the mainstream of the profession should be given preference, institutionalists of the heterodox
tradition would defend a more case to case approach.

Institutions are also chosen by society (Acemoglu et al. 2005). Through the forces of
globalization, institutional diversity is on a downward trend consider the rise of democracies
across the world, the adoption of independent central banks and anti-corruption bureaus, etc.
Nonetheless, the argument we presented here explains why expected and actual institutional
performance can diverge. It is therefore important to differentiate between effective institutions
and institutions as commonly understood. Institutions become effective only when they are
adequately enforced. Consider the following quote from North (1994): “economies that adopt the
formal rules of another economy will have very different performance characteristics than the
first economy because of different informal norms and enforcement. The implication is that
transferring the formal political and economic rules of successful Western economies to third-
world and Eastern European economies is not a sufficient condition for good economic

25
performance.” In short, societies cannot simply download the “best” institutions and expect these
to work.

26
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