New Institutional Economics : A Few Extensions

Markets, Globalization & Development Review Volume 10 Number 1 Article 2 2025 New Institutional Economics : A Few Extensions Murali Patibandla Paari School of Business SRM University Amravati India Follow this and additional works at: https://digitalcommons.uri.edu/mgdr Part of the Development Studies Commons, Economic History Commons, Economic Theory Commons, Growth and Development Commons, International Business Commons, Political Economy Commons, and the Public Affairs, Public Policy and Public Administration Commons Recommended Citation Patibandla, Murali (2025) "New Institutional Economics : A Few Extensions," Markets, Globalization & Development Review: Vol. 10: No. 1, Article 2. DOI: 10.23860/MGDR-2025-10-01-02 Available at: https://digitalcommons.uri.edu/mgdr/vol10/iss1/2 This Article is brought to you by the University of Rhode Island. It has been accepted for inclusion in Markets, Globalization & Development Review by an authorized editor of DigitalCommons@URI. For more information, please contact . For permission to reuse copyrighted content, contact the author directly. New Institutional Economics : A Few Extensions Cover Page Footnote This article is dedicated to my mentor Oliver Williamson: a great scholar (Nobel Laureate) and a great human being. I am thankful to the editors and referees of the journal for useful comments. This article is available in Markets, Globalization & Development Review: https://digitalcommons.uri.edu/mgdr/vol10/ iss1/2 Patibandla: New Institutional Economics New Institutional Economics: A Few Extensions Introduction The New Institutional Economics (NIE) – pioneered by Ronald Coase, Oliver Williamson, and Douglas North – takes the approach that capitalism functions effectively only if it is supported by underlying institutions such as the rule of the law, property and contractual rights, social and economic norms, efficient organization of economic activity, and transaction and information costs of enforcement; and there is nothing called optimality of markets and institutions. A simple empirical verification of this argument is the textbook case of free market reforms implemented by the World Bank and IMF, which resulted in disastrous outcomes in Russia and the Eastern European countries in the 1990s (Patibandla 2013). In his Nobel lecture Ronald Coase (1992) commented: The value of including…institutional factors in the corpus of mainstream economics is made clear by recent events in Eastern Europe. These ex-communist countries are advised to move to a market economy, and their leaders wish to do so, but without the appropriate institutions no market economy of any significance is possible. If we knew more about our own economy, we would be in better position to advise them. (Patibandla 2006, p.2) The above observation emphasizes the importance of institutions for efficient and fair functioning of capitalist nations. What are these institutions, how do they come about and evolve and how do they function? These are the answers this paper attempts to address. The NIE had its origins in Coase’s paper ‘The Nature of the Firm’ in which he argued that market mechanism is subject to the friction of transaction costs of search, and of formulating and executing contracts (Coase 1937). Owing to transaction costs, a firm as an organization comes into existence to economize on transaction costs of markets. The firm internalizes economic activity until marginal internal bureaucratic costs of hierarchy are equal to the marginal transaction costs of the market (boundaries of the firm). Once the economic activity is internalized it is hierarchy that governs resource allocation, and not strictly price mechanism. Coase rejected the neoclassical idea that a firm is just a production function, a mere black box. The neoclassical economists ignored Coase’s idea and still ignore it – even though Coase was awarded the Nobel Prize – largely because it does not fit into their elegant models, especially of the general 1 Published by DigitalCommons@URI, 2025 1 Markets, Globalization & Development Review, Vol. 10 [2025], No. 1, Art. 2 equilibrium kind. Since the 1970s, Williamson (1999; 1985) and North (1990) – in a series of seminal papers and books – applied the transaction cost logic to develop the concept of institutions of capitalism. Subsequently both were awarded Nobel Prizes in economics. North used the transaction cost logic to understand the evolution of institutional environment historically, especially in the U.S. Williamson formalized different elements of transaction costs and applied them to governance mechanism. Although, Coase put forward the concept of transaction costs, he did not formalize their dimensions. It is Williamson who formalized different dimensions of transaction costs through incomplete contract framework in terms of uncertainty, frequency, and asset specificity. High degree of transaction costs motivates firms to internalize economic activities into the organization. Once economic activity is internalized it is hierarchy that govern resource allocation not strictly price mechanism. Williamson’s theory of incomplete contracts is extended by Oliver Hart (Hart & Moore, 1990) and Holmstrom (1979) in terms of contractual theory, modern property rights theory, and principal (saving public) and agent’s (financial intermediaries) organization of capital in modern capitalist nations. North’s focus was on historical evolution of institutional environment in terms of formal and informal institutions, especially with a focus on the U.S. history. He gave lot of credit to the British colonial rule of America in setting the basic institutions of Common Law and property rights system. These institutions evolved after the American revolution of 1776 and the establishment of a democratic constitution. North over-glorified the British colonial rule for the emergence of economic and political institutions of capitalism. In this tradition, some historians went to the extent of observing that the West dominated the rest because of protestant work ethic (Fergusson 2011). The historical example of Asia’s Japan – and later China, Taiwan, and South Korea – refute his emphasis on the British and the Western colonial rule in fostering institutions of capitalism. A powerful, evidence-based refutation of the protestant-ethic thesis, using the case of Japan, was provided by the UK-based Japanese economist Michio Morishima (1984). Japan is a geographically small country, a bunch of islands with limited natural resources. For major part of its history, Japan was characterized by feudal institutions. Japan was never a colony of the West. The Meiji Restoration took place in 1868 under Emperor Meiji who opened Japan to foreign trade and ideas and brought in social, political, and economic modernization of institutions, leading to rapid industrialization of Japan, and subsequently made Japan into an economic and military superpower (see Wes (...truncated)